Thursday, November 13, 2014

Who is afraid of a little deflation?

Who is afraid of a little deflation? Wall Street Journal Op-Ed.

Fears of "tipping" into deflation are overblown. I poke a little fun at sticky wages, Fed headroom, deflation-induced defaults and the long-predicted Keynesian deflationary spiral that never seems to happen, and the doom and gloom language from the ECB, IMF and other worriers who just happen to (of course) want to spend trillions to fix this latest "biggest economic problem."

One point that went by a little too quickly in the interest of space: Deflation can be a symptom of bad things. The issue is whether deflation is by itself a bad thing, and causes further damage.

Also, I should have been clearer on a big bottom line: we don't need huge "infrastructure" projects just to save us from deflation.  

They ask me not to post the whole thing for 30 days, so those of you without WSJ access will just have to google or wait breathlessly.

Update: Ed Leamer wrote a great similar piece for Economists' Voice a while back "Deflation Dread Disorder; 'The CPI is Falling!'"  In addition to a better title, he's got a cool Godzilla reference and picture.


  1. If you aren't a little afraid of deflation you aren't paying attention.

    1. There is nothing to be afraid of - it's necessary and long overdue.

    2. Interesting how Cochrane dosesn't seem to understand supply and demand. 2% deflation implies that demand is low relative to the supply. Cochrane also hypothesizes that productivity is increasing 1% per year, and that wages are not falling. So the amount of employment is constant, so the number of goods being produced each year is increasing. So business is cutting into it's profit margins to lower prices to try and push the ever increasing supply out the door. That model doesn't sound realistic to me.

    3. You are missing an important point there: technological progress. If you consider falling prices due to improvements in production processes and facilities, business does not necessarily cut into its own profit margins (as long as costs fall at a higher rate than prices).

      In this context it is important to understand that there are different types of deflation depending on wheter it is triggered from the demand side or from the supply side. For further information check out thislink.

  2. just wondering if you read the jeff sachs piece a few days ago. and what, if anything, you thought of it.

    1. Sachs: We need long-term public-investment strategies, environmental planning, technology roadmaps, public-private partnerships for new, sustainable technologies, and greater global cooperation. These tools will create the new macroeconomics on which our health and prosperity now depend.

      Grumpy: He's arguing for vast government investment in energy boondoggles that by definition do not earn a positive financial rate of return. It is unclear by what mechanism he thinks this spending is going to improve overall economic prosperity. Summers argues keyensian stimulus of this stuff overcomes "secular stagnation." But Sachs claims not to be keynesian. Perhaps I'm just less enthusiastic about government ability this time, for real, we mean it, to pick good projects not boondoggles.

    2. John,

      "He's arguing for vast government investment in energy boondoggles that by definition do not earn a positive financial (nominal) rate of return."

      Do those government investments yield positive REAL earnings and how should those earnings be dispersed to the tax payer?

    3. This comment has been removed by the author.

    4. Example:

      Government borrows $10 million at 4% for 30 years and has a windmill built and maintained. Windmill over its 30 year lifetime generates 1000 kW x 24 Hrs / Day x 365 Days / Year x 30 Years = 262.8 Gigawatt-Hours of electricity over its lifetime. A market price of $0.075 / kW Hour yields earnings of $19.71 million. Total cost (including financing) is $22.00 million. Nominal return on investment is $19.71 / $22 - 1 = Negative 10.5% - The investment is not profitable.

      At an electricity cost of $0.075 / kWH, that $10 million investment buys 133.33 Gigawatt Hours. The government instead invests in a windmill to produce 262.8 Gigawatt Hours over 30 years. Real return on investment is 262.8 GWh / 133.33 GWh - 1 = Positive 97%.

      Does the real return justify the investment even when the nominal return is negative? For a profit seeking enterprise that can go bankrupt - no it does not. For a not for profit enterprise - yes it does.

      Boondoggles do not generate a positive nominal or a positive real rate of return - think digging holes in the ground.

      The problem with government appropriations is not in identifying worthy projects. It is in making sure that only worthy projects get funded - it is a political I scratch your back and you scratch mine problem.

      What Sachs fails to address is how to overcome the politics of government appropriations.

    5. I've never known Sachs produce anything but hot air, and the above article of his is just the latest example.

    6. I agree with the sentiments expressed above regarding federal outlays for dubious infrastructure projects. I just wish the same gimlet eyes would be applied to the 10 trillion dollars the US will spend on national security in the next 10 years. Also, what has been our return on the trillions invested in Iraq and Afghanistan?

    7. "He's arguing for vast government investment in energy boondoggles that by definition do not earn a positive financial rate of return."

      You mean like the Hoover dam?

      More seriously, where does the "by definition" come from and should society care if a public investment yields a "positive financial rate of return" if it generates enough consumer surplus that there is a positive total benefits return. We do not ask that the public school system generate a "positive financial rate of return."

    8. Absalon,

      "More seriously, where does the by definition come..."

      The federal government does not operate with a profit / loss statement. If a government investment is not profitable, then it retains the ability to cover investment and / or financing costs through taxation.

      "...should society care if a public investment yields a positive financial rate of return?"


      All that being said, government should be beholden to a standard when selecting investment projects, profitability is not that standard.

    9. Cochrane apparently is unaware of economies of scale. By helping to build out, say, wind energy, production ramps up. Across a broad range of industries, increasing production by a factor of 10 reduces price by a factor of 2 because of economies of scale.

      Frank Restly is apparently unaware of the EIA estimates of levelized costs for wind energy. A more realistic estimate is $5 million for a 5MW plant operating 20% of the time financed at 2% interest over 7 years.

    10. Cesium,

      I was pulling numbers out of a hat to provide an example - you are correct, I didn't have an EIA estimate nor do I build / operate wind mills for a living.

      And really on a 30 year horizon, I came pretty close. Over 30 years the government would need to build about 4.29 windmills. Assuming that 7 year financing remains at 2% over those thirty years and construction costs hold so that each new windmill can be constructed and maintained for $5 million, total construction, maintenance, and financing costs for the 4.29 windmills is:

      4.29 * $5 million * ( 1 + 7 * 2%) = $24.4 million.

      In my example

      1 * $10 million * ( 1 + 4% * 30 ) = $22 million

      I am using non-compounded (coupon) interest. If a private enterprise were doing this, they would be paying amortized interest.

  3. guys: wsj let me through the paywall. go through google.

  4. I guess my comment got eaten by the internet. So here it is again.

    No, I am not afraid of deflation. We have had inflation and zero interest rates for 6 years now. It has gotten really old and it has chewed a hole in my pocket. If we are going to have zero interest rates, deflation would take some of the sting out of it.

    However, what I really want to know is why does anybody think that the Fed has the authority to promote inflation (i.e. its so called 2% target). Inflation is a tax on savings, and only Congress can lawfully impose taxes on the American People. The Fed should promote price stability.

    1. The fed also has a mandate to maintain full employment.

  5. Totally agree! Economists always treat symptoms of diseases as diseases.

  6. Thank you, Professor, for an excellent piece on deflation. We should all have concerns about the Fed’s attempts to return to an inflationary cycle. Who is the world’s largest debtor? Who stands to gain most from inflation? Whenever I hear a member of the Fed defend their inflationary policies, I’m reminded of what may be Saturday Night Live’s greatest bit of all time, Dan Aykroyd as President Jimmy Carter and his “Inflation is Your Friend” speech. This was during our worst inflation years in the late 1970s. For your younger readers who won’t remember it, here is the transcript. Unfortunately, the video is unavailable.
    [ open on Presidential seal ]

    Announcer: And now, a special message from the President of the United States.

    [ dissolve to Oval Office ]

    President Jimmy Carter: Good evening. On Tuesday, we Americans will have the opportunity to exercise our role as citizens in a free democracy. Yet, only a third of the eligible voters will actually cast ballots. The other two-thirds are, in a sense, very lucky. Because they do not know what's going on.

    Last week, I delivered a message on inflation. Since then, the dollar has dropped in value, the stock market has sustained record losses, and the whole sow price index increased 0.9%. In other words, our economic system is screwed, blued and tatooed! We just have to face the fact that there is simply no way to fight inflation in a capitolly-intensive, highly-technological, conflict-riddled, anything-for-a-thrill world of today. That's why, tonight, I want you to try to look for in inflation, an entirely new word: Inflation is our friend.

    For example, consider this: in the year 2000, if current trends continue, the average blue-collar annual wage in this country will be $568,000. Think what this inflated world of the future will mean - most Americans will be millionaires. Everyone will feel like a bigshot. Wouldn't you like to own a $4,000 suit, and smoke a $75 cigar, drive a $600,000 car? I know I would! But what about people on fixed incomes? They have always been the true victims of inflation. That's why I will present to Congress the "Inflation Maintenance Program", whereby the U.S. Treasury will make up any inflation-caused losses to direct tax rebates to the public in cash. Then you may say, "Won't that cost a lot of money? Won't that increase the deficit?" Sure it will! But so what? We'll just print more money! We have the papers, we have the mints.. I can just call up the Bureau of Engraving and say, "Hi! This is Jimmy. Roll out some of them twenties! Print up a couple thousand sheets of those Century Notes!" Sure, all these dollars will cause even more inflation, but who cares? Everyone will be a millionaire!

    In my speech last week, I said that America would have to undergo an austerity program, but since this revolutionary new approach welcomes inflation, our economy will be free to grow, and we can spend, spend, spend! I believe the watchwords for the 80's should be "Let's Party!" And in that spirit, I'd like to say, "Live, from New York, it's Saturday Night!"

  7. Can you please explain how you can go from warning about inflation repeatedly over the past few years, to now defending deflation - all without being wrong when you predicated inflation? If you were wrong about inflation, what does that suggest about the policy options you advocated and / or opposed? In other words, what does it take for you to admit you were wrong? Thanks.

    1. I did not "predict inflation." This is one of Krugman's many calumnies. (Look that one up.)

    2. Speaking of Krugman, I came across a recent interview where he advocates for a single-payer health care system and a 70% top marginal tax rate for both the income and capital gains taxes. If I'm not mistaken this would give the U.S. the highest capital gains rate in the world by a huge margin.

      I'm not sure which seemed more bizarre to me: the fact that he claims none of this would have seemed politically radical 20 years ago, or that he equates these tax policies as somehow being a return to the post-war generation. I thought it was pretty much universally acknowledged by economists that the high nominal rates during those years were mainly symbolic- that rates were higher in the 50's and 60's, but the official definitions of income and taxable income were also much narrower back then.

    3. Link to the interview

    4. lmgtfy:
      Nope, France has a 75% top marginal tax rate.

      Looks like you should stop using your faith-based reasoning and try some evidence-based reasoning instead.

    5. Cesium- go back and read what I actually wrote again before accusing me of "faith-based reasoning".

      My exact quote: " If I'm not mistaken this would give the U.S. the highest capital gains rate in the world by a huge margin"

      Your link is for regular income tax rates, not capital gains. The top long term capital gains rate in France appears to be 38%. The highest highest OECD country is Denmark at 42%. So yes, the 70% rate Krugman proposes would appear to be the highest by a large margin. It would also be more than three times the current OECD average.

  8. I will now await the usual series of sarcastic one-liners from commenters who did not read the actual article...seriously though, you make a lot of seemingly obvious points that others always seem to miss (whether deflation is a cause or an effect of other problems, the difference between large vs. small changes in price levels, expected vs. unexpected changes etc.) Good stuff.

  9. There is no deflation, anywhere. Do facts matter?

  10. Dr. Cochrane,
    Scott Sumner has an excellent post analyzing your post

    1. I saw the same post. Unless I'm misunderstanding Sumner, his entire last paragraph seems like a straw man to me. Take the following sentence:

      "But when NGDP growth comes in 10% or 20% lower than workers or borrowers expected when they signed labor and debt contracts, then you have big problems."

      This seems to ignore two of the main points Dr. Cochrane made:
      1. Differentiating between expected vs. sudden, unexpected swings in price levels
      2. Large vs. small levels of deflation. I think Cochrane's argument was that a steady, mild deflation is not a problem in and of itself.
      Correct me if I'm missing something here.

    2. Edward,

      That Sumner post wasn't really an "analysis". If you ignore the extensive quotation of the Cochrane piece, the only substantive sentence in the entire Sumner blog post is this:

      "But when NGDP growth comes in 10% or 20% lower than workers or borrowers expected when they signed labor and debt contracts, then you have big problems."

      That's after he says inflation and deflation don't matter. That's it. A conclusion such as the above counts as an "analysis"? Ask yourself this: how much of avoiding that !0 or 20 percent drop in NGDP would be attributable to higher inflation? Would avoiding that drop actually prevent a decrease in RGDP? Sumner's entire philosophy hinges on the effect of sticky wages. And, inflation and deflation don't matter? It seems to me that those folks are talking in circles. That doesn't make it profound or even an "analysis".

  11. Excellent article, good arguments but I strongly believe that small and stable inflation has benefits to the economy other than deflation. If deflation is okey so why country's has inflation targets?

  12. "Deflation" and "inflation" are not precisely defined or measured. We are having heated arguments over inflation and deflation dealing with effects that are probably smaller than the margin of error.

    We have a Fed trying to create inflation - without that, the US might well be experiencing deflation. We have Japan and Europe with very low inflation or outright deflation. If there is "inflation" in Japan or Europe it is so low as to fall well within the margin of error.

    Before trying to fix "deflation" we should have a better definition and a much better understanding of why there is deflation. My personal hypotheses for deflation would be:
    1) China is accumulating foreign reserves for strategic reasons and as a way of shifting the misery of Chinese peasants to the Western working class.
    2) endemic tax avoidance and the accumulation of wealth in tax havens is creating a fiscal drag on the Western economies (Chinese corruption is having a similar effect)

  13. Okay, but...

    In the U.S. from 1982-2007, we had real annual GDP growth a little north of 3%, and inflation a little south of 35 (CPI).

    In Japan 1992 through 2011, they had mild deflation, and 1% GDP growth.

    Those are long stretches, in the real world, in real economies with real structural impediments.

    I would say that deflation does not cause recession, but is associated with very, very, very slow growth.

    And that moderate inflation is associated with pretty good growth.

    My question for John Cochrane or anyone else: The U.S. economy from 1982 to 2007 posted good growth, and moderate inflation for 25 years, call it "3&3"

    Why would anybody care about moderate inflation? Is not "3&3" a pretty good sustained result?

    Is the Japan " -0.1&1" result better?

    1. "And that moderate inflation is associated with pretty good growth."

      One of the problems that economists across the spectrum seem to have is falling into the correlation is causation trap or thinking that if they can write an equation linking variables then any one of those variables gives them a policy lever to effect the others. The result is that we get policies like the Fed's "pushing on a string" quantitative easing policies.

      Arguing that solid growth was associated with inflation in the past and therefor if we can just force inflation we will have growth is cargo cult thinking. Japan seems to be staking its future on that reasoning.

      I care about inflation because artificially forcing inflation has real costs and probably does not give a meaningful policy lever to promote growth.

    2. It makes no sense to compare Japan with the United States on the basis of overall RGDP growth. During the period mentioned by Cole, the Japanese population (particularly working age population) was decreasing while the population in the US was increasing.

      Come back with an analysis of RGDP per capita or RGDP per working age adult. That is the only meaningful comparison given the demographics.

    3. Deflation means that supply is greater than demand. Business can respond in a couple of ways: they can reduce supply (fire people); they can reduce prices (reduce profit margins) which will eventually cause them to go bankrupt so that they will have to fire people. Or they can maintain price and production and pay for warehousing the excess supply, leading eventually to going bankrupt. Firing people reduces demand further.

      On the other hand, the government could go out and use fiscal policy to borrow at low interest rates to hire people who aren't doing anything and capital that isn't doing anything to increase GDP. That increases demand and reduces unemployment, firming up profit margins. As we approach full employment, employers start bidding up wages which bids up prices, at which point the stimulus can be removed.

    4. Cesium,

      "Deflation means that supply is greater than demand."

      Not always. Technological advances can also fuel deflation with no changes in either supply or demand. New manufacturing method allows company to produce the same amount of widgets at a lower cost. The cost savings in a competitive environment are passed onto the consumer. Prices fall, quantity of goods produced and sold stays the same.

      "Or they can maintain price and production and pay for warehousing the excess supply, leading eventually to going bankrupt."

      That would depend on whether the loans made to said company are collaterized by that warehouse full of goods. If a bank is willing to accept warehoused goods as collateral on a loan, then the company can keep borrowing and producing using any warehoused goods as collateral on new loans.

      Of course, banks don't typically want a warehouse full of widgets if a company can't sell enough widgets - they want cash.

  14. If low deflation becomes the expected norm won't P/E ratios adjust sharply higher since acceptable return for steady earning stocks would become 4-5% (20-25P/E) and much higher for modest predictable growth?

    1. That might depend on how exactly the deflation manifests itself. Imagine a world where the price of goods and services are constantly steadily falling by 1 or 2% per year and as a result the revenues of every major company are on a gentle glide path towards zero. Companies would be in a constant struggle to grind down wages. There would be few "steady earning" stocks in such an environment.

  15. One thing where I see most economists err, a lot:
    Economy is generally very stable system. Especially developed Western economies. It needs either extreme shocks or long-term severe mismanagement to throw it off so much that it enters into negative feedback loop and can't stabilize. So, all the talk about high inflation loop or high deflation loop is just wrong. Left to itself, economy will always return towards mean, to some stable state. It doesn't mean that you can't get into high inflationary spiral (deflationary one is a lot less likely), but you usually need decade-long concentrated effort (that means that if all the efforts to rise inflation in EU, USA, Japan suddenly succeed, governments and central banks would need to keep those efforts up for considerable time afterwards, years and more, to ensure something like Argentina scenario). So, both inflationists and deflationists should stop talking about their spirals and predict either moderate inflation for a while, or low inflation/low deflation for a while.

  16. Also, when talking about deflation, the effects depend heavily on the cause. If deflation is a result of technological progress, it is positive. Everybody has more money and more value (well, except those who haven't switched from the old technology and those who produce it, but that's standard movement in the economy). If deflation is the result of some one-time measures or series of clear measures, economy and our predictions have to adjust to those measures, but deflation is just a statistical point, not something good or bad for the economy (think of Italy this summer - the deflation there was the result of their telecoms, right after last series of EU-mandated cuts in roaming prices). If deflation is the result of inadequate demand, that is a big problem.
    Any analysis of deflation that does not focus on only one of the causes is wrong, and even intellectually dishonest. (Note: I don't have WSJ access and haven't read the article, so this comment has nothing to do with Mr. Cochrane's article, but with general tone of various articles I've read on the web.)

  17. People may see deflation as a positive because the value of money increases. However, the issue with deflation that maybe is not as obvious is that deflation can lead to periods of high unemployment, since people might be discouraged to spend, with goods and services becoming cheaper in the future. Just something to put out there.

  18. People may see deflation as a positive because the value of money increases. However, the issue with deflation that maybe is not as obvious is that deflation can lead to periods of high unemployment, since people might be discouraged to spend, with goods and services becoming cheaper in the future. Just something to put out there.


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