Tuesday, July 1, 2014

Deflation Skeptics

Michele Boldrin, Giovanni Federico and  Giulio Zanella have an excellent essay on noisefromamerika, Should we worry about deflation? Maybe yes, maybe no. (If your Italian is rusty, Google translate does a fine job with it.) This matters of course, as deflation is the great European preoccupation at the moment.

They remind us that, although deflation was correlated with the Great Depression in the US and some other countries,
Source: noisefromamerika.org. "PIL" is GDP
that correlation is not universal. For example, in the late 19th century, deflation coincided with strong growth,

What's the difference?


Well, read the article, but in short the key to becoming an economist is recognizing that there are always two forces at work, something like "supply" and "demand." Demand-driven deflation is -- or is a sign of -- something bad. (Actually, the "bad" comes from prices being "sticky" which one might argue means not enough deflation!) Supply-driven deflation -- productivity growth making things cheaper -- is a sign of something good. Most analysis presumes it's always "demand," and that the cause runs from deflation to output, not the other way, and not some third cause. It's never so obvious. Is Europe's deflation bad or good? Neither they nor I take a stand, but it's enough to shout from the mountaintops "wait a minute, it's not so obvious."

They blow up the standard story that with deflation people wait around to spend later when their money is worth more.

They remind us of a few articles with similar findings, including David Beckworth on Aggregate Supply-Driven Deflation and  Andy Atkeson and Pat Kehoe in the AER, who confirm some cross-sectional relation between deflation and Great Depression,

Source: Atkeson and Kehoe, American Economic Review

but likewise point out the absence of any relationship in larger more comprehensive historical experience,
Source: Atkeson and Kehoe, American Economic Review.

Andy and Pat conclude,
The data suggest that deflation is not closely related to depression. A broad historical look finds many more periods of deflation with reasonable growth than with depression, and many more periods of depression with inflation than with deflation.
i.e, hyperinflation is usually accompanied by depression,  not a boom. 

"What about Japan?" I hear you ask?
Figure 4 essentially shows a 40-year decline in the output growth rate (Fig. 4A) and a 30- year decline in the inflation rate (Fig. 4B). We think standard theories, either neoclassical or new Keynesian, would have a hard time blaming Japan’s secular growth slowdown on its secular decline in inflation. [JC: What they're saying is that monetary policy is eventually neutral. Prices are not sticky for 30 years in any model.] 
But that slowdown would naturally arise in many growth models in which a country grew rapidly in the early postwar period because it had been below its steady state growth path; as it caught up to this path, its growth would naturally slow. Has Japan’s growth slowed too much? Not relative to countries like Italy and France. At 1.41, Japan’s growth in the 1990’s was dismal compared to the U.S. growth of 3.20, but not compared to the growth of Italy (1.61) or France (1.84)
Boldrin, Federico and  Zanella update and expand on the comparison
Two decades from the beginning of the "deflationary depression" in Japan, it's worth noting that Real GDP per capita in Japan in 2012 was about 18% higher than it was in 1990, while in Italy it was slightly lower. GDP per hour worked (productivity) in Japan is today roughly 35% larger than 20 years ago. In Italy it is 6% larger. The unemployment rate in Japan is nearly a third (1/3!) of the Italian rate, in the face of a 25% larger labor force participation rate. 
In other words: If Japan is in a twenty year recession caused by persistent deflation, we (Italians) have been in a twenty-year disaster that is much worse, and this notwithstanding that the Italian inflation rate, in the same time period, has been positive and among the largest in the euro area.
An intriguing question is left a bit open, what does cause these long periods of slow deflation? Boldrin, Federico and  Zanella endorse a demographic view, that aging societies have low inflation. I find it interesting but not quite obvious to "anyone who doesn't have salami slices on their eyes" (best expression of the month prize.)

Conclusions:
Neither theory nor data suggest that deflation may be the cause of a deep economic depression. Even in the one significant historical case in which deflation and depression went together, the 1930s, the causal relationship is  dubious, and the object of ongoing debate among researchers in economic history. On average, deflation is associated with economic growth, not a recession. From the point of view of economic theory, the argument that "when prices are expected to fall, you defer purchases and this creates a vicious circle of recession / deflation" is, with all due respect to Mike Woodford and all the theorizing about "forward guidance", unfounded both in logic and in predictions. Removing that theory, nothing, or practically nothing remains to motivate the great fear of deflation. 
The only reason by which today, in Europe in 2014, a serious and persistent deflation could be a negative factor is the risk of public debt, whose costs are not indexed to price changes. Countries, such as Italy, which are highly indebted and have issued a substantial amount of long-term debt, at fixed nominal rates,  would see the real burden of debt rise if the price level began to decline or stagnate for many years. This is a real risk, no doubt. But, on the one hand, does not have anything to do with the problems of growth and development, and, second, there is a solution...
where they describe a clever swap of non-indexed for indexed debt.

It's fascinating how many economists, pass on stories that just ain't so, selected anecdotes, and ignore that there is always the possibility of supply, not demand; of reverse or third causality, and so forth.

30 comments:

  1. "The only reason by which today, in Europe in 2014, a serious and persistent deflation could be a negative factor is the risk of public debt..."

    This is B. S. First, governments (even those like Italy) that have the power to tax can never experience a solvency problem. Sure, Italy can experience a cash flow problem - annual interest expense could exceed annual tax revenue in which case Italy can:

    1. Swap coupon bonds for accrual bonds (zero coupon bonds)
    2. Extend maturity
    3. Raise taxes
    4. Swap bonds for equity claims against tax revenue

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    1. You are right but the problem is Italy is in a fixed exchange rate regime, so there are political difficulties related to its commitment to that and European integration. This is nothing to do with economics.

      I believe a return to the Lira and inflation is not the answer for Italy. And Italian and Greeks know that a return to pre-Euro days is not an answer to the fundamental problems in their countries.

      Fiscal union with Germany (in a two speed Europe that excludes the UK and the recent addition of the Eastern Bloc) ultimately is.

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    2. Anonymous,

      The point I was making was that deflation does not affect a government's finances in the same way that it affects private enterprise. But you are correct, monetary union does not work well unless there is fiscal union.

      http://www.theguardian.com/business/2013/apr/09/eurozone-crisis-germany-eurobonds

      From George Soros: "The solution for all these problems of the eurozone can be summed up in one word: eurobonds. If countries that abide by the fiscal compact were allowed to convert their entire stock of government debt into eurobonds, the positive impact would be little short of the miraculous."

      Not included in the article is that for Eurobonds to work, a common tax must be applied throughout the Eurozone to make the interest payments on the Eurobonds.

      Delete
  2. Oh and on this:

    "where they describe a clever swap of non-indexed for indexed debt."

    As it turns out, swapping non-indexed for indexed debt does not help in the slightest, because of actions like these:

    https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_faq.htm#deflation

    "What happens to TIPS if deflation occurs? The principal is adjusted downward, and your interest payments are less than they would be if inflation occurred or if the Consumer Price Index remained the same. You have this safeguard: at maturity, if the adjusted principal is less than the security's original principal, you are paid the original principal."

    And so severe deflation does not reduce the value of TIPs held to maturity below their principle value.

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  3. I take it the authors are not concerned about household debt in europe either?

    I would like to see a supply and demand model of debt for hand to mouth agents...now that ive said im sure ill find one

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  4. This is a somewhat confusing post. Are there any popular pro-stimulus econobloggers who failed to make a case for why they think this is a demand driven recession? At whom is this post directed? With respect to "economists", this argument seems like a straw man, or simply behind the curve. Perhaps it is more accurately directed at blog readers.

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    Replies
    1. This is a paper by Europeans about Europe, bro.

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    2. Google "krugman sticky wages"

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  5. The two comparison periods arrived at deflation by different means.

    The late 1800s was an era of explosive development that spawned the economic empires of Vanderbilt, Rockefeller, Carnegie, Morgan, Edison, Westinghouse, et al. Things got cheaper because productivity rose.

    OTOH, during the Depression things got cheaper because money created during the economic froth of the 1920s was destroyed. Money became scarce relative to goods and services.

    Although technology continues to decrease the cost of certain things, that is offset by the ongoing substitution of debt for income in both the public and private sectors. The deflation that results from the destruction of that debt-money will be more like 1930 than 1880.

    LTV for auto loans now exceeds 100%. Student loans are over $1 trillion and the borrowers have no income. Junk bonds and margin debt are through roof. Public debt is a global problem. The deflation that follows the purging of this debt will be cleansing but extremely painful and amplified by the trillions of dollars in derivatives floating around the financial system.

    I just can't help but think anyone who tries to put a shine on this type of deflation is delusional. The two comparison periods arrived at deflation by different means.

    The late 1800s was an era of explosive development that spawned the economic empires of Vanderbilt, Rockefeller, Carnegie, Morgan, Edison, Westinghouse, et al. Things got cheaper because productivity rose.

    OTOH, during the Depression things got cheaper because money created during the economic froth of the 1920s was destroyed. Money became scarce relative to goods and services.

    Although technology continues to decrease the cost of certain things, that is offset by the ongoing substitution of debt for income in both the public and private sectors. The deflation that results from the destruction of that debt-money will be more like 1930 than 1880.

    LTV for auto loans now exceeds 100%. Student loans are over $1 trillion and the borrowers have no income. Junk bonds and margin debt are through roof. Public debt is a global problem. The deflation that follows the purging of this debt will be cleansing but extremely painful and amplified by the trillions of dollars in derivatives floating around the financial system.

    I just can't help but think anyone who tries to put a shine on this type of deflation is delusional. The two comparison periods arrived at deflation by different means.

    The late 1800s was an era of explosive development that spawned the economic empires of Vanderbilt, Rockefeller, Carnegie, Morgan, Edison, Westinghouse, et al. Things got cheaper because productivity rose.

    OTOH, during the Depression things got cheaper because money created during the economic froth of the 1920s was destroyed. Money became scarce relative to goods and services.

    Although technology continues to decrease the cost of certain things, that is offset by the ongoing substitution of debt for income in both the public and private sectors. The deflation that results from the destruction of that debt-money will be more like 1930 than 1880.

    LTV for auto loans now exceeds 100%. Student loans are over $1 trillion and the borrowers have no income. Junk bonds and margin debt are through roof. Public debt is a global problem. The deflation that follows the purging of this debt will be cleansing but extremely painful and amplified by the trillions of dollars in derivatives floating around the financial system.

    I just can't help but think anyone who tries to put a shine on this type of deflation is delusional. Buonanotte al secchio!

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    Replies
    1. Oy vey. Note to self: don't use your phone's browser to comment on this site. Or increase the lithium dose.

      Delete
  6. Excellent! Thank you for this post.

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  7. Deflation and Inflation are a continuum. After a shock, inflation must be high enough to allow relative wages and prices to reset upward. Too low inflation or deflation puts downward pressure on wages. Wages are sticky and downward wage pressure translates into unemployment rather than paying the same employees less money.

    Inflation that is too low is only marginally less bad than deflation. They are a continuum. Nothing magical happens at zero inflation. Our long bout of too high unemployment suggests that wages are not rising fast enough and 2 percent inflation target is too low to maintain full employment. Inflation should not be stable. Wage inflation needs to increase during recessions and decrease when an economy overheats. After a large economic shock, inflation needs to be high enough to allow relative prices to reset upward easily. Trying to hit an inflation target that is too low unnecessarily impedes relative prices and wages from resetting upward.
    -jonny bakho

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  8. It's fascinating how many economists pass on stories that just ain't so, selected anecdotes, and ignore that in Europe right now there is an enormous demand slack, and try to suggest instead, without showing any evidence, that "supply, not demand" is the problem!

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    Replies
    1. Those crazy Europeans! They decided to stop buying stuff and express their new ascetic approach to life. They cannot revive their economy until they revive their Joie de vivre. If they would only spend their last Euro, wealth would flow into their life to replace it. Keynes says so.

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    2. Believe it or not, but in the Eurozone there is spare capacity and unemployment. Oh! I know: new classical models say this is impossible. I guess we are looking at different things!

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    3. It's not an ascetic approach to life, but fear of the future, that holds demand down.

      Delete
  9. Good to see some analysis rooted in historical analysis, rather than the usual stuff that comes out of macro.

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  10. Economists have emphasized demand driven events ignoring supply driven events? Did you miss the last 30 years (New Classical and Real Business Cycle) were old fashion Keynesian stories were simply ignored by a lot of the modern macro crowd? Incidentally, I must have missed the surge in productivity in Europe over the past few years!

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  11. Physicists have given mathematics a good name. It seems that equations can predict everything because they predict so much about the physical world. But, this is a shallow understanding of math. Physicists have carefully investigated the predictions made by their equations and have thrown out all of the "non-physical" results. Math predicts physics only because physicists have thrown away all of the math and interpretations which turned out wrong.

    In particular, equations do not care about cause and effect, and it is easy to manipulate some equations and then interpret them as saying that the effect produces the cause.

    This is common in economics, where biased economists compute some result and then proclaim that it must be correct because the equations say so. The worst offender is Keynesian economics.

    === ===
    John: Here are my restaurant bills for the last 5 years.
    Mike: Another discovery?

    John: My restaurant spending is always close to 10% of my income. That is, my income is 10 times my restaurant spending. So now I know a fun way to increase my income.
    Mike: I have to hear this.

    John: I will increase my restaurant spending by $2,000, and I will enjoy every minute of it. Then, my income will go up by about $20,000. That is what the chart says.
    Mike: You're nuts.
    John: No, I'm Keynes.
    === ===

    The Kenesian spending multiplier comes from reversing cause and effect.

    Steven Landsburg writes about this problem, but I don't think he gets to the bottom of it.
    ( http://www.thebigquestions.com/2013/06/25/the-landsburg-multiplier-how-to-make-everyone-rich/ )

    I do a further analysis here:
    ( http://easyopinions.blogspot.com/2013/07/the-illogic-of-keynes-multiplier-1.html )

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    Replies
    1. Andrew, on the subject of physicists, math, models and macro, this physicist (and amateur macro enthusiast) has come up with a macro theory unlike any I've seen before (but then, I'm an amateur too, so perhaps that reflects my limited background on the subject). As you can see from the link, the "hard core" of his theory can be stated pretty succinctly. The solution to that equation comes in two flavors: "endogenous" and "exogenous," analogous to how the solution to the equations of electromagnetics can be dynamic (self propagating waves) or static.

      But here's his challenge to professional macro economists: show him your plots of your theoretical model of the price level plotted alongside the empirical data. He does a google image search for that and get's his own plots back!

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    2. Andrew, I may be wrong, I haven't really studied Keyns, but I always understood that the multiplier works when there is lack of demand, which means unemployed resources. It best works at government level:
      Government inputs money into economy through projects (let's say 1% of GDP in construction works). This money employs people and machines (and companies) that would otherwise sit idle (lack of demand!). They earn money and pay taxes. They pay material and earn something extra to pay for preferential stuff. their suppliers also earn money, pay taxes, pay their suppliers and earn enough for preferential stuff. People who produce preferential stuff (cars, luxuries, better food, technical appliances, services...) also earn money, pay taxes and have something to spend and so on.
      Some people say factor is around 5 (if you input 1% GDP, GDP rises by 5%). That would be wonderful. Others say it's close to 1.5 (I'm inclined to agree with them). At minimum, it should be 1.
      When it is lower than 1:
      When home production is very low, and import covers most of the market (much, much more than in the USA) - money would go to producers in foreign countries.
      When everybody saves most of the money - studies have shown that low-income people tent to spend almost as much as they earn, as percentage, much more than people with lots of money. As long as most of the money goes into pockets of lower-class workers, as opposed to high-level managers, more will be spent than saved.
      When there is no free capacity (when there is no lack of demand). This works if government money employs resources that would otherwise sit idle. If those resources would be employed in other ways, there is no positive impact from government funds - actually, if economy is near full employment, it would increase inflation and hurt economy.
      Economists and politicians have lots of tools at their disposal. Key is applying the right one. Think of it as a repairman: if you try to take out screws with pliers, or ram the nails in with the sledgehammer, you can't say the tools don't work. You just need to find the right ones.

      I've seen it mentioned in texts as far as 19th century, governments should spend in times of crises and save in times of prosperity. I just haven't found many politicians throughout history willing to save in times of prosperity.

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    3. To Anonymous - July 3, 2014 at 6:27 AM,

      Yes, you understand the government line justifying its tax/borrow and spend policies. It is a "narrative", a vague story which is supposed to justify its actions.

      Whether tax, borrow, or print, government spending directs current resources (food, housing, entertainment) toward building or creating something. The value of that spending is only what is produced plus vote buying. What is produced is usually small or useless. Valuable resources disappear; the project is all that remains.

      As part of the stimulus package, the US built thousands of sidewalks in the wrong locations. According to government accountants, this boosted GDP. We are all waiting now for the prosperity that is sure to come.

      I invite the government to give me the money. I promise to quickly spend it all, thus doing my difficult and patriotic duty to multiply wealth for all.

      A fantasy supports the idea that our government increases the wealth of our society when it borrows and spends. There is no wealth multiplier from the flow of money. If there were, we would all be living in Aruba by now as a result of huge government borrowing and spending.

      If there were a multiplier such as the supposedly conservative 1.5 claimed by Team Obama, then we could  Counterfeit Our Way to Wealth.

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    4. This comment has been removed by the author.

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    5. Andrew, you misunderstand the multiplier. the multiplier exists only in recessions (and not all of them). Actually, most benefits of government spending on GDP exist only in recessions (I'm not talking here on social benefits, like keeping people who otherwise wouldn't be somewhat healthy and fed).
      The benefit of all those sidewalks is that people who built them earned some money, people who produced concrete earned some money, and so on. Without those projects, nothing would have been built. No valuable resources were spent on those sidewalks, and no more useful project was stopped because workers were building sidewalks. Assuming concrete and other resources came from USA, money spent on sidewalks fully entered USA GDP. If you look at deficit relatively (deficit/GDP) instead of absolutely, even if there is no multiplier, money spent by the government should be at least transferred to GDP in 1:1 ratio, so there is negligible effect on deficit.

      Delete
    6. To Anonymous,

      The cost of the sidewalks is what the workers and concrete suppliers were paid.
      The government's deficit is increased by the amounts paid to them, the increased spending.

      The benefit to our society is the value of the sidewalks which were built. That is little or nothing because of where they were built.

      When a business produces something, GDP is the market value (not the cost) of what it produces.

      When the government produces something, it arbitrarily counts the value (GDP) as what it spent. It doesn't try to estimate the market value, so it just says that everything it spent is good. This goes against simple observation and reason, but it is convenient for claiming that all government spending increases GDP.

      The sidewalk workers are happy to be paid, but don't delude yourself that the government produced anything useful. Those workers exchange their salaries for real and useful goods. Those are the goods which were wasted on the sidewalk. Those goods disappeared into the hands of the workers for almost no useful result.

      If you are happy with that situation, then I assume you would be satisfied with hiring a plumber and finding that he had installed pipes uselessly in the wrong places. That would not add to GDP or to your happiness. You might be happy that they had built something which otherwise would not have been built. You might decide to call this effort GDP by the definition of the government. Your personal expense would have gone up by the amount you paid the plumber. If that amount were on a credit card, then it would be counted in your deficit.

      The government does these projects to hide the real purpose, which is to distribute money to its valued supporters and voters. In the case of the sidewalks these were municipal union employees. The claim of a multiplier is a claim that these projects "really" don't cost anything. But, people have looked around for the multiplied value and can't find it. Where does the extra value appear, other than in complicated equations?

      Delete
    7. That's good! Anybody else who suffered through the Dornbusch-Fischer macro text (the 1st edition before they fixed all the mistakes!) would appreciate this. Of course anybody that old remembers gas lines and stagflation too. I still feel the same as I did then, economists should not be granted their PhDs until they go work retail first. The top-down thinking turns into something approaching a delusional state pretty fast. Do they all have personal shoppers these days or what? Don't they look at their own food bills?
      In the US we have:
      constant double-digit inflation in necessities like food, shelter, and medical/dental care.
      Overwhelming downward pressure on the wages earned by actual working people.
      Constant inflation in what is paid to government workers.
      If you don't have (1) a government job or (2) government benefits or (3) are just plain rich
      you're toast.
      How long can the death spiral of formerly middle class workers go on? Don't the government/entitlement people think about the tax base? Many states and cities face ghastly underfunding of their pensions now. Oh and BTW Social Security Disability fund goes belly up in 2016. Should make for an interesting year.

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  12. DeLong, Summers, Eggertson etc are all a waste of space. MMTers provided a simple solution to all this years ago. But professional economists don’t like simple solutions to economic problems: it puts them out of work. They prefer complexity. That enables them keep themselves employed counting angels on pinheads.

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    1. "But professional economists don’t like simple solutions to economic problems: it puts them out of work. They prefer complexity. That enables them keep themselves employed counting angels on pinheads."

      Hear hear!!! You may not be an angel Mr. Musgrave, but you are definitely heaven-sent!

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  13. I had some trouble understanding the final sentence due, I believe, the punctuation and grammar. If (if) I understand the meaning correctly, wouldn't it be far clearer if the initial comma was deleted, and the "selected anecdotes" clause was a parenethetical after "stories" or moved thus:

    "It's fascinating how many economists pass on stories that just ain't so, selected anecdotes that ignore that there is always the possibility of supply, not demand; of reverse (or third) causality, and so forth.

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  14. Have you read Selgin's classic essay on supply-driven deflation John? www.iea.org.uk/sites/default/files/publications/files/upldbook98pdf.pdf
    I'd be interested to hear your thoughts on it.

    ReplyDelete

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