When politicians and economists talk about deflation, what they really mean is price deflation; when the cost of goods and services fall. When the credit crunch hit, this became commonly refered to as a “threat of deflation”, which could lead to a “dangerous deflationary spiral”. Conventional wisdom states that it is dangerous because that’s how the Great Depression got started. The drop in housing prices caused a drop in consumer spending, causing a drop in retail and commodity prices, as producers consentrated on reducing inventories, causing a drop in job growth, which led back to a further decline in consumer spending. Around and around it went.
But, does deflation really lead to depression? A good article on this is from Matthew Lynn of Bloomberg which points to a study commissioned by the regional Federal Reserve Bank of Minneapolis. In the study, researchers Andrew Atkeson of UCLA and Patrick J. Kehoe of the University of Minnesota compiled data from 17 countries spanning 100 years.
Deflation, far from being a harbinger of depression, is a natural component of a free and dynamic economy.
“Our main finding is that the only episode in which we find evidence of a link between deflation and depression is the Great Depression (1929—34). We find virtually no evidence of such a link in any other period.
“There are 65 episodes of deflation without depression and 21 of depression without deflation. Thus, 65 of 73 deflation episodes had no depression, and 8 of 29 depression episodes had no deflation. What is striking is that nearly 90% of the episodes with deflation did not have depression. In a broad historical context, beyond the Great Depression, the notion that deflation and depression are linked virtually disappears.”
To simplify this, let’s look at the US inflation rate with special attention on the period 1920 to 1930, the so-called “Roaring 20’s”.
As the chart from Wikepedia shows, the 1920s had two major and one minor deflation episodes. The balance of the decade was deflationary. So why didn’t the Great Depression start in 1922? Why, according to the Buraeu of Labor Statistics, did the 1920’s see an average unemployment rate of 3.3% while most wages rose? What made the roaring 20’s roar; good old-fashioned American technological progress.
In the early 20th Century, American cities were becoming “electrified”, that is, we were building what would become the electrical grid. New equipment was coming online to take advantage of the new source of power. The telephone had recently replaced the telegraph, providing increased communication, and with the automobile, the horse was now a rare sight on city streets. Increased industrial production, better transportation, and an increase in the quantity and velocity of communication all leading to lower prices. The 1920s are a textbook case of how a marketplace is supposed to work. Deflation, far from being a harbinger of depression, is a natural component of a free and dynamic economy.
So, why the fear on the part of our leaders? Sunday, in Part 2, we’ll look at the winners and losers in a deflation episode and see who is being threatened.