Is deflation a threat to our prosperity? Part 1

Published on May 11, 2016

10 September 2009

Hi everyone,

If you follow financial news, you will have read dozens of articles and commentaries about the dangers of deflation since the beginning of the economic crisis. Deflation is the opposite of inflation. It is a sustained fall in the level of prices.

We are told that if we let prices go down, consumers will put off their purchases to benefit from even lower prices. This will reduce business activity, workers will get laid off, consumers will be even more reluctant to buy, and we will end up in a big depression like the one we had in the 1930s.

Almost everyone agrees that very high inflation is bad, but they tell us that deflation would be even worse.

This is one of the main reasons why central banks in most countries have flooded markets with new money and rescued failing banks. We had to do all we could to keep prices from going down, which would lead to a depression.

Well, there are several problems with this economic theory.

Let’s start with common sense and what’s happening in our daily lives. Do you, as consumers, prefer to buy stuff that is cheaper or more expensive? I think we all know the answer to that!

We are all consumers, and we all benefit when prices go down. If we pay less for one good, it means we have some money left to buy other goods.

Economic activity does not stop. It simply means we can buy more with the same amount of dollars. And more purchasing power means a higher standard of living for everyone.

In fact, there is nothing mysterious about the effects of lower prices. Think about computers.

Fifteen years ago, they were big, not very powerful, had few gadgets, and cost a lot more than today. Prices in the computer business have been going down all the time since then.

Have people stopped buying computers or waited years before buying a new one to benefit from even lower prices? Absolutely not. On the contrary, more computers are being sold as their prices go down.

But perhaps these are too anecdotal examples dealing with only a limited aspect of reality. The economy as a whole might work differently, and if you observe a sustained drop in the overall level of prices, you will get different results.

So I did a little search to try to find out what had happened in the past in periods when there was deflation.

Two economists at the Federal Reserve Bank of Minneapolis, Andrew Atkeson and Patrick J. Kehoe, did precisely this five years ago. Their paper is entitled “Deflation and Depression: Is There an Empirical Link?”

Their conclusion is quite interesting.

They examined dozens of episodes when prices went down in 17 countries over a period of a hundred years. In the large majority of cases, these were periods not of depression, but of economic growth. The only major exception is the period of the Great Depression.

This is what they conclude: “Overall, the data show virtually no link between deflation and depression.”

So! There you have it! The idea that falling prices lead to depression is simply not true historically. But it seems that almost nobody took the trouble to check the historical record.

Which makes you wonder if central banks did not overreact when they printed hundreds of billions of dollars to make sure we would not be entering a deflationary period.

Could deflation instead be a positive economic phenomenon? That’s what I will discuss in my next video message. Thanks for listening and see you then.