Unemployed men queued outside a depression soup kitchen opened in Chicago by Al Capone.
The Bank for International Settlements, or the “central bankers’ central bank,” is out with an important new study on deflation. Economists’ obsession with deflation and the new made-up problem of “low-flation” (inflation below the central bank’s target) has the world’s central bankers flooding the global financial system with liquidity in an effort to turn the tide. Sweden’s central bank was the latest to pump more liquidity into its economy by further reducing its policy rate into negative territory and increasing the size of its bond buying program.
Central bankers are obsessed with deflation. This obsession is no doubt colored by the deflationary spiral during the Great Depression. But is the Great Depression the rule or the exception on deflation?
According to a new study by the BIS that spans over 140 years of history and 38 economies, economists “…deep-seated view that deflation, regardless of context, is an economic pathology that stands in the way of any sustainable and strong expansion” is out of sync with the historical record and, I will add, is utterly misguided.
The BIS goes on “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.”
It should be obvious even to folk with only a rudimentary understanding of supply and demand that lower prices result in greater demand and thereby greater economic output. Somehow this seems to have been lost on the world’s central bankers. When there is low inflation or deflation, the world’s central bankers mechanically assume it is a problem caused by weak demand rather than a supply-driven benefit.
Why is this a problem? As the BIS points out “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. Yet the strength of that effect is an empirical matter. One problem in assessing the cost of goods and services price deflations is that they often coincide with asset price deflations. It is possible, therefore, to mistakenly attribute to the former the costs induced by the latter.”
Easy money is being used to fight the prospect of goods and services deflation that has at worst an ambiguous effect on economic growth at the cost of inflating asset price bubbles that have a clear and devastating impact on economic growth.
In the U.S., the Fed’s obsession with “low-flation” in the early part of the last decade pushed the bank to keep rates too low for too long. The result was the worst financial crisis since the Great Depression.
How will today’s period of excessive monetary accommodation end? Here’s hoping that this time is different!
You can read the full BIS paper here.