Why falling prices are good for business

Introduced by Murray Sabrin, Joseph Salerno spoke on "Why Falling Prices Are Good for Business" at Ramapo College in New Jersey on October 4.

Dr. Salerno's portion of the talk begins at 6:20. The lecture is followed at the one-hour mark by a panel discussion covering business cycles, the Fed, interest rates, and financial crises.

Should we be spooked by deflation?

Concerns about deflation – falling prices of goods and services – have loomed large in many recent policy discussions. In such discussions deflation is seen as always and everywhere a bad phenomenon. But as I have discussed a number of times before, see for example here, here and here, you need to draw a distinction between good and bad deflation The basic point is that we indeed do have two forms of deflation, the bad driven by demand shrinking and the good caused by supply expanding. The good kind of deflation is the result of increases in productivity. Research and development means new technology, efficiency gains, cost-cutting, price-cutting and, yes, deflation. Productivity gains mean that businesses could afford to sell their products for less since it is costing less to make them. The bad kind usually follows a collapse of aggregate demand. There is a severe drop in spending: producers have to cut prices to find buyers. This has the effect of causing recession, high unemployment and widening financial stress. This the 1930s type deflation that people fear.

The deflation debate is shaped by the deep-seated view that deflation, regardless of context, is an economic pathology that stands in the way of any sustainable and strong expansion. This view is largely based on the experience of the Great Depression. But in a new column, Should we be spooked by deflation? A look at the historical record by Claudio Borio, Magdalena Erdem, Andrew Filardo and Boris Hofmann, at VoxEU.org it is argued that it is misleading to draw inferences about the costs of deflation from the Great Depression since it was the archetypal example.

Borio, Erdem, Filardo and Hofmann write,

The evidence from our historical analysis raises questions about the prevailing view that goods and services price deflations, even if persistent, are always pernicious. It suggests that asset price deflations, and particularly house price deflations in the postwar era, have been more damaging. And it cautions against presuming that the interaction between debt and goods and services price deflation, as opposed to debt’s interaction with property price deflations, has played a significant role in past episodes of economic weakness.

Inevitably, our results come with significant caveats. The data set could be further improved. We have focused on only a few drivers of output costs. We have only a few episodes of persistent deflation in the postwar period. And present debt levels are at, or close to, historical highs in relation to GDP. This should caution against drawing sweeping conclusions or firm inferences about the future.

Even so, the analysis does suggest a number of considerations relevant for policy.

• First, it is misleading to draw inferences about the costs of deflation from the Great Depression, as if it was the archetypal example.

The episode was an outlier in terms of output losses; in addition, the scale of those losses may have had less to do with the fall in the price level per se than with other factors, including the sharp fall in asset prices and associated banking distress.

• Second, and more generally, when calibrating a policy response to deflation, it is critical to understand the driving factors and, as always, the effectiveness of the tools at the authorities’ disposal.

This can help to better identify the benefits and risks involved.

• Finally, there is a case for policymakers to pay closer attention than hitherto to the financial cycle – that is, to booms and busts in asset prices, especially property prices, alongside private sector credit [...].

So deflation is not a good reason for running round screaming the sky is falling as many commentators, journalists and politicians seem to want to do. Reality is more complex and subtle. The VoxEU.org column finds a link between output growth and asset price deflations, particularly during postwar property price deflations, that there is no evidence that high debt has so far raised the cost of goods and services price deflations, in so-called debt deflations and that the most damaging interaction appears to be between property price deflations and private debt.

George Selgin interview

George Selgin, Professor of Economics in the the University of Georgia's Terry College of Business, was interviewed on RT television's "Boom and Bust" show and talked about price and debt deflation. The segment with Professor Selgin comes on about halfway through.

The deflation debate

I have discussed the difference between good and bad deflation a number of times before, see for example here, here and here. The basic point is that there are two forms of deflation, the bad driven by demand shrinking and the good caused by supply expanding. The good kind of deflation is the result of increases in productivity. Research and development means new technology, efficiency gains, cost-cutting, price-cutting and, yes, deflation. Productivity gains mean that businesses could afford to sell their products for less since it is costing less to make them. The bad kind usually follows a collapse of aggregate demand. There is a severe drop in spending: producers have to cut prices to find buyers. This has the effect of causing recession, high unemployment and widening financial stress. This the 1930s type deflation that people fear.

In a new column at VoxEU.org Mickey Levy argues that a popular view among economic commentators is that rich countries face a serious risk of deflation, and should adopt aggressive macroeconomic stimulus policies to ward it off. His column argues that despite similar headline inflation rates, the US, Europe, and Japan in fact face very different macroeconomic conditions. In the US, much of the recent disinflation is attributable to positive supply-side developments. In Europe, an aggressive round of quantitative easing might encourage policymakers to delay the reforms that are necessary to avoid a prolonged Japanese-style malaise.

Levy goes on to argue,

Deflation stemming from insufficient demand and growth-constraining economic policies can drain confidence and become negatively reinforcing, as Japan has shown. In such situations, aggressive macroeconomic policy stimulus designed to jar expectations and boost demand is appropriate. Europe’s downward price and wage pressures are necessary adjustments to its earlier excesses, and relying excessively on aggressive monetary policy to stimulate demand is not a lasting economic remedy. Europe is not destined to fall into a Japanese-style prolonged malaise, but it must continue to pursue reforms that lift productive capacity and confidence.

The US situation is very different. The economic expansion is gaining momentum (temporarily sidetracked by unseasonal winter storms), unemployment is falling steadily, personal income is growing faster than inflation, and household net worth is at an all-time high. Expectations of deflation are not apparent in either household or business behaviour. Concerns about lingering labour-market underperformance are warranted; angst about deflation is not.

Prices of some goods and services in the US have been falling, benefitting from technological innovation, improved product design, or heightened competition and distribution efficiencies through the internet. Examples abound: flat-screen TVs, computers, automobiles, reduced fees on financial transactions, online consumer and business purchases, etc. These lower prices and quality improvements explain the vast majority of the recent deceleration in inflation – the PCE deflator for goods continues to decline and is flat for nondurables, while it has been rising at a fairly steady pace of 2% for services.

These innovation-based price reductions improve standards of living and free up disposable income to spend on other goods and services. They boost aggregate demand and enhance economic performance. And they contribute positively to longer-run potential growth.

It is unclear why US policymakers and commentators fear disinflation that stems from innovation-based price reductions amid accelerating aggregate demand. European policymakers face tougher choices.

In short, the proper policy response depends on the underlying causes of deflation. One size does not fit all when it comes to deflation.