Deflation is the natural state during an era of expanding markets and technological innovation.
Chris Farrell, Deflation
In May inflation hawks got what they had been praying for these last twenty years--a blip upwards in the CPI that might justify their long vigilance and repeated calls for destructive interest rate hikes by the Fed. Indeed, the Fed did respond with a quarter point increase, only to have the June numbers show that producer prices had actually fallen, not risen. And so, once again, for the umpteenth time over the past two decades, we receive confirmation that not only is inflation whipped but the primary pressures on prices are not inflationary but deflationary.
This represents such a momentous change from the nightmare of the 70s that folks have had an understandably hard time processing it, but what's not understandable is the failure to discuss and face up to what its implications might be. The last great deflation came during the Depression and was obviously catastrophic. Japan has spent about a decade in the grip of deflation and has had terrific difficulty getting out of it and getting its once mighty economy growing again. Given these precedents one would think that folks would be as concerned about deflation as about inflation, yet the topic is seldom even mentioned in the mainstream media.
One of the few journalists who has sought to bring the issue to the fore is Chris Farrell, contributing economics editor at Business Week and a host and essayist for several of NPR's economics shows. This book caps his efforts and offers an invaluable guide to how we've gotten to the point where a long period of deflation is a real possibility if not already a reality and what the potential consequences might be--good and bad.
Rather than my restating the case he makes, here's an extended excerpt from the book, one easily found on-line, that explains the structural forces behind deflation and offers hope that this will be a period of largely beneficial deflation like the one we experienced at the end of the 19th Century:
Deflation in America reflects fundamental changes on the economy's supply side. At the same time, a new international monetary system has evolved that contains a bias toward lower prices. Deflation is built on three fundamental changes dating back to the late 1970s and early 1980s: (1) the embrace of market capitalism at home and abroad; (2) the spread of information technologies; and, most importantly for understanding the economy of the next half-century, (3) the triumph of the financier. None of these factors is new, but what is surprising is how powerfully each change has informed and reinforced the other.
First is globalization -- that abstruse, abstract word frequently invoked by everyone from politicians to business executives to trade protesters. Globalization is really the spread of market capitalism. Communism's collapse in Eastern Europe and the former Soviet Union, the embrace of freer market's by China's profit loving mandarins, and the turn toward market capitalism by many authoritarian governments in the developing world led to enormous increases in global commerce, international investment, and immigration flows. For instance, in 1980, only 25% of developing countries were manufacturers. By 1998 that figure had swelled to 80%. Trade as a percent of America's GDP -- the sum of exports and imports of goods and services -- was 13% in 1970. It is now around a third.
The U.S. has absorbed more than 1 million immigrants a year for the past two decades. More than 12% of the American workforce was born overseas, and almost one in five residents speak a language other than English at home.
Taken altogether, competition for markets, profits, and jobs is white-hot, keeping managers and employees on their toes, encouraging creativity and pursuing efficiencies. Capitalist competition and innovation are a force for low everyday prices. Global excess capacity for all manners of goods and services, old and new, is pulling prices down. "That excess capacity is a function of decades of development strategy by successful emerging economies, whereby they sought to create enough capacity to satisfy fully their own domestic needs plus a margin left over to serve export markets," says James Griffin, consulting economist at ING Investment Management. "This goes beyond a low-frequency cycle; it is more like an era."
It is this ratcheting up of capitalist competition that accounts for the rise of the second major factor behind deflation: the Internet and other advanced information technologies. The integrated circuit was invented in the late 1950s, IBM revolutionized computerized data processing with the development of the 360 series in the mid-1960s, and Time Magazine named 1982 the "Year of the Computer" as personal computers gained widespread acceptance. Yet it wasn't until the 1990s, after a long gestation period and the commercial development of the Internet, that business finally started figuring out how to harness the power of high-tech gear by reorganizing the workplace. The Information Age came into being because intense price competition forced management to invest in high-tech gear to boost efficiency and shore up profits.
Innovation doesn't have a straight-line impact on growth. Picture this: a chart with an S-shaped curve. Whenever a major new technology is introduced into an economy or workplace, workers and managers struggle to master unfamiliar skills. Learning how to exploit a frontier technology takes years of experimentation and organizational reshuffling. Over time, though, both management and labor move up the "experience curve." Gains in output per worker showed up in lower prices and higher quality that, in turn, put additional downward pressure on prices. The beauty of the economic impact of the high-tech sector is that it actually lowers inflation as prices drop.
The third factor is a new international monetary system that washed out inflation. The new system is based on a shared commitment among central bankers that their job is to prevent inflation and keep prices stable. And the commitment needs to be firm and credible since the link between currencies and a commodity like gold and silver was severed in the 1970s. Nations adopted a "fiat" system where the value of a dollar, mark, franc, yen, or other currency was backed by the full faith and credit of government.
Central bankers made a number of devastating mistakes in the early years of fiat money. But eventually central bankers in Washington and London, traders in New York and Shanghai, and investment bankers in Frankfurt and Chile, came to share a common ideology or worldview: Inflation is always bad. In America, Paul Volcker and his successor Alan Greenspan gradually contained inflation through a long, cumulative process called disinflation, or lower inflation rates. The CPI for the major industrial nations peaked at more than 13% in 1980; by 2003, CPI inflation had declined to an average of less than 2%. The comparable figures for the U.S. were 14% and 1.5%. Business and consumer expectations of higher prices moderated over the years.
The commitment to price stability goes far beyond the abilities and desires of any central bank. Alan Greenspan and his peers have no choice but to contain inflation since the global capital markets are even more important than monetary policy in dampening inflationary pressures. Investors abhor inflation since it degrades the value of their investments. So, in today's tightly integrated capital markets, linked satellite and fiber-optic communications networks that span the globe, financiers will flee any currency that shows signs of inflation. The global stock and bond markets are a "giant voting machine" that limits the ability of governments or central bankers to tolerate inflation. Investors force central bankers to stick with anti-inflation strategies.
Put it this way: Does anyone really believe the Fed will tolerate a sustained rise in the overall price level? To be sure, there's a debate among economists whether the Fed should have tightened a month or so ago or whether it should still wait few more months. The Fed is still a credible inflation fighting institution.
Deflation is not synonymous with depression. The conventional notion that a persistent decline in prices is always a disaster, an economic disease to be avoided at all costs, a depression in the making, is wrong. University of Minnesota economist Timothy Kehoe examined the record of deflation in 15 countries over 100 years. There were indeed a number of episodes when nations experienced both deflation and depression. But it was more common for economies to grow during periods of deflation.
Hyper-deflation, say a 1930s deflation rate of 5% to 10%, is ruinous. Period. The record is mixed when it comes to mild deflation, say a rate of 1% to 2% a year. Sometimes, mild deflation signals a vigorous, healthy economy. What matters are why are overall prices persistently falling. Bad deflation stems from a "demand shock" perhaps a bankrupt banking system or some other trauma that pushes a weak economy into a downward deflationary spiral. Good deflation can co-exist with strong economic growth when the primary cause is a "supply shock" coming from a string of major technological innovations that push costs and prices down, strong productivity improvements, consumer and business gains from freer international trade, and the like. "Such benign productivity-driven deflation was a common occurrence during the last part of the nineteenth century, when people routinely looked forward to goods getting cheaper," says George Selgin, economist at the University of Georgia.
You have to go back to the 1800s to find examples of persistent supply side deflation, especially in the late 19th century. Like now, the last third of the 19th century and the early years of the 20th century were defined by the rapid emergence of an integrated world economy. International trade flourished. The volume of world foreign trade per capita was more than 25 times greater at the end than at the beginning of the 19th century. It was an era of astonishing technological and organizational innovation. Immigrants crossed borders in astonishing numbers. This was also the period of the international gold standard. A shared belief, a commitment to the economic and political benefits of the gold anchor, facilitated international commerce and investment, and kept the price level stable to down.
Deflation and better everyday circumstances went together in America. The wholesale price level fell about 1.5% annually between 1870 and 1900. Living standards improved as real incomes rose by 85%, or about 5% a year. The U.S. economy grew threefold as America went from an agricultural republic to an industrial empire. In the 1860s, America's industrial output lagged behind Germany, France, and Great Britain. By 1900, the U.S. had became the world's leading industrial power with a combined output greater than its main European rivals. The supply side of the economy, including trade, technology, business organization, and immigration, put enormous downward pressure on prices. Writes George Edward Dickey in Money, Prices, and Growth, The American Experience, 1869-1896: "Such a supply or cost-induced deflation does not have the same deleterious effects as a demand-induced fall in prices.... Deflation in this case is a direct result of the rapid growth of output and is not an inhibitor to growth.... The nineteenth century American experience demonstrated that economic growth is compatible with deflation."
What about stock and bond returns? Stocks returned an average of 8.5% a year and bonds 6.6% from 1870 to 1900. Hardly a disastrous return on investment considering that the long-term return on stocks averages 7% and bonds 3.5% since 1802, according to data compiled by Jeremy Siegel, professor of finance at the Wharton School.
Innovation, creativity, and risk taking are the essence of capitalist growth. The most famous proponent of this way of looking at economic life is Joseph Schumpeter, one of the 20th century's intellectual giants. Schumpeter is best known for his evocative metaphor "creative destruction." It captures the process by which new technologies, new markets, and new organizations supplant the old.
The economic return from the forces driving price level toward deflation is showing up in the productivity statistics. Productivity measures output per hour of work. It is the number economists really care about because the productivity growth rate is the foundation of higher living standards. Strong productivity growth translates over time into more output and lower prices. Productivity growth has averaged 3% a year since 1995 and 3.6% over the past five years—that's more than double the productivity performance of 1973 to 1995. Companies have plenty of leeway to maintain profit margins and keep selling prices stable to down even if management does raise wages. "Ultimately, productivity growth is what determines our living standards, the competitive advantage of companies, and the wealth of nations," says Erik Brynolfssohn, economist at MIT.
-EXCERPT: The Roots of Deflation (Christopher Farrell, 5/14/04, Business Week)
If Mr. Farrell is right and technology, free trade, out-sourcing, a Fed dedicated to fighting inflation, a more mature international monetary system, and all the rest act as natural brakes on price increases--and it's hard to imagine a credible economist denying any of these are factors--then we have to imagine a reversal of most of the trends of the past twenty years in order to conceive of a scenario where sustained inflation might return. It seems far more likely though that currently benighted regions of the world will continue to develop economically and politically--it's The End of History after all--that more and more workers will gain the minimal skills and education needed to do the work that modern economies require, that trade barriers will continue to fall, and that technological innovation will continue apace. The stage would appear to be set for a not inconsiderable epoch of deflation. Read Mr. Farrell's very fine book and you'll be thrilled to see that this portends many happy things for our future.
"We see, therefore, that rising prices [inflation] and falling prices [deflation] each have their characteristic disadvantage. The Inflation which causes the former means Injustice to individuals and to classes--particularly to investors; and is therefore unfavorable to saving. The Deflation which causes falliing prices means Impoverishment to labor and to enterprise by leading entrepreneurs to restrict production, in their endeavor to avoid loss to themselves; and is therefore disastrous to employment.... Thus Inflation is unjust and Deflation is inexpedient.[...] But it is not necessary that we should weight one evil against the other. It is easier to agree that both are evils to be shunned."
"We leave Saving to the private investor, and we encourage him to place his savings mainly in titles to money. We leave the responsibility for setting Production in motion to the business man, who is mainly influenced by the profits he expected to accrue to himself in terms of money. Those who are not in favor of drastic changes in the existing organization of society believe that these arrangements, being in accord with human nature, have great advantages. But they cannot work properly if the money, which they assume as a stable measuring-rod, is undependable. Unemployment, the precarious life of the worker, the disappointment of expectation, the sudden loss of savings, the excessive windfalls to individuals, the speculator, the profiteer--all proceed, in large measure, from the instability of the standard of value." [...]
The Individualistic Capitalism of today, precisely because it entrusts saving to the individual investor and production to the individual employer, presumes a stable measuring rod of value, and cannot be efficient--perhaps cannot survive--without one.