Politicians Need to Learn to Love Deflation
Deflation is a situation where the prices of goods and services are falling on average, so that most things we buy are getting less expensive over time. Central bankers and politicians around the world are pursuing policies designed to create inflation because of an irrational fear of deflation. Rather than trying to maintain stable prices, these policy makers believe they must maintain a safe cushion of inflation, generally taken to be inflation of 2 percent per year, to ensure that if their policies miss the mark we do not accidentally get deflation. Yet, the idea that deflation would have crushing economic consequences is based on faulty thinking and a complete lack of empirical evidence.
First, the faulty thinking. Policy makers fear that if consumers expect deflation, they will delay all unnecessary purchases, waiting for the lower prices to come. That fall in demand will force retailers to cut prices, leading to more deflation and even less demand as consumers continue to wait. This is the much feared "deflationary death spiral." It is also a complete figment of policy makers' and economists' imagination at the sort of deflation rates that are realistic.
What matters to consumers is not whether prices are expected to fall, but whether prices will fall faster than their incomes by at least as much as their intertemporal discount rate. Taking each of these concepts in turn, if prices and incomes fall together at equal rates then things are not really getting cheaper since they all cost the same as before relative to people's purchasing power. In such a scenario consumers would have no reason to delay their purchases. Thus, wages would have to be "sticky," resisting downward pressure to a greater extent than prices. Think of the change in prices minus the change in incomes as the adjusted deflation rate. For a deflationary death spiral, this measure would need to be negative.
In addition, this adjusted deflation rate would have to be greater in magnitude than the intertemporal discount rate. Intertemporal discount rate is a fancy economic term for how much more people prefer to have something now rather than later. Alternatively, you can think of it as the bonus that must be paid in order to get a person to agree to deferring a payment. If you would rather have $100 today than $110 a year from now, your intertemporal discount rate must be more than 10 percent (110/100 - 1). Economists have typically estimated surprisingly high discount rates (sometimes as high as 100 percent per year) and even some recent, improved estimates suggest that Americans have discount rates in the 25-35 percent per year range.
Such an intertemporal discount rate would suggest that unless the rate of deflation minus any rate of falling income was at least 25 percent per year, consumers would still choose to purchase items now, rather than wait for a better price later. Yet, macro policy makers seem to live in fear of deflation rates of not even one percent per year. Have they ever met an American consumer? We are not a society known for delayed gratification.
Given how much we prefer having things now compared to waiting until later, there is virtually no chance of significant negative effects of deflation in the American economy. Nobody believes there is a risk that prices will start falling at 25 percent per year (or even 10 percent per year). The fear seems to be that prices will be roughly stable (say, between -1 and +1 percent annual inflation). At that level of price changes our desire for current consumption is more than strong enough to avoid any risk of delayed purchasing.
To add some empirical evidence to this argument, let's look at Japan. Japan is often pointed to as an example of how deadly deflation can be to an economy. Yet while Japan has definitely struggled economically for some time, it has had much less deflation than many people seem to believe and shows little, if any, evidence of a deflationary death spiral as a result.
Japan's price level peaked in November 1998. In the sixteen years since, it has dropped a cumulative one percent (yes; that is 1 percent, or 0.06 percent per year). Over that entire period, the largest price drop over any twelve month period was 2.5 percent in 2009. In general, price changes bounced between dropping at about 1 percent per year to rising at about the same 1 percent rate. So effectively, what Japan has had is stable prices for a period of sixteen years.
During the same time period, retail sales in Japan have been flat as well. They fell by about 10 percent in the first six years of this period, but have steadily gained all those losses back over the last ten years. In fact, if we look at the decade from 2002-2012 (chosen to be recent, but avoiding the beginning of Abenomics), retail sales rose about 4 percent while prices fell by 2 percent. This seems to be clear evidence that slight deflation is not sufficient to create a deflationary death spiral of consumers delaying purchases.
Given that Americans seem much less willing to delay gratification than the Japanese, we would need more deflation to create a death spiral here than they would there. Thus, I think we are safe from the deflation bogeyman.
Perhaps if we can convince policy makers to lose their fear of deflation, we can get them to embrace the value of stable prices. That would do wonders for the economy.
