Why We Don't Need to Fear Deflation

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The talk about the economy in recent weeks has been somewhat deflating. There's the ongoing crisis in Europe, disappointing jobs numbers, a falling stock market—and the prospect of deflation itself.

Deflation—the evil twin of inflation—rears his ugly head with great infrequency. He hasn't been seen around these parts for nearly 80 years, and there's no committee that convenes to declare his return, as the National Bureau of Economic Research's Recession Dating Committee does for economic contractions.

Economists generally agree that deflation is a widespread fall in prices, as measured by the consumer price index (CPI). "I don't know if there is a textbook definition, but I would want to see a full year of falling consumer prices before I announced that deflation was in process," says Brad DeLong, professor of economics at the University of California, Berkeley. The CPI, up 2 percent in the past 12 months, fell in both April (-0.1 percent) and May (-0.2 percent) and has been basically flat for the first five months of 2010.

What's so bad about deflation? After all, it's a pleasant surprise when prices of many items fall. Generations of Econ 101 students and central banks have been schooled to think that inflation is the great bogeyman, since it erodes the value of savings. And for much of our lifetimes, moderate inflation has been the norm. Well, it turns out there's good deflation and bad deflation.

Bad deflation is the kind we had in the Great Depression. "The last time we really had significant deflation in the U.S. was in the 1930s," notes Michael Bordo, professor of economics at Rutgers University. "Between 1929 and 1933, prices fell on average by 15 percent." This deflation was driven by a decline in output, demand, and credit—too little money and wages chasing too many goods and workers. The Depression-era cratering of wages and prices was disastrous because it rendered companies and consumers less able to pay their debts.

But there have been periods of good deflation, in which prices fell even as the economy boomed. In the 1920s, known to this day as the roaring '20s because of the decade's economic vibrancy, prices fell about 1 percent per year. Between 1870 and 1896, prices fell consistently amid rapid economic growth—with plenty of booms and busts along the way. The reason: innovations like the railroad, the telegraph, electricity, and the assembly line helped farmers, entrepreneurs, and manufacturers to produce and ship their goods more cheaply and efficiently.

Making a value judgment about deflation depends in part on which side of the balance sheet you sit on, and on what's going on in the broader economy. Borrowers with fixed-rate loans—like the government, many companies, and homeowners—will cheer for inflation and worry about deflation. When wages and prices grow modestly each year, it's easier to stay current with existing debt. And when there's lots of unused economic capacity—shuttered factories, large numbers of unemployed people—a little inflation can be just what the doctor ordered. Continually falling prices act as a disincentive to investment and risk taking. Moreover, many economists and most central bankers believe the ideal rate of inflation is slightly above zero. "Experience shows that a rate of inflation around 2 or 3 percent helps the economy to perform at full potential with maximum sustainable employment," says Joseph Gagnon, senior fellow at the Peterson Institute for International Economics. In fact, the Federal Reserve, the nation's chief inflation fighter, actually wants prices to rise. One of the Fed's mandates is to provide "price stability," which means a consistent, reliable annual inflation rate. Without saying it in so many words, the Fed designs monetary policy to target inflation of between 1.5 and 2.0 percent per year.

The next reading of the CPI comes out in mid-July. A negative number will mark the third straight decline and will surely inflate the volume of talk about deflation. (We haven't seen four straight monthly declines in the CPI since the 1930s.) But when considering the risks of deflation, we shouldn't look at the CPI in isolation. The phenomenon of prices falling modestly at a time when the economy at large is growing at a 3 percent click, as it is today, isn't much to worry about. "The combination of slow growth or stagnation and deflation is the thing that's scary," says Michael Bordo. In other words, look out for stagflation.

Daniel Gross is also the author of Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation and Pop!: Why Bubbles Are Great For The Economy.