Deflation is not the problem

2 Mar 2014 by Jim Fickett.

It is widely believed that Japan's slow growth is due to deflation, and that this proves deflation to be extremely dangerous. The facts show otherwise. In two recent blog posts, Andrew Smithers shows that deflation in Japan is correlated with higher spending and higher growth.

Most economists believe deflation to be extremely dangerous, because it seems to them that spending should decrease under conditions of deflation. Japan is often given as an example. For example, a 2011 publication from the Federal Reserve Bank of St. Louis says,

Inflation that is ‘too low’ can be problematic, as the Japanese experience has shown. …

Deflation discourages spending and investment because consumers, expecting prices to fall further, delay purchases, preferring instead to save and wait for even lower prices. Decreased spending, in turn, lowers company sales and profits, which eventually increases unemployment. At the same time, borrowing by businesses for investment or by households for big-ticket items (i.e., cars and homes) becomes equally unattractive.

So the theory is that when prices are falling, people delay spending and increase saving. But in a recent blog post at the Financial Times, Andrew Smithers shows that, to the contrary, since 1980 in Japan, the savings rate correlates very strongly with the inflation rate, exactly the opposite of what is usually claimed. The same is true for the last six decades in the United States.

If one googles this topic, one will find the theoretical reasoning repeated in many places but, for some reason, no one seems to check this theory against reality.

Still, it is true, is it not, that Japanese growth has been slow? Yes and no. Overall GDP growth has been low. However, as I have pointed out before, Japan's slow growth needs no explanation beyond demographics. And, indeed, in a separate blog post, Smithers shows that, in almost all recent years, GDP per person of working age has grown faster in Japan than in the US. Further, Japanese GDP growth has been better in periods of falling prices than in periods of rising prices.

If deflation were really the scourge it is made out to be, one might expect the Japanese themselves to feel quite negative about it. But according to a 2010 survey, the opposite is true:

Last year, the Bank of Japan surveyed its population about attitudes towards deflation. You might have thought this would paint a picture of pain, if not panic. After all, during most of the past decade, as Japanese prices gently drifted down, Western economists and policymakers have recoiled in horror; “deflation” has been a dirty word.

But Japanese consumers apparently feel rather differently. In last year’s survey, 44 per cent of Japanese said deflation was “favourable”, while a further 35 per cent felt neutral about the phenomenon – and just 20.7 per cent described it as “unfavourable”.

It might or might not be true that deflation would cause problems if it were to occur in the US. But the case of Japan, often cited as evidence, does not support that conclusion. Japan's problems are demographics and high debt, not deflation.