Deflation Is Coming, and It Doesn't Have to Be Bad

A specter from the past hovers over the major industrialized nations: deflation. A decrease in the overall price level, deflation was a term relegated to economic history, with the notable exception of Japan following the bursting of its land and stock market bubble in the late 1980s. The everyday experience of the post-World War II generations has been inflation or rising prices. Besides a few exceptions, such as New York Times columnist and Nobel laureate Paul Krugman, many economists, central bankers, and Wall Street strategists primarily fret over prospects for inflation. Sure, prices may be tame at the moment, but inflation’s resurgence is inevitable—or so we’re repeatedly told.

Really? The trend in consumer price indices clearly point toward increasing deflationary pressures. The epicenter of current concern is Europe, with its latest consumer price index reading at 0.7 percent, down from 1.1 percent a month earlier. Spain’s year-over-year inflation rate is at 0.1 percent. Germany sports a mere 1.2 percent annual inflation rate, and a number of smaller, troubled countries are in deflation, such as Greece, Latvia, and Bulgaria. A parallel story unfolds in the U.S. America’s CPI is running at a 0.9 percent year-over-year pace, down from 2.2 percent a year ago.

Here’s the thing: Deflation has become the modern condition. The emergence of deflation isn’t a temporary phenomenon reflecting the economic weakness and high unemployment. No, the underlying trend toward deflation stems from heightened international competition for markets (globalization), widespread migration (immigration), and rapid technological advances ( The Great Recession and the anemic recovery simply accelerated the trend from disinflation and toward deflation.

For the U.S., the return of deflation is a back-to-the-future moment, specifically the 19th century. Deflation was the dominant price movement during an era defined by soaring international trade, technological innovation, and massive immigration. Indeed, the peacetime condition of the U.S. economy lay between price stability and deflation up until the 1960s. The price level soared during wartime, including the ruinous inflations of the Revolutionary War and hyperinflation in the last days of the Confederacy.

Public policy also leans against inflation. In the 19th century the lords of finance praised the virtues of the gold standard for combating inflation. Following the trauma of the high inflation years of the 1970s and early ’80s, central bankers share an anti-inflation ideology. Imagine, a number of Federal Reserve Bank presidents give frequent talks warning about the dangers of inflation even with prices stable and economic growth disappointing. “The European Central Bank (ECB), Fed, and their silly, hyperbolic critics have been so busy worrying about asset bubbles (hyperinflation) and how to exit aggressive programs of asset buying (‘tapering’ in the U.S. jargon) that they have failed to notice a steady drift to outright deflation,” writes John Makin, an economist at the American Enterprise Institute.

How fearful should we be of deflation? It depends on why prices are falling. Bad deflations stems from a “demand shock” in a highly indebted economy, say, a housing market implosion or collapsed banking system (the story of the Great Depression and Great Recession). The downward spiral of debt deflation is potentially ominous. The greater the deflation rate, the higher the real interest rate, the more difficult it is for borrowers to service debts, raising the risk of widespread bankruptcies. The big risk at the moment, especially in Europe, is for the onset of a debt-deflation downward spiral.

Deflation isn’t always bad, however. Sometimes, mild deflation can signal a vigorous, creative, healthy economy. Good deflation stems from a positive supply shock, e.g., a string of major innovations that combine to push down costs and prices while opening up new markets and opportunities. Productivity-driven deflation was common during the last part of the 19th century. For instance, the wholesale price level fell about 1.5 percent annually from 1870 to 1900, yet living standards improved as real incomes rose 85 percent, or about 5 percent a year. The U.S. economy grew threefold, and by 1900 America was the world’s leading industrial power. “The nineteenth century American experience demonstrated that economic growth is compatible with deflation,” concludes economist George Edward Dickey, writing in Money, Prices, and Growth: The American Experience, 1869-1896.

The commonplace assumption is that the zero-bound, quantitative easing and other extraordinary measures taken by the Federal Reserve and, more recently the European Central Bank, are aberrations from the normal ways of central banking business. The belief is misplaced. The unusual will become normal, with deflation the main price trend in a hypercompetitive global economy and quicksilver technological change. The Fed will need to learn more about how to distinguish between deflations reflecting a healthy economy and a fall in prices that threatens to set in motion debt deflation. Thing is, the central bank can’t manage that difficult task on its own. It’s critical that Congress remove an ingrained bias in the tax code favoring debt financing and putting equity at a disadvantage. Encouraging leverage is toxic in a deflation-prone economy. Welcome to the age of deflation.

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