Seven Myths. Nay: Seven Follies (II)

2. Deflation causes persistent depression. Inflation leads to growth.

This is nothing else but the eternal “Phillips curve” or “output-inflation” trade-off myth, dressed in slightly different clothes. Almost four decades after this nonsense was debunked, first theoretically and then by the harsh realities of the 1970s, it still rules the minds of politicians and central bankers alike. Because the old evidence of stagflation and all that should be well known to the readers, let's focus on more recent episodes. But do keep in mind: there was high growth in the 1950s and 1960s, when inflation was very low, there was little growth in the 1970s and until 1982, when inflation was high. After that inflation became lower and lower, and growth resumed. In fact, average growth has been higher between 1992 and today than it was between 1982 and 1992, while the opposite is true for the average rate of inflation. True, never during this period of time we faced a negative growth rate of the Consumer Price Index, still the years during which the inflation rate was below 2% (1986, 1998, 2002) since the stagflation of the 1970s, are NOT years of particularly bad GNP growth, quite the opposite. Historical data are even more interesting: during the 1950s and 1960s, there were many years of very low and even negative inflation and even during that period, low inflation and deflation were not associated with depression. Where does the myth come from, then, apart for the unique episode of the 1929-1939 Great Depression?

Preachers of the deflation scare often mention Japan 1992-2003 as if its lack of economic growth was due to the “deflation spiral”. There was no deflation spiral in Japan: assets were inflated during the 1980s, and their values dropped remarkably between 1989 (which is roughly when the Nikkei picked) and 1996 (when the real estate market first bottomed out). Through ups and downs they never recovered since, and the Nikkei index is now at about 23% of where it was at its historical peak! Now, that was asset deflation on a monumental scale, still the Japanese do not seem to be starving, are they? The very same thing happened in the USA (and around the whole world) in recent months. Hence, we all have already had our major and most needed deflation: asset deflation! Hopefully, the deflation scaremongers are not claiming we need to inflate our assets back to where they were a year or two ago. That would be disastrous: this is an impossible goal and much damage would lie in the collateral effects of trying and failing.

During the same period, in fact after 1992 mostly, Japan also suffered of a relative mild consumer prices deflation, which consisted of near zero inflation for a number of years, with small negative numbers (-1.0% was the biggest, in 2001) during the years 1999-2002. Overall, between 1992 and 2002 the Japanese GDP deflator went from 100.1 to 92.3 (the CPI deflation was half this), while real per capita income grew from 3,878 to 4,244 (that’s about 9.5%) during the same decade. Nothing to write home about, especially when compared to the previous Japanese performances, but not the end of the world either. Most of continental Europe did only marginally better during the same period of time! What’s more important, as we now understand, Japanese low growth rates were not due to deflation and lack of demand but, instead, to lack of incentives for internal investments. Such lack of incentives was due to a crippled banking system where banks were artificially kept alive by allowing them to hoard liquidity beyond any reasonable level. But about this later. The interesting thing is that Japan experienced deflation also in 2003 (-0.8%), 2004 (-.3%), 2005 (-.1%), 2006 (-.3%) and very low inflation in 2007 (.3%). During those years, though, the growth rate of GNP was, respectively, -.3%, +2.7%, +2.95, +2.6% and +2.2%. In other words, Japanese CPI-deflation has continued after 2003, while income started growing again at a pretty substantial rate.

In other words: not only the Japanese experience was not one of major generalized deflation following a big asset deflation twice the size the one we have currently experienced; not only deflation was not associated to a long or even serious depression in Japan but, in fact, after the banking system had been cleansed the recent years of relatively "high" deflation were years or relatively "high" economic growth, whereas during the years before the banking system had been cleansed there was just less growth, not more deflation! More importantly, the Japanese deflation was NOT a spiral and that the country did not collapse. The dramatically negative growth rates we are either observing or expecting in the next few quarters may be due to a variety of bad things (including bad policies) but there is no evidence whatsoever to think they are due to the incipient “deflation”. A very similar analysis of a very similar story could be repeated for the HK experience post-1998, but I will spare the reader a boring repetition.

Given that the statistical and historical evidence does not suggest a correlation (let alone a causation) between CPI-deflation and economic depression, let us consider the two theoretical arguments that “inflation advocates” advance to support their theory and their policy prescriptions. The first is: in a deflationary environment consumers expect durable goods’ prices to drop further in the future, depressing current demand and leading to an even larger decrease in prices, which reinforces the deflationary expectations producing a dramatic downward spiral. Theoretically, this is possible under special circumstances of the kind leading to the existence of multiple equilibria due to search externalities. There are reasons to believe that the substantial public fear created by repeated announcements of disaster to come if this or that bailout plan is not approved - look forward to an Obama's replica of Bush's infamous televised address of September 24th, to push through his version of a "stimulus" package - coupled with the sense of panic that the adoption of exceptional monetary policy measures obviously induces, have created a situation that may be conducive to such bad equilibria. Hence, I cannot exclude such possibility but treat it as (bad) “policy induced”: thinking that the policies that have created the crisis will also get us out of it, is wishful thinking.

Such thinking also omits the fact, obvious to anyone facing pay-cuts or at least freezes, that in a deflationary environment aggregate wages and nominal incomes drop too. In other words, either the deflation scaremongers are asking us to believe that prices will drop but wages will not, so that real income will magically increase (but then: alleluja, let’s deflation rule as we have finally found the solution to all our problems!), or the story of the spiral seems unlikely to materialize even in theory. If you postpone your purchasing waiting for lower prices, you will have to do it with a lower income than today. If, to compensate for the lower expected income, you save some portion of today’s income, then things are fine because today you have actually invested, which is (for the arguments given here) exactly what we need to do. This does not reduce aggregate demand today: it simply changes its composition. The deflation scaremongers, at this point, can only argue that households keep billions of hundred-dollar bills under their mattresses: they do not, but someone else does thanks to the policy BB&Co have enacted (more on this later). In summary: either BB&GWB’s repeated fearful announcements have lead us to an “expectations driven multiple equilibrium environment” (in which case they must reverse their policies and stop talking so much) or the ‘spiral’ argument is nonsense. If the impact that deflation had was to lead us to more saving and investment and somewhat less consumption (which, to a certain extent, it does have) then it would be good, not bad, news.

All these hard facts notwithstanding, it is reasonable to argue that the housing market, both in the USA and in the EU, is in a very low activity state because most potential buyers are waiting to see how far prices will drop, which puts further downward pressure on housing prices, thereby aggravating somewhat needlessly the frequency of defaults. Creating demand for houses, and for durable goods such as cars, would then appear desirable. Desirable it is, but trickier it is also if we want to do it without causing much collateral damages. The reason is the following, which (trust me) is what BB has in mind in his good and benevolent days. He would like to make households believe the following: tomorrow there will be rampant inflation but nominal incomes will not grow, so better start purchasing durable goods now while we can. Once he succeeds in making households believe the above, he wants to make sure to also do the following: do not inflate, instead, as soon as people start purchasing houses and durable goods again, magically lift rates without them (consumers) realizing you are doing so. This way, they will keep spending/producing but there will not be inflation ... Does this sound to you a lot like the circus trick BB and his predecessor tried to perform between 2001 and 2006, breaking all the plates and even a bit of the glasses still standing in the cupboard as a result? Well, indeed: it is the same trick, the results of which we are all currently enjoying. This time, though, BB&Co will perform it right.

The second argument is more cynic: it says that we need to inflate away the debts we are unable to pay back. This is half impossible and half insane, based, as it is, on the idea that the creditors are “someone else” (the Chinese?) and “we” are the debtors. If this were the case, defaulting our debt commitments, like Argentinians have repeatedly done, would be good for us and bad for them at least in the short run - i.e. until the next time we need to borrow: check how those smart Argentinian cheaters are doing in the international financial markets these days! In any case, that is not the case because, today, “them” is “us”!

Imagine, in fact, how a successful form of generalized inflation would work: prices will increase and housing prices will stop falling and maybe rise a bit. The latter must be truly “a bit” and certainly not as much as the CPI will be growing because, as argued above, a realignment of relative prices is needed, healthy and unavoidable. If not, then all the talk about a housing-price bubble would be nonsense, in which case we may as well all go home. Further, a rise in nominal incomes (including wages) of about the same percentage as the CPI wages would be needed for the operation to make sense: if nominal incomes do not grow while the CPI does, we are in even worse troubles because real incomes would be falling and this, after the drop in wealth we have already experienced, would reduce demand even further and, most certainly, increase the rate of default on outstanding loans ... I hope this point is clear, because it is key.

Assume, then, that this inflationary miracle happens: all prices and wages increase of, say, 10% a year for the next two years, housing prices stabilize or raise of, say, 2% and output does not fall. What will happen to financial markets and to banks in particular? Banks, per se, may not care: they are owed nominal loans and owe nominal quantities to depositors and investors, hence as long as those nominal dollars come in from the borrowers the nominal dollars can go out to the lenders/depositors. But, and hereby lies the trap, those lenders are us and we are not as dumb when we act like lenders as we (apparently) are when we act like borrowers. Reason is: interest rates can adjust for inflation, and can do it real quick. Let’s not forget that most of those loans are ARMs, i.e. Adjustable Rate Mortgages, and that Libor, Euribor and all the rest will not sit still out there, should inflation reappear. At which point, you understand, we are back to square one: a 10% inflation implies a 10% increase in nominal rates, which will match the 10% increase in nominal incomes and the real situation of homeowners who are now having troubles to pay their debt will remain exactly the same!

Well, probably not exactly the same because, as we have learned from experience, inflation leads to unexpected and damaging changes in relative prices that lead to economic disruption that leads to, probably, less real income than otherwise. Thank lord that financial markets do not seem (until now) to believe that “BB the defaulter” will succeed: nominal interest rates are going down even in the long portion of the term structure, signaling that banks are taking all the cash he is pumping in, to hoard it and not to spend it. Should they start spending it, interest rates will spike up in a matter of weeks, and the whole mess would be even worse than it now is.
In summary: we needed huge asset deflation, and we have already got it with the drop in the value of houses and stock. To this long-needed asset deflation there will follow a mild CPI-deflation due, among other things, to the fact that the components of cost due to those assets are now lower. Both evidence and theory suggest that such a mild deflation, per-se, does not cause a 'spiral' or a depression as it simply brings about a realignment in relative prices that seems highly needed. If a depression comes, experience shows, it is because the banking system and financial markets remain "clogged" and not operational. This is where the attention of policy makers should focus, not on deflation.

Further, should the "inflationary plan" that BB and associates are advocating succeed, we would be worse not better off than we are now, as we would just have stagflation instead of just a deep recession. Finally, there is the expectation-formation component of current monetary and fiscal policies, i.e. the fact that by looking at a government and a Federal Reserve that are scrambling to take extreme actions, private agents will (reasonably) interpret such actions as a sign that the "government knows something we do not know, and that something is really bad", hence sell those stocks and cut down investment plans because the end of the world is coming. It might, but if it should I will argue BB&Co have brought it upon us.