As UK inflation turned negative in April, some took the news as yet more evidence that the spectre of deflation haunts the world economy.
Deflation is all too often seen as a dark cloud hovering over the horizon, about to unleash its destructive force. But deflation and depression are not synonymous. The Great Depression in the 1930s, with simultaneous deflation (falling prices) and depression (falling output), was more the exception than the rule. During the nineteenth century, deflation and GDP growth went hand in hand – as friends, not enemies. Much of it was an era of good deflation: gently falling prices amid productivity gains and flourishing world trade. Britain was in deflation for 51 years in the nineteenth century.
When it comes to deflation, what matters is what causes it. Periods of deflation can be malign or benign, depending on whether they are driven by a positive shock to aggregate supply, or a negative shock to aggregate demand. Many goods and services display fast-growing output with sharply falling prices – TVs, IT, and communications, for example. Benign deflation is simply an aggregation of greater supply across the whole economy.
And according to economic theory, deflation is not necessarily a bad place to be either. Under the Friedman Rule, deflation with zero interest rates are the optimal economic policy. Moreover, prior to the Keynesian revolution – which began in the 1930s – attitudes towards deflation were very different, with simultaneous deflation and economic growth seen as part of the natural economic order. A secular decline in prices was acceptable because improved productivity meant the cost of making each item was lower. In other words, prices fall at the rate of productivity growth.
Over the past 20 years, around two billion workers have been added to the global workforce, owing to the collapse of communism and economic reform in India and China – the fall of the iron and bamboo curtains. Since then, there has been a surge in the supply of cheap labour and money. Deflationary pressures are not surprising given these fundamental geopolitical shifts.
None of this ignores the potential risk from malign deflation. Worrying deflation comes about through postponed expenditure, rising real interest rates, falls in asset prices, liquidity traps, deleveraging and declining net worth. Things can go wrong – but we’re not there yet.
On Tuesday, the chancellor stated that deflation was good news when set against improving wage growth – and he was right. Deflation in the UK is more technical and transient than systemic and enduring.
Across the globe, the deflationary impulse is relatively benign at present – with the exception of the Eurozone.
Two factors risk shifting the global deflationary threat to malign. First, the negative effects of any eventual normalisation of monetary policy. Second, any negative shock to asset prices. Deflation reduces the threat from normalisation by limiting upward pressure on interest rates. Unfortunately, the knock-on effects of QE, and the associated surge in liquidity, have pushed many asset prices to dizzy heights, leaving the world economy vulnerable to a negative asset price shock. A market correction, rather than a crash, will help to keep deflation benign and avoid its malign cousin.