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Most episodes of deflation have been benign

19 Jul 2014 by Jim Fickett.

The recent annual report from the Bank for International Settlements, a bank for central banks, contains an excellent myth-busting analysis of deflation.

Current economic policy commentary often suggests that deflation is extremely dangerous and must be avoided at all costs. The two scary examples often given are Japan's lost decades and the Great Depression. Both examples mislead. Japan actually has quite healthy growth per working person, and the slow overall growth is entirely explained by demographics (Japan's slow growth needs no explanation beyond demographics and Deflation is not the problem). In the Great Depression, the really scary phenomenon was the debt and asset price collapse, and it was out of this collapse that deflation came.

There have been many other examples of deflationary periods, and the BIS explains that the historical record shows deflation is not usually a problem:

it is essential to discuss the risks and costs of falling prices in a dispassionate way. The word “deflation” is extraordinarily charged: it immediately raises the spectre of the Great Depression. In fact, the Great Depression was the exception rather than the rule, in the intensity of both its price declines and the associated output losses … Historically, periods of falling prices have often coincided with sustained output growth. And the experience of more recent decades is no exception. Moreover, conditions have changed substantially since the 1930s, not least with regard to downward wage flexibility. …

Deflations are not all alike. Owing to the prevalence of price declines in the 19th and early 20th centuries as well as since the 1990s, the historical record can reveal important features of deflation dynamics. Four stand out.

First, the record is replete with examples of “good”, or at least “benign”, deflations in the sense that they coincided with output either rising along trend or undergoing only a modest and temporary setback. …

The second important feature of deflation dynamics revealed by the historical record is the general absence of an inherent deflation spiral risk – only the Great Depression episode featured a deflation spiral in the form of a strong and persistent decline in the price level; the other episodes did not. During the pre-World War I episodes, price drops were persistent but not large, with an average cumulative decline in the consumer price index of about 7%. More recently, deflation episodes have been very short-lived, with the price level falling mildly; the notable exception is Japan, where price levels fell cumulatively by roughly 4% from the late 1990s until very recently. The evidence, especially in recent decades, argues against the notion that deflations lead to vicious deflation spirals. In addition, the fact that wages are less flexible today than they were in the distant past reduces the likelihood of a self-reinforcing downward spiral of wages and prices.

Third, it is asset price deflations rather than general deflations that have consistently and significantly harmed macroeconomic performance. Indeed, both the Great Depression in the United States and the Japanese deflation of the 1990s were preceded by a major collapse in equity prices and, especially, property prices. These observations suggest that the chain of causality runs primarily from asset price deflation to real economic downturn, and then to deflation, rather than from general deflation to economic activity. …

Fourth, recent deflation episodes have often gone hand in hand with rising asset prices, credit expansion and strong output performance. Examples include episodes in the 1990s and 2000s in countries as distinct as China and Norway.

Why does all this matter? Because the real danger is not the mild deflation the Fed is working so hard to avoid, but rather the asset bubbles the Fed is blowing, and their likely eventual collapse:

There is a risk that easy monetary policy in response to good deflations, aiming to bring inflation closer to target, could inadvertently accommodate the build-up of financial imbalances. Such resistance to “good” deflations can, over time, lead to “bad” deflations if the imbalances eventually unwind in a disruptive manner.