"Deflation - The Disease or the Cure"

                 Sydney M. Williams

Thought of the Day

“Deflation – The Disease or the Cure?”

November 20, 2014

Caveat – I am not an economist, so the opinions expressed are mine based on little education, some experience and selective readings. Those more knowledgeable than I might properly challenge my findings. My bottom line is that modest deflation and inflation, by which I mean one or two percentage points, are not reasons for concern. It is when we get rapid changes in either direction that trouble ensues, as the U.S. experienced in the 1930s with deflation and in the 1970s with inflation, and which other countries have undergone to far greater extremes.

We live in an age of technological wonderment, not dissimilar to the closing decades of the 19^th Century when the fruits of the Industrial Revolution were being harvested. The European Space Agency was able to land a vehicle on a comet 300 million miles away, yet only two and a half miles wide, and which was traveling at 40,000 miles per hour. The journey began on March 2, 2004 in French Guinea when the spacecraft Rosetta lifted off on what would be a journey of 3.8 billion miles and which took more than ten years. By any measure this was an extraordinary feat.

Technology has changed our everyday lives in myriad ways, from e-books to smart phones, from home security systems to cars that drive themselves. Technology, along with the lowering of trade barriers, has allowed businesses to design products in one place and produce them somewhere else, lowering prices for consumers – a benign form of deflation that we should celebrate, despite politicians using the term to conjure images of potential catastrophes.

About a week ago John Cochrane, professor of finance at the University of Chicago, penned an op-ed in the Wall Street Journal titled “Who’s Afraid of a Little Deflation?” I read it, and exhaled, finally! Is it possible that we may be exiting an eighty-year period during which deflation, because of the 1930s, has been seen only as a portent of doom? During the 19^th Century deflation was seen as compatible with economic growth.

Using an historical price converter produced by British mathematician and computer scientist, Stephen Morley, average prices in the UK declined 12% between 1800 and 1900. While that seems incredulous, that is what the calculator calculated. (Keep in mind, following the Battle of Waterloo the European continent was largely quiet from a military perspective.) The Industrial Revolution allowed manufactured goods to be produced both cheaper and in more plentiful supply. Global trade reduced bottlenecks between sourcing raw materials, manufacturing and consumption. That same price converter indicated that in the next 100 years prices rose from 100 to 7300, understandably as Europe endured multiple revolutions and two world wars. Price increases also reflected the increased use of debt, with deficit budgets becoming the norm, no longer the exception. UK GDP, according to data from the Bank of England, during the period 1800 to 1900 rose about fourteen times, versus about seven fold for the next 100 years. Deflation did not appear to impede economic growth.

We are again living through a period of rapid productivity improvements, driven by technology and increased global competitiveness – both positive drivers of deflationary forces and economic growth. Admittedly, we do have a War on Terror, but it should not be as economically devastating as were the two world wars to the last century.

There is no question that inflation favors borrowers and deflation benefits savers. A debt-heavy nation will always opt for inflation and the debasement of its currency. It makes more sense to pay obligations with a currency worth less than it was at the time they were incurred. Since 2000, the nation’s GDP has risen 63%, while federal debt is up 193%. Over that same time the Dollar has lost more than a third of its value. Is that the path to sustainable growth?

Deflation Bears cite the effect of deflation on wage growth – that without inflation, wages would decline or stagnate. If deflation is solely a consequence of falling demand that may be true, but deflation can also occur because of productivity improvements and globalization. In the latter case, those who argue that wage growth is more closely aligned with employment numbers than with any fears of future inflation or deflation may be closer to the mark. Weak employment numbers, such as we have experienced for the past five years, have been a drag on wage inflation. But, and despite very low work-force-participation numbers, the employment situation is improving, with unemployment having fallen from over 10% to under 6%. If the current trend holds we should be close to the time when wages will rise naturally. In frustration, Congress may legislate an increase in the minimum wage, but the consequences may not be what the reformers intend. Such decisions, without economic footings, are not likely to prove successful.

Since 1977 when Congress amended the Federal Reserve Act, the Federal Reserve increased its responsibilities. It is now charged with maintaining maximum employment, stable average pricing and moderate long-term interest rates. When objectives are not complementary, the Fed attempts a balanced approach. The Amendment, in my opinion, reflected an abrogation by Congress of their responsibility for fiscal policy. Congress is better positioned to influence employment numbers than the Federal Reserve. They can raise or lower taxes and tighten or loosen regulation. With Congress choosing to renege on their obligation, the consequence has been to becloud the distinction between fiscal and monetary policies. If the Fed’s only job was to maintain stable average prices, it is a valuable service if it allows the nation to avoid the unpleasantness of the 1930s and the 1970s.

The risks of the current policy, it seems to me, lie with Dollar debasement, more a consequence of inflation. A federal government that owes so much does not willingly repay its obligations in Dollars worth more than the ones they borrowed.

Concerns over deflation have been inflated, in my opinion. Modest deflation is neither a disease nor a cure. The best of all possible worlds would be very slight deflation and a tight labor market. It would suggest a world in which consumers and savers would benefit – the latter, a growing constituency in an aging population. It would discourage the use of debt for purposes other than productive investments. Politicians who have no problem with a depreciating currency express concern that a dollar might buy one or two percent more next year than this. It makes little sense.