The collapse of the housing bubble and the subsequent devastation to the economy caught almost the entire economics profession by surprise. Federal Reserve chair Alan Greenspan, along with other people in top policy positions, were left dumbfounded. They didn’t think a prolonged downturn was possible. They were wrong in a really big way.
The current group of central bank chairs and other top policymakers would like us to believe that they’ve learned their lesson and now everything is under control. They want us to think they actually have a clue about how the economy operates. There is good reason to believe otherwise. The European Central Bank (ECB) recognizes that inflation has been running below its 2% inflation target and is likely to stay below that target for several years to come. But the ECB has reassured the public that’s prepared to act, making sure that the eurozone doesn’t see deflation. That the bank cares about the inflation rate crossing zero and turning negative is a sign that it has no clue about how the economy works.
The point here is incredibly simple – apparently too simple for the ECB to understand. The inflation rate in the eurozone is too low right now. If it falls below zero and turns negative, this problem becomes more serious, but there is no qualitative difference between a drop from 1.5% inflation to 0.5% inflation and the drop from a 0.5% inflation rate to a -0.5% inflation rate.
To understand this dilemma, you just have to understand what the inflation rate is. It’s an aggregate of millions of different price changes. When the rate of inflation is near zero, there will be tens of thousands of prices that are falling. But these will be outweighed by the prices that are increasing, thereby making the aggregate inflation rate positive. What possible difference can it make to the economy if the mix of falling prices and rising prices goes from 45% falling and 55% rising to the opposite?
Another factor that shows the absurdity of deflationary fears is another pretty simple one: prices in our indices are quality adjusted prices. The price that people pay for a car or a computer may rise year-to-year, while the inflation index shows a decline for these items.
This would happen if the statistical agency calculated that the quality improvements were larger than the price increases, leading to a fall in the quality adjusted price. So we are supposed to believe that the economy is in trouble if the quality of computers and cars starts to increase more rapidly?
One of the oft-repeated deflation horror stories only needs a moment’s thought to realize its absurdity. Supposedly, if prices start to fall, then consumers will put off purchases. Really? If the price of a $30 shirt is falling at an annual rate of 0.5%, will many people delay buying a new shirt for six months to save 8 cents? Even in the case of a $20,000 car, delaying the purchase for a year only saves a consumer $100.
Of course, the quality adjusted price of computers has been falling for decades. This sector has not exactly been struggling.
Sometimes we hear a story of a deflationary spiral, wherein deflation reduces demand, leading to more deflation and a still further drop in demand. It’s a great story, but no one has seen anything like this since the start of the Great Depression. Even in the Japanese deflation horror story, the rate of annual deflation never exceeded -1.0%.
Incidents of runaway deflation, like hyperinflation, are extremely rare and would occur under extremely unusual circumstances. Both may make for good fairy tales for the kids, but they are not the sort of thing with which serious people need concern themselves.
While the concerns about deflation can be dismissed as silly children’s tales, there are two reasons that we should be troubled by their appearance in policy discussions. The first directly relates to current policy.
The eurozone is suffering from a lower than desired inflation rate now. With the overnight interest rate near the zero bound, the real interest rate cannot fall further unless the inflation rate rises. Since a lower real interest rate would help move the economy to full employment, the ECB should be trying to raise the inflation rate, not saving its ammunition against the risk that the inflation rate would turn negative. The menace of deflation provides an absurd excuse for inaction.
The other reason that we should be troubled by deflation talk is that it seems our top policymakers still don’t have the most basic understanding of the economy. The failure to see the bubbles was not a one-time lapse in judgment, it stemmed from seriously confused thinking about the economy. There really was no excuse for an informed economist not to recognize these bubbles and the threats they posed. It doesn’t appear that much has been learned in the last six years. The basic problem is that the economy is far too simple for economists to understand.