Has it ever struck you as somewhat odd that the prime objective of central banks is to achieve modest price inflation?
Fundamentally, the purpose of economic advancement is to spread prosperity and perhaps the simplest way to achieve this and alleviate poverty is to reduce the cost of goods and services in an economy.
After all, what is the point of our technological wizardry if not to reduce drudgery and free up time for more rewarding activities – intellectual, artistic, spiritual and social?
When you think about it, it’s absurd to be increasing the age of retirement, while at the same time struggling with rising youth unemployment. If the cost of living were to fall over time, we could encourage people to retire early and do the things they always wanted to, while at the same time freeing up opportunities for the young.
The economic theory of inflation has changed little in the last quarter of a century since my university days. Evidently high levels of inflation can be very damaging, as demonstrated repeatedly throughout history, but the evidence against deflation is far harder to find, indeed until recently, the apparent perils of deflation were accepted and largely unchallenged by the economic community.
Deflation achieved its near mythical reputation after the US Great Depression of the 1930s which was characterised by a negative deflationary spiral. But, this was a symptom and not the cause of the Great Depression, which followed a period of rapid expansion during which the banking system became hopelessly over-extended. The bubble was burst by a series of catastrophic bank failures that triggered a rapid contraction in money supply. US authorities failed to respond to, or even recognise the threat posed by such a rapid monetary contraction, resulting in a destructive deflationary spiral.
It is important at this point to distinguish between three primary drivers of deflation:
A monetary contraction can drive a fall in prices for the simple reason that in order to share a smaller quantity of money over the same value of goods and services, it is a mathematically necessity that prices must fall. Note, however, that this is simply a re-basing of the economy, it does not in itself lead to lower real costs or other consumer benefits but can trigger damaging secondary effects.
Where demand for a good falls below the level of supply, prices will fall. This is demand led deflation which can be a healthy process in the economy forcing inefficient legacy industries to shape up, reduce costs and modernise. Eventually a new equilibrium is reached and consumers benefit from lower prices or better products. This is the ‘Invisible Hand’ of markets at work, as first described by Adam Smith in his seminal book ‘The Wealth of Nations’.
Of course, where aggregate demand falls rapidly across an entire economy it can have very damaging effects. Economies cannot adjust fast enough and the imperative to reduce costs triggers yet further reductions in demand, perpetuating a vicious downward spiral. But such a demand led deflationary spiral is almost always preceded by a speculative boom and subsequent financial collapse.
Productivity growth is the third deflationary force. Increasing the rate at which value can be created with the same amount of resources, or increasing productivity, will lead to lower prices. This deflationary process is entirely positive and has the power to enrich all in society. It is extraordinary that in the 1980s 1 gigabyte of data cost in excess of $400,000! Today that cost has fallen to roughly 1 cent. Productivity deflation is truly the great leveller and it is notable that the decade following the 2008 financial crisis has been marked by the absence of productivity growth.
The Great Depression was first and foremost a monetary contraction, driven by less money in the financial system, and only subsequently did this perpetuate a collapse in aggregate demand and the secondary deflationary effects of excess supply.
The only other major example of deflation in modern times is that of Japan from the 1990s, where deflation is (wrongly) vilified as the cause of the ‘Lost 20 Years’. In fact, the seeds of Japan’s problems have a striking resemblance to that of 1920s America – rapid expansion in the 1980s fuelled a speculative asset price bubble on a massive scale. Funded by Japan’s overly-leveraged banking sector, land and stock market prices tripled.
Trying to reduce speculation and keep inflation in check, the Bank of Japan raised inter-bank rates sharply in late 1989, bursting the asset bubble and triggering a stock market collapse. This caused virtually the entire Japanese banking sector to become insolvent. Rather than see the Japanese banks fail, as in the US Great Depression, the Japanese government pumped in billions of new capital and delayed the recognition of losses, effectively turning the banks into zombie companies. This served only to slow the deflationary process and drag it out over two decades.
Again, Japan’s ‘Lost 20 Years’ was triggered by a monetary contraction and was perpetuated by the Bank of Japan’s continuing intervention in support of their banks. History suggests that the US approach in the 1930’s of letting the storm rage enabled the economy to reset rapidly and led to strong and healthier growth over the long term. By comparison, Japan is still grappling with the problem some 30 years later.
In more recent times, economists have started to challenge old interpretations of deflation. A 2004 study by economists, Andrew Atkeson and Patrick Kehoe demonstrated that in the past 180 years, 65 out of 73 episodes of deflation occurred with no economic downturn, while 21 out of 29 depressions had no deflationary aspects.
Nobel Prize-winning economist, Milton Friedman, argued that deflation arose naturally in a healthy economy and famously stated that “Inflation is always and everywhere a monetary phenomenon”. Indeed, Friedman argued that an optimal approach to monetary policy would target a rate of deflation such that nominal interest rates should be zero.
Friedman was a vicious critic of centralised control and particularly government power that creates artificial barriers, hampering the effectiveness of markets through excessive regulation and protective practices. These prevent the positive effects of price deflation from filtering through to consumers and almost invariably do more harm than good.
With interest rates around the world at historically low levels and an astonishing $12 trillion of global government debt now trading on negative yields, perhaps now is the ideal time to stop fighting deflation and start embracing the positive effects it can have on society.
In practice, of course, governments have been desperately trying to inflate their way out of ballooning government debt levels. By pushing up inflation, governments hope to erode the value of their debt piles without having to raise taxes. The primary mandate of central banks to maintain positive price inflation may, therefore, be nothing more than a slight of hand trick, hiding the true cost of spendthrift governments to society by increasing the cost of living for all.
Disclaimer: The views thoughts and opinions expressed within this article are those of the author, and not those of any company within the Capital International Group (CIG) and as such are neither given nor endorsed by CIG. Information in this article does not constitute investment advice or an offer or an invitation by or on behalf of any company within the Capital International Group of companies to buy or sell any product or security.