Standard economic orthodoxy seems to be that deflation is a terrible thing that all economies should avoid. Most central banks now seem to have an inflation target that is greater than 0%, and move their interest rates to try and keep inflation inside this target; inflation numbers are eagerly anticipated economic indicators, with anything below 2% or so greeted with horror; and one of the core goals of Abenomics is getting Japan out of its deflationary situation. Indeed, one of the central criticisms of Japan’s economy is that it has long been deflationary, which is supposed to be terrible.
Recently Paul Campos at Lawyers, Guns and Money observed in a somewhat surprised tone that deflation has been the norm for a large part of American history, and before world war 2 inflation often only accompanied major economic shocks and war. He writes:
(1) Overall prices in the American economy were about the same at the beginning of FDR’s presidency as they had been at the end of George Washington’s second term.
(2) Prices were nearly 25% lower in 1900 than they were in 1800 — that is, on net the 19th century was deflationary.
(3) Prior to the middle of the 20th century, significant inflation, rather than being seen as a normal thing, was very closely associated with, and clearly caused by, war. Indeed, prices would have been very strongly deflationary over a 200-year period if not for bouts of severe inflation during the Revolutionary War, the Civil War, and World War I.
(4) If we consider American economic history from colonial times to the present, the last 75 years have been an almost freakish exception to the normal course of events, in which prices are as apt to fall as they are to rise.
The tone of his blog post is mild surprise, and it includes a request for a recommendation for a cultural history of inflation. He notes that until recently American economists could compare average prices in nominal terms over very long periods, because prices would be relatively similar even over 200 year periods, though in the short term they might not be stable. His observations about the history of inflation in America surprised me as well.
It’s obviously difficult to compare economies across 100 years, and the economic fundamentals of expansionary, colonialist America with a gold standard currency were obviously very different to modern America or Japan, but it should be obvious I hope that for large periods of time during these deflationary eras the US economy was both growing, something of a miracle around the world, and also generally working to enrich and improve the lives of its residents. So what is going on with this deflation thing? Why is it so terrible?
This question bugs me a lot because I live in Japan, and for a country that is supposedly suffering under deflation it seems to be doing pretty well. It’s difficult to say people aren’t consuming, for starters, and indeed the same newspapers that will decry the dampening effect of deflation on the Japanese economy will also carry stories stereotyping Japanese as brand-obssessed hyper consumers. I certainly don’t notice a lack of consumer effort in this country, and in just the last year in my suburb three new department stores have been built. Economists often tell you that the problem with deflation is that it discourages people from buying things today because they know they will be cheaper tomorrow. If that is the case then in Japan it is probably working as a very useful dampener on economic activity – if Japanese people consumed any more than they do, everyone in Japan would have to work without sleep just to deliver the goods. It certainly doesn’t appear to be stopping people from consuming, and furthermore life in Japan is excellent, the standard of living is high and it is a peaceful, functioning society with excellent quality consumer goods and (comparatively) low rents … So why are economists so worried about deflation, and why do they constantly criticize Japan for its deflationary situation?
My theory is that deflation is viewed by most mainstream economists (and especially economic commentators) through the same narrow, biased lens as inflation and printing money. There are several aspects of Japan’s deflationary economy that most economic commentators completely ignore, because they would mean taking into account the whole nature of the economy and the behavior of individuals and institutions in it, rather than reciting a simple mantra. These aspects are:
- Japan’s population is aging and older people consume less goods from many sectors, so reduction in consumption is to be expected as part of population realignment
- Japan has a long history of infrastructure growth and investment, and still does, and as population growth stalls this historical infrastructure has to do less and less work, so maybe prices don’t have to rise
- When you can’t compete on lower prices because everyone expects prices to fall anyway, you have to compete on quality, which is why Japanese services are such high quality
- For a long period of time Japanese companies have been avoiding raising prices by giving more work to the same number of people, making their workers work longer hours without hiring new people, and I think this is an inevitable aspect of an economy with very low unemployment
- The bubble saw prices rise way too high, and a long period of deflation has been necessary to reset these prices to a more reasonable international standard, so here deflation is at least partly a correction to a historically stupid mistake
None of these things (except the overwork thing) are necessarily bad, and fixing the overwork problem would require that Japanese institutions find a way to employ the last 3-5% of the population who aren’t working but want to work, or employ more women, and there are lots of reasons why this can’t happen. You would think that with Japan’s labour economy bumping up against structural unemployment limits, prices would rise under labour constraints, but I think this is balanced by the aging of the population and reduction in consumption in many areas of social life, plus automation, and it all just ends up balancing out.
It is sometimes said that inflation is the friend of the poor and the working class, because in chewing away at the value of money it prevents the rich from getting richer. I think this is very far from a universal truth, because whether inflation works in this way depends on what prices are inflating and why, and what the balance of interest rates and inflation are. If interest rates have to be raised to keep inflation in check, there may be long periods of time when prices are growing as fast as wages but interest (and therefore accumulated wealth) is growing faster. Or the opposite may occur. The same applies with deflation – it’s the friend of the working class if it arises because access to infrastructure and land is falling in value (which may have happened for long periods of time in US history as it opened the interior), but the enemy of the working class if it is arising because of economic collapse that leads to labour instability and loss of work. Looking at the history of the USA as presented at Lawyers, Guns and Money it appears that inflation was the enemy of the working class before world war 2, when it was associated with instability and job losses; perhaps deflation was largely irrelevant to them.
What is the real story now? Is deflation to be universally feared, or is it just one more partial indicator of the quality of the total economy?
Update: Subsequently to writing this post I discovered a chart of historical inflation at Eli Rabett’s, which shows the step change in 1950, with his opinion about what this means for discount rates and future costs of climate change.