A Short History of Deflation

This is a follow-up to my previous post called Why Not Deflation? I argued that inflation, even the modest two percent targeted by the Bank of Canada, strips wealth from people, particularly those on fixed incomes, and was a form of taxation. I cited an interesting article from former Tory MP Maxime Bernier in this regard, as well as speculating on what a deflationary environment might mean. That sparked a comment in Facebook that bears examination.

"Have you got some empirical data?" my reader asked. "I remember Germany had deflation of a few percent during one period in the 70ies which caused major panic there due to a grinding halt in purchases. Only the export market, which was and still is a large percentage of their GDP kept the economy going."

Historically, deflation is often linked to depressions.

Austrian economists have argued that depressions originate with inflation. A steady and constant inflation of the money supply results in boom times that result in mal-investment. Businesses borrow to expand led by the false hope that inflation inspired. When the inflation stops, those businesses that expanded too fast or were under-capitalized find themselves insolvent. They have trouble meeting their debt obligations.

Because of these defaults and bankruptcies, banks tighten credit. They become more stringent in their criteria for who qualifies for a loan. Money dries up. In other words, deflation.

The important thing to note is that deflation is a symptom, not a cause of depressions. Murray Rothbard, in America's Great Depression, notes that there is also an increase in demand for money. There are three reasons for this: "(1) people expect falling prices, due to the depression and deflation, and will therefore hold more money and spend less on goods, awaiting the price fall; (2) borrowers will try to pay off their debts, now being called by banks and by business creditors, by liquidating other assets in exchange for money; (3) the rash of business losses and bankruptcies makes businessmen cautious about investing until the liquidation process is over."

Critics of such measures call it hoarding. It might better be characterized as prudence. In any event, there is a widespread belief that these factors feed on and compound each other leading to more bankruptcies and more unemployment and more tough times. They call this a deflationary spiral.

Contemporary economists, building on the ideas of Keynes, argue that the government should pump money into the economy during a deflationary period. Supply liquidity to tide things over, then when things improve, pay down the borrowed money. Run deficits during periods of crisis and surpluses at other times. The thinking has become so entrenched that even Conservative governments such as Canada's in 2008, pumped out cash to prop up the faltering economy when the real estate boom collapsed.

But the point of my article was not extreme deflation. It was to have a stable money supply. As the Bernier article put it, " If the economy grows, let’s say, by 3% a year, while the money supply grows by 0%, then we will necessarily get price deflation." It would be deflation in the sense of falling prices, not in a drop in the money supply.

My reader asked if there were any periods of deflation in history that were successful, vibrant economies. In fact, there have been.

The Bank for International Settlements (BIS) did a study from 1870-2013 covering 38 economies which shows that there have been many periods of deflation. Their study unveiled the statistics shown below.

As can be seen, inflationary and deflationary periods roughly balanced out until after World War II when inflation became the norm. It's also worth noting that the table looks at goods and services price deflations which they distinguish from asset price deflations.

"A preliminary assessment of the link between deflations and growth does not suggest a negative relationship," the authors say. "Price deflations have coincided with both positive and clear negative growth rates. And a comparison of all inflation and deflation years suggests that, on balance, inflation years have seen only somewhat higher growth. The difference in average growth rates is highest and statistically significant only during the interwar years, particularly in the period 1929-38 that includes the Great Depression (some 4 percentage points), and much smaller at other times. It is the experience of the interwar years that influences the full sample results. Indeed, in the postwar era, in which transitory deflations dominate, the growth rate has actually been higher during deflation years, at 3.2% versus 2.7%." The data is shown in the table below.

So post-war, in those relatively few situations where deflation occurred, the economies involved had better growth with deflation than with inflation.

However, asset price growth is positively correlated with economic growth. This is likely due to the creation of asset bubbles, like the dot-com stock market bubble of the late 1990s and the real estate bubble which popped in 2008. The subsequent asset deflations coincided with a correction in the economy. But this is a separate issue from goods and services price deflation where there is no corrrelation with economic downturns (except for the Great Depression).

The paper goes on to discuss debt driven deflation which I won't go into here.

In another paper presented at the Third Annual Conference of the Bank for International Settlements, economists Michael Bordo and Andrew Filardo note that "in the century before World War I, price levels in many countries declined as often as they rose and, moreover, falling prices were not always associated with recessions. Indeed many deflation episodes were “good” in the sense that they were associated with productivity-driven economic growth."

While deflationary spirals can be ugly, with "self-reinforcing waves of price pressures" moving prices ever lower, these are built to some extent on expectations and fears.

But "theory at least provides some support for the notion that a modest steady-state deflation may be welfare enhancing relative to a modest steady-state inflation".

"In history," they continue, "deflation has often coincided with robust economic growth". But our general view of deflation is skewed by the experience of the Great Depression and the Japanese deflation of the 1990s.

Prior to the Great War, the United States was on a gold standard and inflations and deflations varied with gold rush booms and busts. "Alternating waves of inflation and deflation were an integral part of the commodity-based classical gold standard regime, with a general tendency for falling prices from the 1820s to the mid-1840s; then rising prices following the Californian and Australian gold discoveries in the late 1840s until the early 1870s; then deflation from 1873 to 1896; and finally inflation from 1897-1914 following gold discoveries in South Africa and Alaska."

They go on to discuss various deflations, some good, some bad and some ugly. The article is long, technical in many places and abstruse. By abstruse, I mean conclusions like this. Good bad and ugly deflations can be defined by these formulas:

That's getting to a level of complexity that, for my poor brain at least, amounts to so much jibber jabber.

There are other articles on the history of deflation, but the two cited are the most scholarly. The important thing for the layman is that deflation is not necessarily bad and can often be very beneficial.

Asset deflation, which strongly correlates with negative growth, is problematic, but it is, in my opinion, usually a correction of bubbles which needed to be reined in. Goods and services deflation seems to be a good thing, especially post-WWII, though episodes of this type of deflation are a rarity in a world seduced by Keynesianism and inflation.

It might be worth the Bank of Canada adopting a zero inflation target. It would be an interesting experiment, and one that I, for one, would welcome.

Links of Interest

• Why Not Deflation? – my previous article
• The Costs of Deflations: A Historical Perspective
• Deflation in a Historical Perspective
• My Vocal Profile – a complete list of my articles, short fiction and poems on Vocal