Monday, December 15, 2014

Who is afraid of a little deflation? Op-Ed

This was a Wall Street Journal Op-Ed from a month ago. Now I can post the whole thing in case you missed it then.

Who is Afraid of a Little Deflation?

With European inflation declining to 0.3%, and U.S. inflation slowing, a specter now haunts the Western world. Deflation, the Economist recently proclaimed, is a “pernicious threat” and “the world’s biggest economic problem.” Christine Lagarde , managing director of the International Monetary Fund, called deflation an “ogre” that could “prove disastrous for the recovery.”

True, a sudden, large and sharp collapse in prices, such as occurred in the early 1920s and 1930s, would be a problem: Debtors might fail, some prices and wages might not adjust quickly enough. But these deflations resulted directly from financial panics, when central banks couldn’t or didn’t accommodate a sudden demand for money.

The worry today is a slow slide toward falling prices, maybe 1% to 2% annually, with perpetually near-zero short-term interest rates. This scenario would unfold alongside positive, if sluggish, growth, ample money and low credit spreads, with financial panic long passed. And slight deflation has advantages. Milton Friedman long ago recognized slight deflation as the “optimal” monetary policy, since people and businesses can hold lots of cash without worrying about it losing value. So why do people think deflation, by itself, is a big problem?

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.

Sticky wages would be a problem for a sharp 20% deflation. But not for steady 2% deflation. A typical worker’s earnings rise around 2% a year as he or she gains experience, and another 1%—hopefully more—from aggregate productivity growth. So there could be 3% deflation before a typical worker would have to take a wage cut. And the typical worker also changes jobs, and wages, every 4½ years. Moreover, “typical” is the middle of a highly volatile distribution of wage changes among a churning job market. Ultimately very few additional workers would have to take nominal wage cuts to accommodate 2% deflation.

Curiously, if sticky wages are the central problem, why do we not hear any loud cries to unstick wages: lower minimum wages, less unionization, less judicial meddling in wages such as comparable worth and disparate-impact discrimination suits, fewer occupational licenses and so forth?

2) Monetary policy headroom. The Federal Reserve wants a 2% inflation rate. That’s because with “normal” 4% interest rates, the Fed will have some room to lower interest rates when it wants to stimulate the economy. This is like the argument that you should wear shoes two sizes too small, because it feels so good to take them off at night.

The weight you put on this argument depends on how much good rather than mischief you think the Fed has achieved by raising and lowering interest rates, and to what extent other measures like quantitative easing can substitute when rates are stuck at zero. In any case, establishing some headroom for stimulation in the next recession is not a big problem today.

3) Debt payments. The story here is that deflation will push debtors, and indebted governments especially, to default, causing financial crises. When prices fall unexpectedly, profits and tax revenues fall. Costs also fall, but required debt payments do not fall.

Again, a sudden, unexpected 20% deflation is one thing, but a slow slide to 2% deflation is quite another. A 100% debt-to-GDP ratio is, after a year of unexpected 2% deflation, a 102% debt-to-GDP ratio. You’d have to go decades like this before deflation causes a debt crisis.

Strangely, in the next breath deflation worriers tell governments to deliberately borrow lots of money and spend it on stimulus. This was the centerpiece of the IMF’s October World Economic Outlook antideflation advice. The IMF at least seemed to realize this apparent inconsistency, claiming that spending would be so immensely stimulative that it would pay for itself.

4) Deflation spiral. Keynesians have been warning of a “deflation spiral” since Japanese interest rates hit zero two decades ago. Here’s the story: Deflation with zero interest is the same thing as a high interest rate with moderate inflation: holding either money or zero-interest rate bonds, you can buy more next year. This incentive stymies “demand,” as people postpone consumption. Falling demand causes output to fall, more deflation, and the economy spirals downward.

It never happened. Nowhere, ever, has an economy such as ours or Europe’s, with fiat money, an interest-rate target, massive excess bank reserves and outstanding government debt, experienced the dreaded deflation spiral. Not even Japan, though it has had near-zero inflation for two decades, experienced the predicted spiral.

There are good reasons to believe it can’t happen. Most of all, government solvency fears that don’t matter for 2% deflation kick in and stop a deflation spiral. If prices fall 20%, or 30%, bond-holders will see that governments cannot pay back debts. They try to get rid of their bonds before the coming default. They buy things or other currencies, nipping the deflation spiral in the bud.

There is an unsettling feature of the current inflation situation, however. Clearly, our central banks want higher inflation, and the current slow decline was unintended. So, just as clearly, central banks have a lot less understanding of and control over inflation and deflation than most people think.

According to the conventional worldview, the economy is inherently unstable. Central banks control inflation the way you balance an upside-down broom, with interest rates on the bottom and inflation on top. Central banks have to actively move interest rates around to keep inflation and deflation from breaking out. And if they want more inflation, they must temporarily move interest rates the wrong way, let the inflation increase, and then move quickly to stabilize it.

Hence the zero-bound worry. When interest rates hit zero and the Fed can’t move the broom handle any more, the top of the broom must topple into deflation. Except we hit the zero bound, and almost nothing happened. Maybe the economy isn’t so inherently unstable and in need of constant guidance after all.

Bottom line? Relax. Every few months we hear a new “biggest economic problem” from which our “policy makers” must save us. Wait for the next one.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution and an adjunct scholar at the Cato Institute.


  1. Oh, goody, I can repeat myself:

    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. I wonder how you might term inflation caused by other forces than Fed interaction - natural taxation, temporary taxation, or perhaps just transfer costs. And isn't price stability a market function - and if so, why would you want the Fed to interfer?

  2. When I've seen 2% inflation touted as "stable prices", I just counter that the inflation rate states how many times prices will double in your lifetime. By the "rule of 72", 2% inflation causes prices to double every 72/2 = 36 years. Using 72 years as roughly a lifetime, prices will double twice.

  3. I agree with Prof Cochrane that a little deflation is not a total disaster. But I still think 2% inflation is the optimum.

    “…if sticky wages are the central problem, why do we not hear any loud cries to unstick wages?” Because there is a widespread desire not to have anyone’s wages reduced in nominal / dollar terms!

    Winston Churchill tried to cut coal miners’ wages in the UK in the 1920s. That sparked off a general strike lasting a couple of weeks, so the entire country ground to a halt. Plus coal miners themselves remained on strike for a full year. The country would have been far better off with a little inflation.

  4. Very interesting article. You bring up a lot of convincing arguments. However, I still have some reservations regarding the conclusion:

    Assuming that a deflation spiral can't happen simply because it has never happened thus far seems a little shortsighted to me. Furthermore if bond-holders see they will not get their money back, others will most likely see that too. In that case there won't be anybody willing to buy the bonds, resulting in a significant price drop.

    What I am trying to say is: I do agree that we hear about a new "biggest economic problem" every other day, and it gets tedious at times. However we should still remain alert. I would even argue that the alertness (and awareness) considering the issue actually contribute a great deal to preventing a deflation spiral.

    Methaporically speaking, people do not touch hot coals becasue they know they will burn their hands. If we were to tell them (based on that) not to worry about it, since we don't know anybody who has ever burned their hands on hot coals... well, you can guess what would happen.

  5. Great article, Professor Cochrane, it highlights what should be obvious, moderate deflation is not nearly as scary as moderate inflation, for the median individual or family, but somehow, the economic stablishment has been convinced otherwise. It would be nice to read about the incentives of the economic establishment to defend inflation, if you don't write about it, could you please point at other researchers that do so? Thank you.

    1. I think that speculating about other people's incentives and hence implying they are dishonest is unethical. Let's leave that to you-know-who at the New York Times. Macroeconomics is so uncertain that honest people can disagree.

    2. Yes, Macroeconomics is very uncertain, therefore people should welcome dissenting views, absolutely. I am no macroeconomist, but in my line of work I must read macro stuff everyday, and to be frank, I am a little fed up, not with the content itself, but with the repetion of things written long past (in some cases, many decades!). I don't want to imply that a lot of people are dishonest, actually, it is the opposite, many people I know truly believe some views are "the only truth" in macro, deliberately ignoring conflicting evidence, and they do so without any specific intention or in a situation where there is no evident gain for them. After all, Dr. Kahneman and others have showed us that the human brain is eager to believe in any story that put an explanation on otherwise random events, even if these events are truly random in nature. I was really thinking on a serious research that might reasonably show that people are bound by incentives, and therefore their views should be discounted, like, "stock analysts seldom put a sell recommendation on a stock", something quantitative, because I happen to not know any such work, although I am inclined to like this kind of view ...

    3. I agree with your references to Kahneman's work. Unfortunately it seems economists on either side of any debate are easily goaded to defend preconceived positions despite evidence to the contrary.

    4. Ever heard of "fallacy of composition"?

  6. So Prof. Cochrane sees no problems with moderate deflation. Is he volunteering for a pay cut?? I doubt his productivity will significantly increase in the near future to warrant keeping his pay the same.

    Will he like it when the value of his house declines? - - - - while the mortgage debt remains about the same?

    1. I may have to add "show some sign you've actually read the post" to my qualifications for comments.
      And yes, happily. If prices are going down why would I object to a wage cut?

  7. Pr. Cochran,

    During periods of economic contraction, "panics", "recessions", "depressions", &c. there is downward pressure on prices. Falling prices accelerates the economic contraction, it produces a negative feed back loop, i.e. a deflationary spiral. Before the creation of the Federal Reserve Bank (FRB) and the Federal Deposit Insurance Corporation (FDIC), deflationary spirals were common.

    You are correct that there have been no deflationary spirals since 1934. However that is because of actions by the FRB and FDIC. The only reason that there was not a deflationary spiral following the Crash of 2008 was because the FRB created inflationary pressures. The FRB "printed money" (i.e. had the United States Treasury Bureau of Engraving and Printing print Federal Reserve Notes (FRNs) and coins). The Currency component of the M1 Money Stock increase from 800 BUSD to 1200 BUSD between 2008 and 2012 [1], a 50% increase, which quite significant. During the same period the size of the M2 Money Stock increased dramatically as well, from 7,600 BUSD to 11.500 BUSD, a 40% increase. Of course the size of the Monetary Base rose by a staggering 400% [3] in the same period. Increasing the size of the money stock created inflationary pressures, which countered the deflationary pressures of a declining economy.

    So what the US economy would be experiencing is not some small amount deflation in an otherwise balanced economy, what Dr. Friedman was describing. What the US economy is experiencing is an economy that has tremendous deflationary pressures (which can be measured by the declining M2 velocity) which is being held in check by tremendous inflationary pressures created by the FRB. The FRB is exerting the maximum possible effort to prevent deflation and yet deflation is still a threat. The "little deflation" is a very dangerous thing.

    This is why the Federal Reserve Bank has an "Inflation Bias"[4].





    1. M2 stock increases and M2 velocity declines. But declining M2 velocity is evidence that "the US economy is experiencing... tremendous deflationary pressures"?

      Hold on to that chestnut, tis a good one!

    2. Hello Anonymous,

      Do you believe that there are no deflationary pressures in the US economy?

    3. Well I don't believe there are "tremendous" pressures. But what I believe isn't important here.

      Nobody is arguing that a rapid increase in demand for money against a backdrop of restricted supply isn't deflationary (nor that this is deflation wouldn’t be “bad”).

      The question for you is how powerful is the Fed in actually “controlling” inflation(deflation) in the direction it wants using its current methods, today, sans crises?

      Evidently, you believe it is very powerful, albeit still not quite powerful enough. You may be right, but this isn’t borne in current data; hence you must invoke a counterfactual story.

      But what if this story is wrong? The good professor has a few recent posts on that possibility…

      Back to deflation. Why is any deflation automatically bad? Goods and commodities can deflate all they want - taking the CPI downward - but if the price pressure doesn’t extend to services, should we really be that worried?

    4. Hello Anonymous,

      We agree that there are deflationary pressures on prices. I argued that falling M2 velocity is diagnostic of those conditions (a point you appeared to take exception to in your first reply but did not pursue in your second).

      The Federal Reserve Bank (FRB) is quite clear that the Quantitative Easing Policy (QEP) is an anti-deflationary policy. Here is an excerpt from an interview with then FRB Chair Dr. Bernanke.


      Mitt Romney recently said that QE2 had a relatively little impact on the economy. He said that was in part because of the President’s policies, and he said that QE3 was unwarranted and could have negative effects.

      Do you agree that QE2 had little effect on the economy?


      Well, I’ll just say first that we think that both of the asset purchase programs, so - called QE1 and QE2, did have significant effects on asset prices and financial conditions. And although there were certain problems in transmission — for example, the housing market has not been as responsive as it’s been in some times in the past — we do think that they were both effective in providing support for the economy, and in particular, so - called QE2 ended what looked to be an incipient deflation problem when we first introduced it.[1]

      So the FRB was attempting to control deflation. How did they do that. My argument has been that they increased the supply of money to create a countervailing inflationary pressure. This is why I cited the increase in the size of the money stock by a variety of different measures. Most every one understands that an increase in the supply of money, faster than the supply of goods, creates inflationary pressures.

      Dr. Friedman's has a famous quote to this effect, to wit: "Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output." Using the MV = PQ equation, Dr. Friedman's quote only applies if delta M is greater than delta Q and if V is stable, as he assumed it was [2]. During the period following the Crash of 2008, the money supply did indeed increase faster than the gross domestic product but prices did not rise, in no small part because velocity was declining as well. So it would appear that the actions by the FRB increasing the supply of money had some inflationary impacts which prevented deflation, at least for a while.

      It must be noted that this is not actually unusual. Following each of the last four recessions the FRB increased the supply of M1 Currency [3], the stock of money that the FRB has the created control over. In each case the increase was more than 10% on a year over years basis and was counter-cyclical. Through the period of 1975 - 2014 the quantity of goods and service (Gross Domestic Product - GDP) and prices (as measured by the Personal Consumption Expenditure Chain-Type Price Index - PCE) track each others movements. The correlation coefficient between the year over year percent change was 0.71 and the probability that this was due to random effects was <0.001. There was also a statistically significant correlation between the year over year percent change in the supply of M1 Currency and GDP and PCE but it was weaker and less significant.


      [2] "The relative stability of monetary velocity and the investment multiplier in the United States, 1897 - 1958" by Friedman, M. and Meiselman, D. (1963) in Stabilization Policies. Prentice Hall .


  8. John,

    "Debt payments. The story here is that deflation will push debtors, and indebted governments especially, to default, causing financial crises. When prices fall unexpectedly, profits and tax revenues fall. Costs also fall, but required debt payments do not fall."

    Tax revenues on a yearly basis may fall, but all tax revenue that a government will collect (barring insurrection, overthrow, or armageddon) is unchanged. Hence the argument for extending maturity using zero coupon securities.

    Government debt payments (as a whole) fall when principle is retired through revenues in excess of spending or through debt to equity conversion.

  9. Cochrane: "Bottom line? Relax. Every few months we hear a new 'biggest economic problem' from which our 'policy makers' must save us. Wait for the next one."

    This is "laissez faire, real business cycle, anti-government" ideology at its starkest. Milton Friedman, who said the Fed could and should have prevented the Great Depression, was way to the left of Cochrane's position.

  10. This article is very convincing. There are a lot of great arguments brought up and to which most I have to agree with. Reaching a deflation rate of zero interest seems highly unlikely at these times especially with people beginning to notice when the economy begins to make a turn for the worst. The people begin to take action themselves whether its pulling money out of the banks, putting money in the banks etc. Even bondholders will notice that the government is in debt way to deep like Professor Cochrane stated "They try to get rid of their bonds before the coming default. They buy things or other currencies, nipping the deflation spiral in the bud". In the end I think our economy is flexible enough to adjust when these problems occur. Even when the smallest problem for our economy is rumored to be the biggest it always gets fixed or is realized to not be that much of a worry. " Bottom line? Relax. Every few months we hear a new “biggest economic problem” from which our “policy makers” must save us. Wait for the next one." To conclude, Professor Cochrane's statement is the easiest way to put it, problems will always be reoccurring whether it is small or the "biggest economic problem". We will just have to wait and see what is in store for us these next few years!

  11. "Again, a sudden, unexpected 20% deflation is one thing, but a slow slide to 2% deflation is quite another. A 100% debt-to-GDP ratio is, after a year of unexpected 2% deflation, a 102% debt-to-GDP ratio. You’d have to go decades like this before deflation causes a debt crisis."

    Fisherites gotta read their Fisher.


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