Friday, June 26, 2009

Is Deflation Really Something to Fear?

This morning the inflation numbers for Japan hit the tape showing a decline of 1.1 percent in Japan's Consumer Price Index for May -- the third straight month of decline. This news prompted the Japanese finance minister to express concerns about a significant slowdown in demand. Why should deflation imply a slowdown in demand?

If prices fall, does that mean consumers get less interested in buying? What economic theory suggests that?

When you pose a question like this, you often get silly answers like: "Well, that's what history tells us?" Oh, really!

What is the biggest period of deflation in US history? It was the period after the American civil war and up to the beginning of the twentieth century -- a span of more than forty years. This period was simultaneously: 1) the period of the fastest rate of growth of real GDP in American history; and 2) the period with most persistent and consistent deflation. (In fact, it is about the only period of deflation in American history). So, where was the economic catastrophe that is supposed to take place with deflation in this episode?

No doubt, someone can find, somewhere in history, an example of an economy struggling (Japan in the 1990s) where the price level is not rising. So what? The America of the 1970s was an example of rising inflation and a stagnant economy. So what?

It is a myth that a rise in the price of one's currency (which is the definition of deflation) must lead to bad economic times. The main evil of deflation, similar but opposite to inflation, is that there are unanticipated redistribution effects. If there is deflation, debtors are hurt and creditors are helped. If there is inflation, creditors are hurt and debtors are helped. And that's that.

The idea that deflation is some looming catastrophic event to be feared is ridiculous.

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