I almost always skip the opinion section in nearly every publication that I read. When I do read an opinion piece, it’s because it’s written by someone that isn’t affiliated with the editorial board and someone that I admire.
Back in November, I read an editorial in the Wall Street Journal by John Cochrane, a respected University of Chicago professor and one of the world’s leading experts on central banks and monetary policy.
He also writes a blog, The Grumpy Economist, that I read occasionally, and although I definitely don’t agree with everything he writes (or understand all of it for that matter), it’s always interesting. He also happens to be Gene Fama’s son-in-law.
The opinion piece is provocatively titled, ‘Who’s afraid of a Little Deflation,’ (found here, though a subscription may be required), and he writes that a little bit of deflation might not be a bad thing.
Deflation is the general decrease in the price of goods and services, which is the opposite of inflation (and is sometimes called negative inflation).
It’s a terrible condition because falling prices leads to lower consumer spending which is a major component of economic growth. Furthermore, falling prices leads to debt defaults and bankruptcies, which turns into layoffs and wage reductions that leads to falling demand, which then turns into even lower prices.
What’s more, it’s a difficult problem to break out of – the Japanese have been dealing with it since the early 1990s. If inflation gets out of control, you can break the cycle with higher interest rates, but interest rates can’t really go below zero (they have, but it’s new and small so far), so the options are limited.
It was pretty surprising, therefore, to see Cochrane make the case that some deflation isn’t so bad. The scenario that I described above is the true death spiral and he says that would be a real problem. But, what if deflation ran at negative one or two percent for a number of years?
He thinks it might not be so bad because it would actually take three percent deflation to offset the standard three percent annual raise, so most workers would be unaffected if deflation were contained.
Regarding the debt problem that I referenced above, Cochrane essentially says that if deflation is slow and steady, it takes a very long time for an actual problem to develop.
He makes several more well articulated points that I won’t cover, to conserve space, but it’s a fascinating article and he doesn’t seem too worried and recommends that we all relax.
A different article, published by the Director of Research at the St. Louis Federal Reserve (and one of my neighbors), essentially said the same thing in an article that you can find on his blog Macro Mania, by clicking here.
He points out that after the Civil War in the US, we enjoyed substantial economic growth and deflation. Recognizing that this was more than a century ago, he then points to Japan following the 2008 financial crisis, which has experienced higher real per capita economic growth during a period of falling prices.
At this point, I have to admit that I’m still afraid of deflation, but the articles have got me thinking. Maybe the conventional wisdom isn’t wholly right. It seems likely to me that if investors really thought that Europe was on the precipice of a deflationary spiral, their assets would be doing a lot worse.
European stocks actually gained four or five percent last year, but because the dollar was strong, US investors lost around six percent. Those aren’t great numbers, but they aren’t the worst either.
Either way, we’ll be watching to see what the ECB does later this month with bated breath.