14th January 2015
When the ONS published the UK CPI for December 2014 recently, showing a drop to just 0.5%, the great deflation debate re-started in both traditional and social media. This is going to go on because the slide in goods and services inflation is far from over. By February, the UK’s CPI could be zero or negative, and the US CPI will be hard on its heels. The momentum in CPI inflation, measured by the 3 and 6 monthly rates of change is already zero or negative in pretty much every major western economy.
But the ‘watch out’ warnings of people like your scribe here were more than matched by different views. George Osborne celebrated it as some sort of victory. Some prominent economists saw nothing malign about lowflation, as it’s now called, and even asserted it is a big positive for economic growth. Several economic and financial journalists assured us that while deflation might be a problem in parts of Europe, there was no risk or reason for concern in the UK (or the US). One well-known broadcaster said that if it was good for the Victorians — prices were 9% lower at the end of Queen Victoria’s reign than at the beginning — how can it be worse for us today?
So how should we think about deflation trends? This post offers some historical and current perspectives. I’m going to give short shrift to the wonkish bits of the argument but provide a good discussion reference for those who want to pursue it. My view is twofold. First, there’s nothing good about deflation, and this is not the last quarter of the 19th century, which is one of the few periods of deflation that was mostly benign, later being called ‘the falling price boom’. Second, even if the immediate risk of deflation in the UK, and the US, seems much less than in the Eurozone or China, for example, this is no reason for complacency or being dismissive. Indeed, from a policy perspective, once the risk is greater, it’s often too late or more complex to deal with it.
Yesterday’s deflation was mostly damaging
Since the early 1800s, there have been roughly six deflationary periods, only two of which could be described as benign, and even then with caveats as they were characterised by recessions and in one instance by severe financial instability.
As the BIS has noted (reference below), in the 19th century, the level of prices went through alternating periods of rise and fall, though it’s as well to remember that this was a century in which monetary relations were governed by the gold standard for the most part. These were the most remarkable periods of deflation:
Bad deflation was pervasive between 1837-43, starting with a financial crisis. Prices fell sharply in the US, the UK and France and, according to economic historians, the UK’s economy contracted over the period.
The last quarter of the century was a period of largely benign deflation. Prices fell in many countries by about 2% a year, but economic growth averaged about 2-3% a year. Pride of place goes to the productivity boom instigated by the ubiquitous spread of coal, steam and railway technologies, and the growth of steel and heavy industries. Nevertheless, we should not take away a totally warm and cosy feeling. There were three recessions — 1873-75, 1884-85 and a particularly bad one from 1890-96, which featured the Baring Crisis, Argentinian default and a banking crisis in the US and Europe. Some social groups, especially farmers and debtors, were badly affected. Social unrest increased — witness the growth of labour unions and political parties — as did demands for trade protection.
After the First World War, a further period of bad deflation ensued, specifically from 1919-1921. In their attempts to roll back the inflation generated by the war, scarcity and speculation, central banks tightened monetary policies, and some returned to gold. Output contracted by between 18-30% in the US, UK, France, Germany, Japan and Canada.
A second period of benign deflation set in the years from 1921 until the Wall Street crash of 1929, except of course in Germany from 1921-24. These ‘roaring 20s’ were, like the last years of the prior century, a period of rising productivity thanks to the spread of oil and fossil fuel technologies, and automobile, telephone, radio and mass production manufacturing and consumption. Output soared in many countries, though not in the UK, aided and abetted also by temporary fixes to Germany’s war debts, and the revival of world trade and capital flows. Prices fell by about 1-2% per annum.
The Great Depression of 1929-1933 needs no special mention as it is the subject of a vast array of literature, resides in our consciousness, and has been referred often since the Great Financial Crisis. The one thing that merits a mention is that the substantial shock to output and jobs put the impact on prices in the shade. We understand how the shock to output in the US was propagated, for example via a failure of policy, wage rigidity, dysfunctional credit institutions, rising real interest rates and debt deflation. But it isn’t clear why the impact on prices wasn’t as consequential as it had been earlier. In any event, this was without a question a chronically bad deflationary period.
Last but not least, note two recessions in the US in 1937-38 and 1948-49 characterised by falling prices and very low interest rates. The contraction in output and prices was especially marked in the former, following a tightening of both monetary and fiscal policies in 1936.
In the last 60 or so years, there have been isolated instances and short periods of mild deflation, for example, in Singapore, Hong Kong, and Taiwan where falling prices were largely benign or a peripheral consequence of other policies. And of course, the major example of deflation was Japan but even here, the deflation was marked not so much by the scale of price falls — just 4.6% between December 1998 and February 2013 — but by the protracted period over which it has happened. The funk has been stopped temporarily at least by the Bank of Japan’s stepped up QE, but as things stand, the rise in inflation, fuelled by the fall in the Yen, is reversing as the economy weakens again. We are no wiser as to what Japan might look like if the BoJ’s balance sheet is compromised by adverse interest rate or exchange rate movements, or, for example, if relentless ageing leads to a more dramatic decline in national savings and the external balance, and foreigners become more active in Japan’s debt markets.
Today’s deflationary trends are not benign
In theory, economists can show why protracted lowflation or even mild annual deflation can be relatively benign. But this depends on the existence of economic conditions which, in practice, don’t really exist. And the idea that we can all buy things more cheaply tomorrow is fine for us as individuals, but this line of reasoning falls under what we call the ‘paradox of aggregation’. In other words, if we all hold off from purchasing things we expect to get cheaper, and companies behave similarly, deflation becomes self-fulfilling. If you’d like to bury yourself in a comprehensive discussion about the theory underlying the costs and benefits of deflation, go to the BIS source referred above for a rather prescient paper written about a decade ago but still oozing relevance.
The world’s experience of deflation over the last 200 or so years, as suggested above, has had a couple of benign periods, both associated with the march of technology and productivity, although not without macro-stability risks. But for the most part, periods of deflation have been ‘bad’. They have been related to deficient aggregate demand, and have either been exacerbated or triggered by high levels of debt.
Self-evidently, if we could be confident today that lowflation or mild deflation would continue, thanks to digital technology and robotics, we would have little cause for concern. But we can’t be confident because productivity growth isn’t what is causing prices to slide. If you take the Robert Gordon view of the world, you have every reason to stay concerned. If you’re more optimistic and subscribe to the Brynolfsson and McAfee view, perhaps not but you could be in for a long wait.
There are several reasons to be wary of deflationary trends, especially when policy rates are already at zero and bond yields are very low, because they:
- are creating a low nominal world, that is, the monetary value of income, revenues and sales, taxes and so on. If top-line revenues are stagnant or falling, companies suffer and refrain from making investment decisions. Look what’s happening to Tesco and other food retailers in a sector where prices are sliding. Check out commodity producers and suppliers, and follow the early signs of retraction in the oil industry. Governments suffer from weak tax revenues, as the nominal value of incomes and taxable goods and services stagnates or falls
- can lead to adverse changes in income distribution, especially for the lower paid
- generate increases in real interest rates, which affect debtors. As debt obligations stay the same, but the denominator of income, cash-flow or GDP weakens or falls, debt sustainability is impaired. This is happening in real time to Greece and other European sovereign debtors in a more damaging way than, say, in the UK and US
- are associated with asset market inflation and financial instability
- are likely to spread around the world as countries experience or resort to currency depreciation, in effect exporting deflation to others. In its attempt to reverse deflation, in which it is again failing, Japan has allowed the Japanese Yen to fall from around $/Y75 to over $/Y120, and both the Euro and the Pound have been weakening this year
- complicate the conduct, communication and implementation of effective monetary policy, in particular when, as today, deflationary trends are global and non-cyclical. For example, the consequences for wage and price setting behaviour of China’s deflation (rooted in excess capacity and change in the economic development model), and the deflation attributable to both digital technologies and to ageing demographics go much further than be accommodated by a pure domestic monetary remit.
But are UK and US exceptional?
A lot of people argue, quite fairly, that what really counts in the deflation debate is not so much what’s happening to the CPI itself, which measures differently across continents and which can be influenced strongly by sharp movements, for example now by fuel and lubricant prices which have been in freefall. And no one really argues seriously that lower petrol/gas prices are bad for households and companies.
So what we have to do is look at different, and broader indicators. Duncan Weldon of the BBC has just posted a blog in which he says that the two things that would worry him about deflationary trends taking root in the UK would be slippage in wage and salary formation, and the core rate of the CPI, which is still (in December 2013) 1.3%. The latter is more likely than the former because of lower-end wage rigidity. We did have 1% core CPI at various brief points between 2000 and 2009, but it is worrying that it’s come down from 3.5% a couple of years ago. My hunch is that the real issue will be its behaviour when the economy itself slows down again.
As a very recent FT editorial suggested, the key to the debate is what’s happening to nominal demand — something which is barely predictable, and which can turn direction without warning, as you can see from the graphs below — first for the UK, then for the US. In both cases, the blue line is the annual change in nominal GDP, and the red line is the annualised 2-quarter change.
UK Nominal GDP
US nominal GDP
But these charts also show that nominal GDP growth is back to the comfortable levels associated with the Great Moderation period, and the growth in the deflators isn’t dissimilar either. So far, so good, then. And they contrast with more worrisome trends in the Euro Area and Japan.
Euro Area nominal GDP
Japan nominal GDP
So long as the nominal world in the UK and the US continues to expand a 4-5% annual rate, we shouldn’t have to worry about sliding into a deflation where revenues and sales wilt for everyone and where the debt burden becomes intolerable. But this doesn’t mean we should be complacent either. After all, if we ever had to worry about deflation as Europe and Japan should, it’s already quite late from a policy perspective. So there is a case for keeping this under close scrutiny, even if there is no immediate need to change monetary and fiscal settings.
But how long can this nominal expansion persist before it starts slowing again? Looking at the world economy, the World Bank’s just published Global Economic Prospects sees global growth picking up a bit in 2015-16 but it has cut its projections back. Like many other forecasters, it sees significant uncertainty in China’s prospects, and worries about why China is experiencing strong deflationary tendencies. The implication is that over the next 1-2 years, a more pronounced lancing of China’s capacity and debt problems would have broader global trade and stability consequences. On top of that, what is likely to arrest the slowdown in world trade — up 4% a year from 2012-14, almost 50% lower than the years before the financial crisis? There seems little hope for a change in weak import demand in high-income countries, or in the more subdued relationship between trade and income due to stagnant global supply chains, and a shift in global demand and output toward less import-intensive items.
In the end we are, after all, 6 years into an expansion where average duration is about 10 years. Investment spending has picked up a bit in the UK and US but, as current policies stand, the best part may be over. Consumption growth has been driven by falling savings rates, which means slower growth unless there is stronger wage and salary income formation. To boot, the funk in Europe and Japan, and the ubiquitous slowdown in major emerging markets, and especially oil and commodity producing states, mean the world is essentially flying on one (US) engine, and the UK is hostage to developments there and in Europe. It’s not that comforting.