It's Time to Banish the Deflation Bogeyman

A fair number of economists, including many of the top officials at the Federal Reserve, have an unnatural fear of deflation. So afraid of it are they, that they prefer the insidious tax on savers and business investors of two percent annual inflation to stable prices simply because stable prices are too close to declining ones. Yet, there is ample empirical proof that deflation is not the bogeyman it is made out to be.

Japan is often held out as the example of the dangers of deflation. The idea is that if prices fall, consumers will delay purchases to take advantage of lower prices in the future. This decline in demand will cause prices to fall, and a deflationary cycle begins from which the economy cannot escape. The problem with this scenario is its complete departure from reality.

First, Japan's CPI is actually almost exactly flat over the past ten years. From January 2004 through January 2014, Japan has had inflation of 0.4 percent (not per year, but total). So, no actual deflation is happening economy-wide. Second, Japan's economy has been growing, albeit slowly. Over the past decade and even over the past twenty years, Japan has recorded positive growth in real GDP. Certainly Japan's growth has been slower since its gigantic real estate bubble burst in 1990. However, how much of that is due to deleveraging, overhanging government debt and spending, the rest of Asia catching up to Japan in productivity while having lower labor costs, the low birth rate and aging of its population, or the lack of inflation is an empirical question. Frankly, it is unclear to me why economists would look at that list of possibilities and choose the lack of inflation as the problem.

We can move closer to home (in fact, all the way home), and examine the experience here in the U.S. While the Fed is fearful of deflation and all the smart debtors (the U.S. government first among them) are pushing for inflation to reduce their debt levels, there is actual deflation going on all around us. A quick look at those examples can prove that deflation does not have guaranteed negative consequences.

While the overall inflation rate in the U.S. is consistently positive, many sectors of the economy have experienced deflation for their products over the past decade. Examples include furniture (prices down 9.7 percent over ten years), appliances (prices down 2.8 percent in ten years), durables (which includes furniture and appliances; down 3.4 percent in the last decade), and most spectacularly personal computers which have seen their prices drop by 63.9 percent in the past nine years. Yet none of these industries have collapsed.

In the face of these declining prices, which the deflation hawks tell us will make consumers delay purchases, the real output of the durable goods sector has risen about 5 percent, furniture and appliance sales have remained roughly flat (meaning quantity sold has increased enough to offset the drop in price per unit), and computer sales have actually risen in inflation-adjusted dollars.

Durable goods should be the perfect example to prove the deflation hawks' point. Such products, designed to last for a while, are exactly the sort of purchase that can be postponed. In fact, in recessions, durable good purchases typically drop sharply as people delay those purchases to offset the decline in their incomes. Thus, we know people can adjust the timing of their durable good purchases. Computer purchases follow a similar pattern (some computers count as durable goods and some do not).

Yet, in the face of sustained deflation, we see no sign of a deflationary death spiral of delayed durable good purchases by American consumers. The empirical reality is completely opposite of the promised and much-hyped calamity that central bankers fear so much. In fact, as Christopher Neely of the St. Louis Federal Reserve Bank points out, in 1876-1879 U.S. prices fell by 5 percent per year while output rose at nearly 8 percent annually. Hong Kong had a deflationary period after the 1997 Asian financial crisis, accompanied by a recession, but recovered.

Clearly a deflationary death spiral is not a certain event in a deflationary period. In fact, deflation was not uncommon in U.S. history until we abandoned the gold standard. Since then, we have had only one short period of mild deflation during the recent recession. Given the lack of evidence in favor of severe consequences from deflation, one wonders what so many economists are worried about. If we want economics to be considered a science, we really ought to adjust our theories and actions to the empirical facts.

After all, we know the bad effects of inflation are real: a hidden tax on all savers, transaction costs imposed on all businesses, and a drag on investment due to the uncertain real value of future returns. Given inflation's proven damage, why do we accept it as necessary in order to avoid a completely unproven bad outcome from deflation? It is time to banish the deflation bogeyman and try stable prices for a while.