Monday, 25 November 2013

Good Deflation better than Bad Inflation

Central banks seem to be keen on avoiding deflation at any costs but inflation for its own sake is likely to be worse  

Inflation is on the retreat in much of the world giving rise to concerns about deflation.  Economic theory along with the experiences of Japan makes deflation one of the most feared outcomes in economics.  The central bank in Japan is planning to double its money supply as part of its battle to end deflation while the European Central Bank cut interest rates after inflation figures in October were too low for comfort.  The fears about deflation have resulted in policies which suggest that inflation in any form is better than deflation.  But deflation is a symptom of bigger problems and the prescribed cure may do more harm than good.

Economics textbooks paint a grim picture when it comes to deflation – lower prices translate to less money to pay
off debts for both businesses and governments with consumers holding off on purchases if today’s prices are likely to be lower tomorrow.  Japan has been a case study of the damage done by deflation –the bursting of a gigantic financial bubble in 1989 resulted in around two decades of falling prices seen as sapping the life out of the Japanese economy while government debt has reached around 230% of GDP.  The years of deflation reinforced the notion of deflation feeding upon itself to reduce demand for goods and services and further drive down prices.

However, according to this rationale, deflation is the cause of the problem rather than simply a sign of a sluggish economy.  The reasons behind deflation are based on prices being too high as a result of unsustainable price increases in the past.  We can see an example of how this works in that stock prices in Japan are still less than half their peak value, highlighting the extent to which prices can be massively overinflated.  Prices for consumer goods are not subject to the same price pressures as in the stock market but the example illustrates the consequences of economic overheating.

There are parts of Europe with similar issues but nowhere is close to being on the same scale.  So, while Japan shows what can happen, its relevance to Europe is likely to be limited.  The deflation emerging in Europe, such as in Greece and Spain, is the result of weak demand coupled with falling wages which helps businesses by lower their costs.  The lower wages are needed for these countries to regain their competitiveness relative to the rest of Europe as other options, such as currency devaluation, are not available for countries in the Eurozone.


The response of central banks in Japan and Europe has been to use monetary policy to weaken their respective currencies but this targets the symptom and not the problem.  A weaker currency increases the price of imports and is tantamount to paying foreigners more to buy stuff just to create inflation for its own sake.  However, higher prices are more likely to result in consumers tightening their belts as their purchasing power diminishes.  The idea that low inflation requires more of the same approach misses the fact that these monetary policies bring their own costs with little benefit.  Deflation doesn't seem so bad in comparison.

7 comments:

  1. "The reasons behind deflation are based on prices being too high as a result of unsustainable price increases in the past."

    This is complete nonsense. Deflation is either the result of extraordinarilly high productivity growth (rarely) or excessively tight monetary policy (normally). Period.

    "So, while Japan shows what can happen, its relevance to Europe is likely to be limited. The deflation emerging in Europe, such as in Greece and Spain, is the result of weak demand coupled with falling wages which helps businesses by lower their costs. The lower wages are needed for these countries to regain their competitiveness relative to the rest of Europe as other options, such as currency devaluation, are not available for countries in the Eurozone."

    A much better solution would be to shift aggregate demand (AD) to the right which in the Euro Area's case is largely under the control of the ECB:

    http://schools-wikipedia.org/images/366/36652.png

    This would increase prices/wages and increase output/employment.

    This would also enable the readjustment process in prices/wages in the eurozone to occur more quickly and far less painfully. Why? Krugman explained it very well here:

    http://krugman.blogs.nytimes.com/2012/07/29/internal-devaluation-inflation-and-the-euro-wonkish/

    Essentially, being near full employment, Germany is near the vertical portion of the AS curve where an increase in AD would result mostly in an increase in equilibrium prices/wages. Spain, having over 26% unemployment, is near the horizontal portion of AS curve where an increase in AD would result mostly in an increase in equilibrium output/employment.

    In other words this is a two-for-one policy. It brings prices/wages into alignment while increasing output/employment in all the eurozone countries.

    The alternative is to shift all the individual AS curves of the peripheral eurozone members to the right by cutting wages, which, as we have seen, is a very long and very painful process.

    Why not go with a policy that requires little intervention and is of proven success (after all that's how the Euro Area got into this predicament in the first place) than with a policy that is cumbersome to implement and that for five years now has proven to be a dramatic failure?

    "The response of central banks in Japan and Europe has been to use monetary policy to weaken their respective currencies but this targets the symptom and not the problem."

    Actually having too expensive a currency *is* the cause. Everything else (even deflation) is a symptom.

    "Deflation doesn't seem so bad in comparison."

    There are very few examples of good deflations, and absolutely none of those were caused by tight monetary policy.

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    1. Thank you for your comments.

      I still think that my reasoning behind deflation (as per below) holds.

      "The reasons behind deflation are based on prices being too high as a result of unsustainable price increases in the past."

      A temporary shift upward in aggregate demand which is not sustainable (such as a lending boom) will result in higher prices and a stronger economy but the aggregate demand will shift back once the temporary boosts ends (due to a crisis in the banking system). This adjustment will involve a fall in prices but this typically takes time as prices are slow to adjust downward. I think that this is an appropriate way to describe what is going on in countries such as Greece and Spain.

      Policies to shift aggregate demand upward again would be beneficial but a fiscal stimulus is off the table and monetary policy seems to be gaining little traction as banks are not lending and the links between the financial system and the actual economy are weak.

      You made a good point with regard to the currency - it is too strong in comparison with the weak economy in Europe. I did not agree with the policy of the ECB with the implied link between weaker currency and push for inflation.

      A better policy for countries such as Greece and Spain who cannot influence their currencies would be to speed up the adjustment to ensure an earlier exit from the economic stagnation.

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    2. "A temporary shift upward in aggregate demand which is not sustainable (such as a lending boom) will result in higher prices and a stronger economy but the aggregate demand will shift back once the temporary boosts ends (due to a crisis in the banking system)."

      You are assuming that financial crises are the cause and the decline in aggregate demand is the effect. But in fact in every single financial crisis you could care to mention the rate of increase in nominal GDP declined long before there was a financial crisis. It is decreased nominal incomes which makes debt unsustainable, and nominal income is determined by monetary policy stance.

      "Policies to shift aggregate demand upward again would be beneficial but a fiscal stimulus is off the table and monetary policy seems to be gaining little traction as banks are not lending and the links between the financial system and the actual economy are weak."

      I see no evidence at all that more expansionary monetary policy has even been tried in the Euro Area. The MRO rate was raised from 1.00% to 1.25% in April 2011, and to 1.50% in July 2011. The 6-quarter recession started the following quarter. Even now Draghi has made it clear the ECB could lower the MRO rate to 0.0% if it chose to, but it does not.

      And since the Euro Area has yet to be at the zero lower bound in interest rates, it comes as no surprise that they have never done QE and have no plans to do any. The monetary base has expanded by less on a percentage change basis in the 63 months from August 2008 through November 2013 than it did in the 38 months from June 2005 through August 2008.

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    3. I do agree with your point on the relatively weak monetary stimulus - I have not noticed this disparity but it does make sense. The ECB might be holding off as it does not see too much point - the banks are in too much trouble to act as means for transmitting the effects of the extra money supply through to the actual economy. And the Germans would have been putting the brakes on any attempts for a monetary stimulus.

      I do also see the reasoning behind your point about financial crises - there has to be a trigger outside of the financial system itself to bring on the crisis and that could be slower growth in nominal GDP but it does not have to be. But I perceive the trigger to often be a change in consciousness about the unsustainability of the imbalances in the financial system. The global financial crisis started through sub-prime mortgages in the US which did not involve a slowdown in the economy or even a fall in house prices - these changes came later. But I may be wrong....

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    4. "The ECB might be holding off as it does not see too much point - the banks are in too much trouble to act as means for transmitting the effects of the extra money supply through to the actual economy."

      1) The Bank Lending Channel is only one of nine channels of the Monetary Transmission Mechanism (MTM) as enumerated by Frederic Mishkin. You're evidently forgetting about the Exchange Rate Channel, the Wealth Effects Channel, the Tobin Q Channel, the Balance Sheet Channel, the Unexpected Price Level Change Channel, the Liquidity Effects Channel etc.
      2) Banks are in trouble in the Euro Area precisely because monetary policy has been so tight. In the US, where the Fed went straight to ZIRP in December 2008 and where it has been there ever since, and where over $2.7 trillion in QE has been done so far, financial sector leverage has plummeted between 2009 and 2013, unlike in the Euro Area where it has remained more or less constant.

      "The global financial crisis started through sub-prime mortgages in the US which did not involve a slowdown in the economy or even a fall in house prices - these changes came later."

      Year on year nominal GDP growth in the US fell from 6.5% in 2006Q1 to 5.3% in 2006Q3 to 4.3% in 2007Q1 to 3.1% in 2008Q1 to 2.7% in 2008Q2:

      http://research.stlouisfed.org/fred2/graph/?graph_id=135856&category_id=0

      Lehman Brothers filed for bankruptcy in 2008Q3. So the rate of change in nominal GDP had been falling significantly and steadily for two years before the financial crisis hit with full force.

      Real US house prices started falling in 2006Q2 and had already fallen 24.9% by 2008Q2:

      http://research.stlouisfed.org/fred2/graph/?graph_id=148985&category_id=0

      So once again house prices had been falling for over two years before Lehmans filed for bankruptcy.

      And the US yield curve became inverted in August 2006 and stayed that way through May 2007:

      http://research.stlouisfed.org/fred2/graph/?graph_id=75581&category_id=0

      Every US recession since WW II has been preceded by an inverted yield curve in the previous 6-18 months. An inverted yield curve is strictly a matter of monetary policy choice.

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    5. Thanks for your comments.
      Your time and effort in setting me right has been greatly appreciated.

      Delete
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