Borio, Erdem, Filardo and Hofmann on the Costs of Deflation

Claudio Borio, Magdalena Erdem, Andrew Filardo and Boris Hofmann have a nice paper, "The costs of deflations: a historical perspective"

Deflation remains the looming zombie apocalypse of international monetary commentary.  Before we argue too much about cause and effect, it's nice to get the correlations straight. And the correlation between deflation and poor growth is much weaker than most people think:

The authors:

...Price deflations have coincided with both positive and clear negative growth rates (Graph 2). And a comparison of all inflation and deflation years suggests that, on balance, inflation years have seen only somewhat higher growth (Table 2). The difference in average growth rates is highest and statistically significant only during the interwar years, particularly in the period 1929-38 that includes the Great Depression (some 4 percentage points), and much smaller at other times.... Indeed, in the postwar era, in which transitory deflations dominate, the growth rate has actually been higher during deflation years, at 3.2% versus 2.7%.

Really, the concern at the moment is not a sharp large deflation, such as occurred in the 1930s and is felt by many to epitomize the demand or debt deflation story. Rather, the concern is over a moderate but persistent deflation, such as Japan has experienced. (One in which each individual is likely to never experience a wage decline, more here.)

To summarize the historical record surrounding persistent deflations, the authors organize the data around the peak in CPI before a deflation episode, and show average CPI and GDP around that peak:

The authors:

 While mean growth rates are mostly lower in the five years post-peak, the difference is large, 3.6 percentage points, and clearly statistically significant (i.e.cannot be attributed purely to chance) only in the interwar years, when the Great Depression took place...The difference during the classical gold standard period is 0.6 percentage points but it is not statistically significant. In fact, in the postwar era, average growth was even 0.3 percentage points higher in the five years after a price peak, although the difference is not statistically significant. Moreover, only in the interwar years did output actually fall post-peak.

In a multiple regression sense, does variation in output correlate better with falls in the overall price level, or with falls in house prices or equity prices that accompany deflation?

The graph presents regression coefficients. Read it as the partial correlation, if (blue) property prices go down but consumer and equity prices do not, how much output gain or loss does that event signal?House price or stock price "deflation," not overall price deflation matters. Of course, stock prices and property prices are strong symptoms of economic trouble, so don't be quick to read causality into correlation and ask the Fed to punch up stock and house prices.

The introduction offers a corrective that every financial journalist should take with morning cappuccino. Any price change can come from supply or demand, and is as likely a symptom as a cause:

Concerns about deflation - falling prices of goods and services - have loomed large in recent policy discussions. The 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. 

The almost reflexive association of deflation with economic weakness is easily explained. It is rooted in the view that deflation signals an aggregate demand shortfall, which simultaneously pushes down prices, incomes and output. But deflation may also result from increased supply. Examples include improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labour or intermediate goods like oil. Supply-driven deflations depress prices while raising incomes and output.

Conversely, note the simultaneous worry in the US about "wage inflation" and that wages have stagnated. Wage inflation with stable prices is a good thing!

A minor quibble: Asset price "inflation" and "deflation."

Moreover, while the impact of goods and services price deflations is ambiguous a priori, that of asset price deflations is not. As is widely recognised, asset price deflations erode wealth and collateral values and so undercut demand and output.

First, "asset price inflation" sounds sexy, but our first duty as economists should be to help readers understand that relative price changes are not inflation. All relative price changes, including asset prices, are relative price changes, not inflations and deflations. Health cost "inflation," wine "inflation" and chewing gum "inflation" are not inflation. Don't encourage misuse of the word, misunderstanding of relative prices vs. price level, and consequent policy mistakes like using anti-inflation tools to manipulate relative prices.

Second, asset price "deflations" are in large part a transfer of wealth, not a loss of wealth. House prices go down. The houses are still there. This is a qualitatively different fact than if houses wash in to the ocean. If you are young, live in an apartment, and have a job, a house price decline is a great thing. If you plan to buy the same size house as you want to sell, a house price decline is a wash. If you are young, a bond price decline is a great thing. You get the same future payments at a lower price. To some extent the same is true of many stock price movements.