The Benefits of Chronic Deflation
There is an important distinction between good deflation caused by excess supply and bad deflation created by deficient demand.
Good deflation is the result of new technologies that power productivity and output as the economy grows rapidly and as supply outpaces demand. The bad kind stems from financial crises and deep recessions, which increase unemployment and depress demand below the level of supply.
The Industrial Revolution began in the late 1700s. But in the U.S. it didn’t achieve sufficient scope to drive the economy until after the Civil War. Value added in manufacturing and mining leaped. As bottle machines replaced glass blowers, the price of a dozen goblets dropped to just 40 cents in 1888, from $3.50 in 1864.
At the same time, railroads connected the nation, enhancing productivity and supply. Real gross national product grew 4.5 percent each year from 1870 to 1898, an unrivaled rate for a period that long, and consumption per consumer jumped 2.3 percent a year. Good deflation reigned, with wholesale prices dropping 34 percent, a 1.7 percent annual rate of decline, and consumer prices falling 47 percent, or 2.5 percent annually.
Good deflation also prevailed in the 1920s, when the new technologies were electrification of factories and homes and mass-produced automobiles. Electrification contributed to the development of other goods, such as household appliances and radio. Industrial production almost doubled in the 1920s, but prices fell as supply outran robust demand.
By contrast, bad deflation ruled in the 1930s as the Great Depression pushed demand well below supply. The money supply, prices, banks and real goods and services all shrank. As prices collapsed, the jobless rate rose to 25 percent. That depression was truly global, affecting almost every developed country. Industrial production dropped 45 percent in the U.S., 34 percent in Austria, 41 percent in Germany, 12 percent in the U.K. and 23 percent in Italy.
Japan has endured bad deflation over the last two decades after the housing and stock-market bubbles of the 1980s. But the lack of demand wasn’t caused by a dearth of employment and income, as in the U.S. in the early 1930s. Instead, it was a result of the government’s delay in cleaning up financial institutions, while consumers, and later businesses, refused to spend their incomes.
I have been forecasting chronic good deflation of excess supply because of today’s convergence of many significant productivity-enhanced technologies, such as semiconductors, computers, the Internet, telecommunications, robotics and biotechnology, that should continue to increase output. As a result of rapid productivity growth, fewer man-hours are needed to produce goods and services.
At the same time, I am aware that the bad deflation of deficient demand could occur as the result of severe and widespread financial crises or global protectionism. Both are clear threats. Furthermore, I expect slower global economic growth during the next five years or so of deleveraging, for the reasons discussed earlier in this series and in previous columns.
With the completion of the deleveraging process later this decade, the federal budget deficit will shrink quickly, assuming there is no war or other events that cause oversized government spending. The resumption of meaningful economic growth will reduce the pressure for economic stimulus and rising incomes, and corporate profits will boost tax revenue. Serious work on the baby boomer-related bulge in Social Security and Medicare costs will also reduce the deficit.
That means oversized federal spending and deficits are unlikely once the economy resumes normal growth, removing a barrier to deflation. Indeed, deflation may well set in while deleveraging and slow economic growth proceed. The Federal Reserve’s decisions and the elimination of excess bank reserves, however, could create problems.
In his speech at Jackson Hole, Wyoming, last August, Fed Chairman Ben Bernanke said a “potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability.”
This is a serious threat. Bernanke has stated that the Fed could easily get rid of excess reserves by agreeing to sell securities from its $3 trillion portfolio. But things would look different about five years from now, when deleveraging is completed and real growth moves from the current rate of about 2 percent per year to its long-run trend of about 3.5 percent. Even then, it would take at least several years to deploy excess capacity and labor.
In any event, when Wall Street gets the slightest hint that the Fed is thinking about removing the excess liquidity, interest rates will leap and the danger of an economic relapse will seem very real. Political pressure on the Fed might be intense. After about 10 years of deleveraging and slow growth, the central bank might be accused of taking away the punch bowl before the party even gets started.
This recalls the 1937-1938 recession. In 1936, with the economy a long way from full recovery after the 1929-1933 collapse and prices still below their 1929 levels, the Fed and President Franklin Roosevelt worried about a return of rapid inflation. So they tightened monetary and fiscal policy. Real GNP dropped 11 percent. That was less than the 36 percent decline during the Great Depression but more than twice as much as the 4.7 percent drop in gross domestic product in the recent recession.
This time, the central bank may be able to chart a smooth course. It could, for example, simply let excess bank reserves decline by not reinvesting its huge pile of Treasuries and mortgage-backed securities as they mature.
That way, there would be no shock announcement of the Fed shifting course. But there remains a possibility that the Fed’s removal of excess bank reserves could precipitate an increase in interest rates and a very deflationary recession and financial crisis. The Fed, however, might succumb to political and investor pressures to delay the removal of excess reserves. And that could strain the central bank’s credibility and result in considerable financial difficulties.
Growth in real GDP has averaged only 2.1 percent a year in this recovery. This pace has led many economists to join me in forecasting continuing slow growth of about 2 percent.
We point to the deleveraging of the private sector, increased government regulation, fiscal restraint and global protectionism, as well as other causes, such as the aging population, rising health-care costs, growing income inequality, high federal-government debt and poor levels of education.
Furthermore, theory follows fact, and the slow recovery and the 1.6 percent average annual real GDP gains over the last 12 years have spawned theories that the weak pace will persist indefinitely. Recall that in the mid-2000s, steady economic growth with low inflation rates were held as evidence that central banks had essentially eliminated business cycles and had led us to a “Great Moderation.”
Robert J. Gordon, an economist at Northwestern University, maintains that all the growth-driving technologies, such as cheap energy, urbanization, the railroad and electricity, are fully exploited. Recent developments, such as the Internet, computers and mobile phones, have induced only short-term growth spurts, he says, and no big new technologies are likely.
I believe, however, that once deleveraging is completed, long-term trend growth of about 3.5 percent a year will resume. Biotechnology, robotics, the Internet, telecommunications, semiconductors, computers and other relatively new technologies promise tremendous productivity and economic growth.
(A. Gary Shilling is president of A. Gary Shilling & Co. and the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the fourth in a five- part series. Read Part 1, Part 2, Part 3 and Part 5.)
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