Deflation Can Be Fun

This article also appeared in The Sunday London Times, January 17, 1999.

Remember when the bogey-man of policy-makers and economy-watchers was inflation? Probably not, if you are a thirties-something currency or bond trader, accustomed to a long period of price stablity. But for the rest of us, only now adjusting to the fact that an inflationary surge is not lurking behind every new economic development, it is difficult to absorb the notion that we perhaps should be planning for a period of deflation.

Start with what deflation isn't. It isn't a decline in some prices, or even in many prices. It isn't a general downdrift in the prices of commodities, even many commodities. It is a decline in the overall, average price level in an economy.

So lesson number 1: we are probably not in a deflationary period, at least not just yet. Even if we correct the reported, headline inflation numbers to eliminate their overstatement of the actual rate at which prices are increasing, the price level is probably increasing at an annual rate of something like 1%, or is stable. Not much, but still not deflation.

Lesson number two: deflation comes in two flavours. There is the evil deflation that results from inadequate demand, and the good deflation that comes from increased productivity. The evil variety occurs when consumer demand is insufficient to absorb what the nation's, or in case of many globalized markets, the world's factories are capable of producing. With too many goods chasing too few dollars, competition drives prices down.

Consumers, expecting them to fall still further, defer purchasing. Which drives prices down still more, in a vicious spiral that eventually results in high unemployment, and is ended only when enough factories are scrapped or consumers decide that prices have reached their nadir.

Then there is the wonderful sort of deflation, more common than the evil sort. It is the type that America experienced in the latter part of the 19th century. Between 1865 and 1900 the price level fell by about 40%, reckons James Paulsen, chief investment officer of Norwest Investment Management. Simultaneously, industrial output soared by over 600%. The industrial revolution saw the introduction of new and cheaper ways of making everything from steel to textiles. Prices fell because costs fell. Worker's paypackets stretched further. Businesses remained profitable. Living standards rose.

Lesson three: just as with inflation, so with deflation – there are winners and losers. Leftish politicians who profess delight at the resurgence of interest in the theories of John Maynard Keynes may have forgotten that one thing that troubled the great economist about deflation was that it led to an increase in real wages. Robert Skidelsky, in his magnificent biography, reports that in 1922 Keynes delivered a lecture to the Institute of Bankers in which he set forth the thinking that "was to become central in the development of the Keynesian Revolution".

Keynes argued that "trade will never go ahead until the people are certain they [prices] hve touched bottom... so that I am in favour of a moderate rise in prices as the only way of getting our of the present period of depression." Price rises were needed, Keynes continued, because it takes too long to force wages down, so that in a period of falling prices "we have got the level of wages ... out of gear with everything else." Unskilled labour "is now being overpaid in relation to the cost of living", making British exports uncompetitive. So, drive down "sticky" money wages by raising prices to reduce real wages. Not exactly a policy that should appeal to the Keynes-loving, Prescott wing of New Labour.

In short, wage-earners as well as consumers can be winners in a period of deflation. Commodities producers, on the other hand, can be losers, witness the current tribulations of the oil-producing countries and of nations such as Brazil and Chile, which rely heavily on commodities exports. Debtors, too, get hurt when prices fall, for they are selling goods for fewer and fewer dollars while remaining committed to pay fixed dollar amounts in interest and principal.

The questions concerning investors today are whether we are entering a period of deflation, and if so, whether it is the good or the bad kind. Paulsen is candidly uncertain. He says "This could be the deflationary abyss that everyone is talking about. Or this could be the deflationary boom."

Those who see the world on the edge of that abyss point to the excess capacity that exists in many of the world's industries, causing prices to be slashed in a competitive scramble for markets. Steel producers in Russia are taking almost any price they can get, forcing British, American and other producers to cut prices to levels that has them whingeing for protection. The world's auto producers fear a similar fate: hence the talk of "rationalization", a fancy word for mergers that will permit the shutting down of enough capacity to reduce output to levels that can be sold at profitable prices.

Japan is offered as an example of a country bedeviled by "bad" deflation. Excess capacity is driving down prices. Consumers expect that anything they refrain from buying today will be cheaper tomorrow. So they stash cash in safe deposit boxes. Keynes would prescribe a dose of inflation for the Japanese, driving prices up 15-to-20%.

But an equally powerful argument can be made that we are in the early stages of a deflationary boom. We may be seeing a shift to industries that are capable of generating profits and productivity growth even though they have no pricing power. Hence the popularity of some Internet shares. The steel industry may run at a loss because prices are falling, but the computer and telecoms industries are profitable in spite of, or, indeed, perhaps because of falling prices that are making their products attractive to more and more consumers.

Lower costs, lower prices, higher profits – all in high-wage industries. No wonder New Labour is casting envious glances at Silicon Valley.