Friday, February 28, 2014

What is deflation, really?

What is deflation? This seems like a fairly simple question at first blush - negative growth of some price index, possibly allied with some arbitrary decision on how many quarters of data we need to judge a trend. But that's just a technical description of how to measure deflation, which is frankly, pretty boring.

Mario Draghi has 
offered another definition of deflation. “We don’t have any evidence of people postponing their expenditure plans with a view to buying the same thing at lower prices, in other words we don’t see what is defined to be deflation,” Draghi said after a Group of 20 meeting in Sydney. 

I'm surprised more people didn't respond to Draghi's claim. Firstly, that's a symptom of deflation, so not particularly useful as a definition per se. Second, this is a symptom/definition/cause that you see in textbooks, but I find it incredibly hard to believe. Japan is obviously the most recent example of deflation, so I hope some Japanese friends can comment on this, but it seems that purchases need to be highly time-elastic (i.e. people need to be very willing and able to postpone consumption) for this to be valid. 

I think we get at the "deflation" issue better if we look at what the word means in regular English. Deflation is the condition of being deflated, either physically, or figuratively. To deflate in the latter sense
 is "to depress or reduce (a person or a person's ego, hopes, spirits etc.); puncture; dash, as in "Her rebuff thoroughly deflated me." Deflation is essentially a crisis of confidence. Workers are scared to ask for higher wages. Businesses are afraid to ask for higher prices. No-one believes they have pricing power any more. And so the crisis of confidence feeds on itself as a deflationary mindset takes hold.

It seems unusual to me that confidence is seen as an important feature of booms and busts, but less of deflation and inflation. Perhaps that's because we couch it in monetary jargon like "monetary velocity". I don't dispute Friedman's dictum that inflation is always and everywhere a monetary phenomenon, but it seems to me that sustained deflation can only occur with a dwindling of confidence. It's not the shuddering, jarring collapse of confidence we see in busts. Instead, it's a slow draining of confidence and the subtle yet pernicious readjustment of expectations.

Wolfgang Munchau reports
 that Germany's federal statistics office said last week that real wage (i.e. after inflation) fell in 2013, which, as he notes, is shocking. I've seen many friends - again, experienced professionals graduating from a well-regarded programme - who have adjusted their expectations down from expecting full-time offers to seeing internships as the only way to convince employers of their worth. It's a reflection of the power differential between them and employers. Some of those employers, meanwhile, are no doubt facing fee pressure from investors. And so the daisy chain of ebbing confidence continues. I'm not Richard Fisher - I know that's anecdotal and has specific problems related to the finance industry. But it's worth considering, and I'm sure you can think of other examples in European labour markets where the insider-outsider problem has only been reinforced by this crisis.

I've gone on and on about deflation, but the worst thing is that deflation is itself just a symptom of insufficiently low nominal GDP or aggregate demand. So, as we (hopefully) criticise the ECB for low CPI inflation verging on deflation, let's keep the bigger picture in mind: ad hoc attempts to increase inflation will likely fail if they do not raise nominal GDP in a sustained fashion. After all, one of the lessons we've learned from high inflation (especially hyperinflation) is that the cycle cannot be broken with stop-and-go policies. What's required is a firm commitment to a sustained regime change. The same, we will probably see, is true of deflation.

1 comment:

  1. The long-term damage that deflation would cause does seem understated in the media. It's the crisis of confidence that we should be really worried about (BTW, great blog).