Thursday, January 8, 2015

Deflating Deflationary Fears

Source: Charles Plosser
From a nice paper by Charles Plosser with that catchy title.  Yes, it's 10 years old, but the lesson is appropriate in today's hysteria. That dreaded deflationary spiral is always just around the corner.


  1. Aha, the deflationary period of which everyone knows was driven by some major positive supply shocks.

    And how does that relate to our current situation of a deflation threat caused mainly by a major negative demand shock?

    1. How do you know that it's "demand" not "supply" at the moment? Fracking and oil price collapse don't look superficially like "demand."

    2. John,

      Interesting graph. Of note were the numerous banking "panics" in the U. S over the time when real GDP was growing and prices were falling:

      Panic of 1873
      Panic of 1884
      Panic of 1893
      Panic of 1907

      "The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907."

      And so, how do you get positive real growth in a deflationary environment without the banking panics / crises that were prevalent in the late 19th century?

    3. How do we know it is not supply? That's easy my dear sir. We used to produce 5 million barrels/day of oil in 2008. Today we produce 9 million barrels daily. If you assume some constant price - let us say $80/barrel (you can pick whatever you like) - you will see that the value of oil produced has gone up from ~$145 billion in 2008 to $263 billion in 2014 - so an increase of $117 billion. If you say that the US economy's real GDP in 2008 was $14 trillion, the increase in the value of domestic oil accounts for less than 1% of GDP. If this is enough to explain all of the real growth or all of the change in the price level since 2008, then may be this is a positive supply shock. If you list other things you think have contributed to a potential supply shock - list them. I am sure I can come up with some sort of valuation for those as well.


      PS: Data on oil production from EIA

    4. "How do you know that it's "demand" not "supply" at the moment? Fracking and oil price collapse don't look superficially like "demand." "

      Well 5y5y inflation is falling quite rapidly (1.55 vs 2.2 a year ago in Europe and 2.22 vs 2.93 a year ago in the US). Falling realised inflation today is no doubt affected by the collapse in oil but for 5y5y inflation to be driven by oil prices, would you not have to expect oil prices to fall in the future?

      The current median forecasts for Brent this morning were:

      Spot - 50.78
      Q415 - 80
      2016 - 84
      2017 - 89
      2018 - 77

      The Current forwards are:

      2015 - 56.88
      2016 - 64.72
      2017 - 68.68
      2018 - 71.10

      So oil prices are expected to rise.

      How do you conclude from this that the drop in the oil price is behind falling 5y5y inflation expectations? Are you suggesting that current drop will still be feeding through to the inflation rate in 2020? Or do you expect the oil price to drop further in the future?

    5. And how do you know that it is not both? (And why do economists tend. To assign one cause to economic trends?). James Hamilton is an exception: per his analysis 44 percent of the drop in oil prices is due to demand factors.

  2. And the positive supply shock of declining oil prices [Bruno/Sachs!] is emerging only now. If they last, we'll have a Clinton boom, just like Clinton had! :-)

    I can't help feeling that the fracking boom isn't endogenous to the previously high oil price. I don't know, but we shall certainly see.

    1. Fracking boom is the result of advances in technology and Bush's law that put such operations outside of EPA control and need for environmental impact study (damage done to drinking water in those areas will be determined over the next decade or so, but some indications are that it is not drinkable anymore).
      On financial side, there would be no fracking without subsidies, and there would be no fracking if oil price stayed around $40/barrel. Even now, very few wells are profitable at less than $70/barrel.

    2. Not too surprised, Anonymous, about the $ estimate of profitably. But subsidies? Anything fracking gets more than other energy exactors get from the existing tax code?

      Damn, this is hard: Details matter!


  3. As always seen such great opinions motivates deep thought, professor Cochrane, greetings from Peru. Sincerily Mario Bravo

  4. Japan's problem with deflationary gloom seem real, not exaggerated. In the two deflationary deacdes following 1992, equities cratered by 80%, property values fell by 80%, real wages fell by 15% and the yen soared in value. For 20 years Japan obtained j7st the sort of mild deflation recommended by Plosser and Cochran.
    The only is that it resulted in a debacle.

  5. Really> Data from the pre-industrial era is comforting?

    How the Japan's deflation from 1992 to 2012, in which real wages fell 15%, property values cratered by 80%, likewise equities, and real growth was about one-third that of the United States?

    I would say concerns about a recessionary-deflationary doldrum are sensible.

  6. Replies
    1. Marc,

      Excellent question. The United States government was on a gold standard at the time and the U. S. Federal Reserve was not created until 1913.

      "It formed the height of the Klondike gold rush from the summer of 1897 until the summer of 1898. It began on July 15, 1897 in San Francisco and was spurred further two days later in Seattle, when the first of the early prospectors returned from the Klondike, bringing with them large amounts of gold on the ships Excelsior and Portland. The press reported that a total of $1,139,000 (equivalent to $1,000 million at 2010 prices) had been brought in by these ships, although this proved to be an underestimate. The migration of prospectors caught so much attention that it was joined by outfitters, writers and photographers."

      "Various factors lay behind this sudden mass response. Economically, the news had reached the US at the height of a series of financial recessions and bank failures in the 1890s. The gold standard of the time tied paper money to the production of gold and shortages towards the end of the 19th century meant that gold dollars were rapidly increasing in value ahead of paper currencies and being hoarded. This had contributed to the financial panics of 1893 and 1896, which caused unemployment and financial uncertainty. There was a huge, unresolved demand for gold across the developed world that the Klondike offered to fulfil and, for individuals, the region promised higher wages or financial security."


      The last major gold rush on the American continent was the Porcupine Gold Rush (1909-1911). The U. S. federal reserve was created two years later (1913).

      The next major gold discovery was the Kakamega rush in Kenya, about 20 years later (1932).

  7. Wage rigidity. Next?

    1. So why is it that Keynesians cite wage rigidity as an explanation for nearly every negative economic consequence, yet none of them push for the gov't to repeal policies creating that very rigidity?

    2. Nonsense. Wage rigidity has nothing to do with the government. Read Bewley's " Why Wages Don't Fall During a Recession" and you will learn that companies are reluctant to decrease wages for a number of reasons.
      If you don't like polls but prefer theory, the standard New Keynesian rational for downward wage or price rigidity is imperfect competition.

      The seminal papers are Mankiw's "Small Menu Costs and Large Business Cycles" as well as Blanchard's "Monopolistic Competition and the Effects of Aggregate Demand". Sorry to be so blunt but this is really basic stuff from the 80s and there is no excuse for not knowing these papers (if you wanna talk about macro).

  8. Milton Friedman wrote a paper in 1998 advocating QE in Japan to get out of their recessionary deflationary trap. I guess by then Friedman had concluded minor deflation was economic poison.

  9. It’s absurd to attribute any change in macroeconomic aggregates to a single cause. If we observe deflation, could it not be that negative pressure on prices due to productivity increases (e.g. massive, continual increases in computational power over the last 50 years, for those who can’t seem to think of a reason for increased productivity) outweighs positive pressure on prices due to rising demand? If we observe inflation, could it not be the opposite? Perhaps if the enormous (and consistent) increases in the monetary base since the early 1970s hadn’t put upward pressure on prices, we would observe a general decline in prices. True counterfactuals are difficult (impossible?) to observe in economics.
    Scott Sumner warns against reasoning from a price change. As much as I disagree with him otherwise, I think he’s right about this. To the degree that markets and entrepreneurs are allowed to guide the employment of resources, we will have increases in productivity that result in increases in demand. Worries about where prices move in such a system are, at best, secondary.

  10. Assuming inflation (and by extension, deflation) to be, per the monetarist Friedman, always and everywhere due to monetary phenomena, and given the Fed's QE etc $3T+/- expansion of its balance sheet, there ought to be more than enough inflation to go around, vis a vis the anemic GDP expansion of the last 6 years.

    Except much of that newly printed money sits in bank reserves, and what has found its way into the economy seems to have done so exclusively via the equity and debt markets.
    So, given the inflation index excludes equities and debt instruments, and given suspected price bubbles in the same, our measure of inflation seems misleading. Ergo, fear of deflation is likely overblown.

    The stronger case for for the lack of strong inflation (aside from the financial markets), seems best explained by the ripple effects of cheapening oil/energy, and the continuing effects of ever cheaper and more powerful technology.

    Expansion of the individual's purchasing power is the goal of economic activity - much as was seen in the US in the 1870-1910 period, appears to have repeated itself from 1980 until the present.


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