If inflation, a rising general price level, hurts people, don’t falling prices help them?
If so, why is there all the news about central banks, including the U.S. Federal Reserve, being scared of deflation? And why is Narayana Kocherlakota, the president of the Minneapolis Federal Reserve Bank, citing insufficiently high inflation as the reason for his dissents from the slight monetary tightening voted for last month by all the other members of the policy-setting Open Market Committee.
The answer is that deflation, a falling general price level, can harm an economy — and the households that make it up — just as badly as inflation. This isn’t controversial among economists, even if only a minority would agree with Kocherlakota’s stance.
It is inflation, however, that remains a greater fear for most ordinary people in our country and elsewhere, particularly countries such as Germany and Brazil that had traumatic experiences with hyperinflation, wiping out the value of their currencies.
Our own bout of inflation, in which the general price level tripled from 1967 to 1982, remains in the minds of most people over 50.
A century ago, views might have been different in the wake of the Panic of 1907, which plunged the country into deep recession and which threatened a return to “The Long Depression” of falling wages and farm prices that had plagued the nation in the 35 years after the Civil War. The consumer price index fell nearly by half, and economic conditions were harsh for most, even though the overall economy was growing.
Deflation is often coupled with recession, in complicated links in which it can be both cause and result. Indeed, deflation can be like a spin in an airplane, a hard-to-control situation involving a downward spiral into a crash, unless something is done to wrench the plane, or economy, back into a stable situation. Japan has grappled with deflation over most of the past quarter-century after its stock and real estate markets collapsed in 1989. Despite half-hearted measures, it never has returned to sustained growth, even at lower levels than those for which Japan was famous in the four decades after the end of the postwar U.S. occupation. This is the specter that haunts Kocherlakota and other economists who oppose any Fed tightening.
The general public’s judgment of the relative risks of inflation and deflation is complicated by “money illusion.” Money is just a yardstick to measure these goods and services. What is really important in an economy is the amount of goods and services that can meet the needs and the wants of its people.
When there is inflation, a given amount of money buys fewer goods. People rightly say “with our current income, inflation reduces what we can buy.” If deflation were to occur, the same continued income would buy more goods and services. That obviously is better.
The error is to assume that one’s income would be exactly the same regardless of what happened to the general price level. That would not be true for many people. Wages, salaries and the prices of things sold by businesses do rise with inflation. So the real decrease in levels of living is less than tabulated price rises. Outlays increase, but so do nominal incomes.
So we think of the 1970s as a bad economic decade. The 1980s have taken on an aura of a golden decade in popular memory, since the Paul Volcker-led Fed reduced inflation.
But inflation-adjusted personal income, both for the nation as a whole and on a per-capita basis, rose as fast in the 1970s as in the 1980s. And in both, the increase was much higher than for 2000-10 decade, which actually was worse in this regard than the 1930s.
Civilian employment actually grew faster in the 1970s than in the 1980s and in both, the growth was even faster than in the 1960s, which many also remember as a go-go time for the U.S. economy.
This certainly doesn’t mean that inflation is a good thing or that the high inflation rates of the 1970s were the cause of good growth of employment — and of real output and incomes. Inflation, especially when it is high and variable, causes uncertainty for businesses, which deters them from making investments in new plants and equipment that would make the economy more productive. It corrodes long-term economic growth, and it is important to avoid.
But deflation is also economically harmful. One immediate effect is that when prices are falling, there are large incentives to defer spending. This depresses purchases by both households and businesses. Don’t buy the new car or clothes dryer if it is going to be even cheaper in six months. Buy only the bare minimum of business inputs such as steel or styrene pellets, if a railcar full will cost less next spring than now. Overall demand across the economy falls and thus output, business profitability and employment.
Wages are “sticky”; they don’t tend to fall as quickly. But if businesses are selling less and netting less, they have to adjust costs somehow. So some workers get laid off if pay rates cannot be cut for all. New employees replacing retiring ones often do get paid lower wages. Higher unemployment means even less consumer spending, which leads further to lower output and profits.
Businesses, including farms, mines and mills, see market prices of their products fall, so they have to sell more goods to make the same principal and interest payments on loans contracted before deflation set in. The price of real estate falls, and the asset side of business and family balance sheets shrinks relative to debts.
So most economists agree that although high inflation, say that of 5 percent or more, is harmful and becomes increasingly so as it rises and fluctuates, annual price rises under 2 percent or 3 percent are innocuous, particularly when they are stable and generally anticipated.
If economies can grow at full potential, with low unemployment and an inflation rate of 2 percent, can’t they do the same with a low and stable deflation rate, such as prices falling 2 percent? Kocherlakota thinks not, and a majority of economists agree, although there certainly is not unanimity. But the majority opinion is strong enough that most central banks aim for general price fluctuations of around plus-or-minus 2 percent.
The Fed under Volcker, the Bank of England in the Thatcher era and numerous other central banks have demonstrated that inflation can be tamed. Deflation is more troublesome to short-circuit and can have more immediate depressing effects on real incomes and employment. So a bias toward low, but not zero, inflation is warranted.
The key question is whether the likelihood of slipping into deflation in coming months is as great a risk as Kocherlakota fears for the United States and as many fear for Europe. I personally am not as alarmed for our country as the Minneapolis Fed president is, but dangers for the global economy, especially in Europe, are real indeed.