Friday, March 20, 2015

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.

11 comments:

  1. It is true that nuance have left the discussion of deflation. There can be both supply and demand side causes of deflation, and we shouldn't excessively worry about the supply side kind. However, what intrigues me is graph 1 of the linked paper. There is a stark difference between the classical gold standard/interwar periods and the Post WWII period in the number of bouts of deflation and their lengths. Deflation was common and for long periods time in the former periods and less likely and short in the latter period (with the notable exception of Japan). I think this difference is related to the changing correlations you highlight. If monetary policy across the world (and I use “If” intentionally here, because I am by no means an expert on the conduct of monetary policy by all the central banks in the sample) was used in the post war period to prevent demand based deflation, then I would expect the change in correlations. Central banks would allow supply side deflation, like that caused by a recent reduction in oil prices, since it is something that they can’t really do anything about, and it can be beneficial. Growth might correlate with deflation, because the bad demand type became extinct from the data for a while. However, that wouldn’t mean that demand based deflation wasn’t actually a problem, but that central banks around the world had combated it well in the recent past.

    ReplyDelete
  2. Central Banks hate deflation because they love to pay off debts in debased paper. It is their reason for being.

    ReplyDelete
  3. " All relative price changes, including asset prices, are relative price changes, not inflations and deflations. "

    A factory can spit out toasters , or cars , or houses. Calling certain outputs goods , and others assets , seems to me completely arbitrary as related to what to call the price changes associated with them. " Inflation" and "deflation" , as used by the BIS , represents evidence of an advance in economic thinking , not an error , IMO.

    An economy can be set up to generate "income" as "paychecks" or as "wealth" , in varying proportions depending on policies and the desires of the policymakers. To prevent this from becoming common knowledge , best to keep the terms inflation and deflation in their proper place , I suppose.

    ReplyDelete
  4. Inflation is when the aggregate of the price level rises (all goods, services etc). When your house price goes up or down, this can subsequently influence the aggregate price level by an minuscule amount (and so inflation/deflation), but your actual house going up in price is not inflation itself.

    Semantics are sometimes important.

    ReplyDelete
  5. 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.

    YES YES YES YES YES YES YES

    *takes deep breath*

    YES YES YES!

    ReplyDelete
  6. Reading your blog affords endless amusement, but it can be so terribly predictable at times.

    "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."

    You forgot to add the operative phrase to each and every one of these sentences. "If you are relatively wealthy." Those people without lots of disposable income to play with do not benefit in any way from any of those scenarios, and the housing price decline is not, for them, likely to be a wash even if they have somehow been able to afford to buy a house and are now trying to trade it in for a new one... because their house is probably now (after said decline) underwater.

    I've known a lot of people from the University of Chicago. It has only been the business, finance, and economics people who have had this puzzling assumption that everyone worth talking about is just like them.

    ReplyDelete
  7. Erm no.

    Inconsistent unless you think that Consumer Price Inflation is also not inflation.

    ReplyDelete
  8. History is fun.

    But for modern developed economies, with all the structural impediments of modern democracies, I would say the recent and substantial track records of Japan and the USA cannot be wished away.

    From 1982 to 2007, the US economy expanded in real terms at 3+% annually, and inflation was just under 3% annually compounded. Call it "3+3"

    Japan from 1992 to 2012 had minor deflation, and may have grown at 1% annually real, if that. International comparisons are always treacherous. Real wages fell in Japan, and, of course, property and equity values were eviscerated. Call it "-1-1".

    I am not sure, especially given the lengthy, real-world U.S, performance of 1982-2012, why anybody promotes deflation as an economic cure-all. We know the U.S. can prosper with mild inflation (to say nothing of the very robust growth of the 1960s, with even higher inflation).

    A deflationary policy strikes me as a very risky business, full of chances of catastrophic financial instability and a cratering of institutional and residential real estate values. Wall Street may find a bottom, but in four digits or five?

    True, you can buy another house in a deflationary environment--but first you have to pay off the mortgage on the one you live in now. Or, walk away from it, as in the US we use non-recourse loans.

    Certainly, robust economic growth should be the target of monetary, fiscal and regulatory policies.

    The substantial, real-world and relevant track records of Japan and the U.S. suggest deflation is not compatible with robust economic growth.

    But who would benefit in a deflation? Would sue group get a larger slice of the smaller pie?

    ReplyDelete
    Replies
    1. "We know the U.S. can prosper with mild inflation (to say nothing of the very robust growth of the 1960s, with even higher inflation)."

      Inflation was generally very low during the early and mid 1960s. In fact CPI inflation was well below 2 percent every year from 1959 through 1965. And I don't think I have ever heard anyone promote deflation as an "economic cure-all." Some people just don't think it necessarily leads to disaster. I think this gets back into the issue of supply-side vs. demand-side deflation.

      https://www.minneapolisfed.org/community/teaching-aids/cpi-calculator-information/consumer-price-index-and-inflation-rates-1913

      Delete
    2. I don't think that you have thought through the implications of a long period of deflation. A period that lasts 20 to 40 years. Inflation is a gift for debtors (the overwhelming majority of people who go into debt to buy a car, a house, a major appliance, or even a painting, as I did last year). The inflation gift is that they pay off a debt over time in ever cheaper dollars. If the debt payment is fixed over a period of thirty years the benefit of being a debtor is obvious.( I know that the 30 year mortgage is a GI Bill historical oddity. I know that most such mortgages are really ten year loans).
      The reverse will also be true. Long term debt in a deflationary economy is a millstone for a debtor (most of us). Prices sink. But wages also sink. The long term debtor will be paying a thirty year debt off with a decreasing salary, while the value of his house shrinks, but the terms of his debt is fixed. Few people will take these loans, and even fewer banks will make these loans. Deflation is a gift to the owners of money, just as inflation is a boon to the owers of money. The present system of purchasing a home will cease to exist. It will probably become a system of 50% down payments or 5 year term loans that have to be rolled over, or both.
      But make no mistake. The beneficiaries of a long period of deflation are not first time home buyers. The beneficiaries of deflation are the owners of money.
      It is true that this is a phenomenon for loans that endure for probably five or more years, but in a rational world of deflation, rational people will be very hesitant about taking on long term debt. The deleterious effects are obvious and inevitable: ever decreasing economic activity.
      I realize you put up a chart that showed growth in a deflationary era of the late 19th century. The deflation occurred because of the discovery of large deposits of gold the world over. If your economy is based upon a rock that you dig out of the ground and you discover a whole lot of rocks, prices will decrease but your economy will grow.

      Delete

Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.