Deflation, Demand-driven deflation, Federal Reserve, John Cochrane, Keynesians, Malinvestment, Mises Daily, negative interest rates, Public debt, rate of time preference, Science Times, Supply-driven deflation, Thorsten Polleit, Underconsumption, ZIRP
Deflation is not the evil so many journalists have been taught to believe. The historical evidence does not support the contention that deflation is always a consequence of “underconsumption”, that it leads to a self-reinforcing spiral, or that it is destructive in and of itself. A new academic paper on the costs of deflation is reviewed here by John Cochrane, who reproduces some of the interesting evidence from the paper showing that deflation is not correlated with output growth historically. Cochrane quotes the paper’s authors:
“‘The almost reflexive association of deflation with economic weakness is easily explained. It is rooted in the view that deflation signals an aggregate demand shortfall, which simultaneously pushes down prices, incomes and output. But deflation may also result from increased supply. Examples include improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labour or intermediate goods like oil. Supply-driven deflations depress prices while raising incomes and output.’”
The Science Times has a succinct review of the same paper:
“After analyzing figures going back to 1870 from 38 countries, Borio [one of the co-authors] concludes that declines in consumer prices are not actually the problem. He argues that the negative effects associated with deflation are in reality caused by huge declines in real estate prices and equity values. All this time, he posits, economists have been deceived by the fact that prices for goods and services have at times decreased at the same time that asset prices have gone down, especially during the Great Depression.”
An earlier op-ed on deflation by Cochrane was the subject of this Sacred Cow Chips post a few months ago, which noted an unfortunate tendency among traditional Keynesian economists related to the statist agenda they often support:
“Quick to blame insufficient private demand for economic ills, they propose to ratchet government to higher levels to make up for the supposed shortfall. That diagnosis is often debatable; the prescription may be a palliative at best and destructive at worst.”
Deflation is usually a symptom of other, more primary economic phenomena. Whether it can be taken as a sign of economic malaise depends on the underlying cause. Certainly, as noted above, deflation is quite welcome when it results from supply-driven growth of output, especially if wages are supported by advances in labor productivity.
On the other hand, deflation may be a demand-side symptom of weakness engendered by restrictive monetary policy, fragile confidence among consumers or employers, trade restrictions, excessive taxation, over-regulation, or adjustments to a binge of malinvested capital. It does not follow, however, that a resulting deflation is unhealthy. Quite the opposite: Downward price adjustments help to clear the economy of excesses and pave the way for renewal, as excess goods, capital and other resources are repriced to levels at which purchases become gainful. This may involve more severe declines in some relative prices due to specific excesses, such as real estate. Some recent examples of deflation and reversals of economic weakness are discussed in this post at The Mises Daily.
One consequence of expected deflation is that market interest rates are driven below “real” interest rates, or the rates at which economic agents are indifferent between present and future consumption (abstracting from risk and liquidity premia). The latter is sometimes called the rate of time preference, the natural interest rate, or the originary interest rate. Recently, some short-term market interest rates in Europe have been negative, prompting some to offer arguments that the natural rate may have turned negative. This post by Thorsten Polliet reveals these arguments as nonsense:
“If the originary interest rate was near-zero [let alone negative], it means that you prefer two apples available in, say, 1,000 years over one apple available today. A truly zero originary interest rate implies that the actor’s planning horizon or “period of provision” is infinitely long, which is another way of saying that he would never act at all but would continually push the attainment of his goals into the future.”
Polleit discusses the fact that market real interest rates may be negative, but that is a consequence of central bank manipulation of nominal market rates, including the Federal Reserve’s so called ZIRP, or zero interest-rate policy. Polleit has this to say about the destructive consequences of this kind of behavior, albeit in extreme form:
“Should a central bank really succeed in making all market interest rates negative in real terms, savings and investment would come to a shrieking halt: as time preference and the originary interest rate are always positive, “capitalistic saving” — the accumulation of goods designed for improving the production process — would come to an end.”
While Keynesians imagine that expansive government policy can rescue the economy from the ravages of weak private demand, they also know that accumulation of public debt is an unavoidable by-product. That reveals an underlying motive for policies such as ZIRP, as Polite explains:
“It is an actually perfidious policy for debasing the real value of outstanding debt; and it is a recipe for wreaking havoc on the economy.”
An otherwise innocuous supply-side deflation, or a deflation corrective of demand-side forces, may well be accompanied by intervention by an activist central bank. The ostensible purpose would be to stimulate the demand for goods, but a more direct consequence is a reduction in the government’s interest costs. If the policy succeeds in pushing real market interest rates to zero or below, the intervention may well undermine capital formation and economic growth.