Why worry about deflation?

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Our perception that inflation is the normal condition is no more than a reflection of the experience of people alive today. In 1913, unlike now, a pound or a dollar would have bought the same goods as a century earlier. The longest semi-official price series we have reports a 140 fold rise in prices in the UK since 1750 — but even then all the increase up to 1938 is accounted for by inflation during the Napoleonic and first world wars. Indeed, while the price level roughly doubled during both these episodes, it fell slightly over the rest of the period.

This historical perspective may offer a partial antidote to the fears of investors over the arrival of deflation in Europe, where a euro today buys more than a year ago. But there are other reasons not to panic. For one, there is no qualitative difference between an economy in which prices are rising slightly and one in which prices are falling slightly. Unlike water, liquid at temperatures above 0C and solid below, the consumer price index is a complex statistical construct not a physical fact. You can see and feel the difference between ice and water, and you can skate on one but not the other. Similarly, with a commodity such as petrol, you can tell whether the price at the pump is rising or falling because petrol is a homogeneous product that changes little over time.

But what has been happening with cars, or smartphones, or medical services? In the CPI, the price component for cars comprises the sticker price adjusted for changes in quality. Such quality adjustment is subjective — and, it is generally conceded, too low. So we could have been experiencing deflation for years without realising it.

Moreover, the surface of a pond will be cold enough to skate on when the average temperature of the whole pond (ice on the surface and water beneath) is well above zero. With a good deal of effort you could compute the average temperature of the entire contents of the pond. But the answer will not tell you whether it is safe to skate.

The central point is that the significance of a fall in a price index depends on the causes of that fall. The declining price level in the second half of the 19th century was the result of rising manufacturing productivity and the opening up of new lands, particularly in North America. Global grain prices tumbled from the end of the US civil war until the 1890s. This raised real industrial incomes in more advanced economies but also reduced agricultural rents — the beginning of the end for the Old World’s landed aristocracy. The 19th century technological developments and shifts in global trade patterns have obvious parallels today in the development of a digital economy and the rise of China, which have similarly contributed to the fall in the inflation rate since 1980.

On the other hand the deflation, and the associated depression and social strife, that Britain experienced between the world wars was largely the result of a misguided attempt to restore the 1914 exchange rate against the dollar. Prices in Britain fell steadily after 1920 until President Franklin Roosevelt finally wrecked the gold standard at the London Conference on exchange rate stabilisation in 1933.

This dismal economic policy and economic performance finds modern parallels, too — here, in the travails of the eurozone. Falling prices have often been associated with economic transformations or recessions; but, contrary to the fears and hopes of investors, price deflation is the effect rather than the cause.

The development that is tipping western economies into “deflation”, defined as a negative year-on-year change in CPI, is the fall in energy prices, which is good news for importing countries.

Raised body temperature might be a sign of fever or the result of a relaxing hot bath: it is wise to determine which it is before you start to worry, far less prescribe remedies.

This article was first published in the Financial Times on January 28th, 2015.

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