Most people think of deflation as malign, since it raises memories of the slump of the 1930s. Yet some periods of deflation have been benign, coinciding with booming output and declining unemployment. How do we know which is which? Essentially, malign deflation occurs when aggregate demand declines, so prices are reduced in a climate of declining sales. Benign deflation occurs when productivity and supply increase, so that firms can reduce their prices while profitably expanding sales.
We are not seeing deflation at the moment, but we are close to it. OECD price inflation, as measured by GDP deflators, has dropped to 1 per cent, and it is declining.
If deflation is beckoning, will it be benign or malign? There are symptoms of both. In Japan, the Far East and Latin America the dominant force is malign; prices are falling in slump-like conditions. In the US there is evidence that productivity growth has improved.
In the early stages of the world economic upswing, from 1991-1996, it was possible to argue that benign forces were in the ascendancy. Price inflation was falling while output growth was rising. Since 1997, however, this pattern has reversed. There is now no doubt that a collapse in global demand is dragging down prices and output. Can this threat of malign deflation be stopped?
It depends on assuming an enlightened role for public policy. In the 1970s Milton Friedman attained notoriety by pointing out that inflation is "always and everywhere a monetary phenomenon". In principle, the same applies to deflation. Although prices are not determined simply by the behaviour of any single measure of the money supply, Friedman was proved right in the greater truth that the overall monetary framework determines the price level, while long-run output is determined by the forces of supply.
Thus deflation can usually be prevented by an appropriate expansion in monetary or fiscal policy. The fact that governments and central banks around the world have allowed malign forces to gather momentum in the past two years represents powerful prima facie evidence that policy has been too tight.
Where should macro-demand policy be eased?Where the threat of excess capacity is most extreme. There is not much doubt about what this implies. The US economy is working 2 per cent of GDP above its normal capacity. Meanwhile, excess capacity in Japan remains at a remarkable 5 per cent of GDP, while in continental Europe it stands at a wasteful 1.5 per cent. It is time for Japan and Europe to stop freeloading on the strength of the US economy.
In Japan there is little prospect of this happening. The scope for fiscal easing is rapidly being circumscribed by the explosion in the budget deficit, which now exceeds 10 per cent of GDP. Furthermore, the central bank has, amazingly, allowed monetary conditions to tighten markedly in recent months.
By a process of elimination, that leaves continental Europe, where inflation is sinking below 1 per cent and unemployment stands at 11 per cent. Fiscal policy is planned to tighten by 0.5 per cent of GDP this year. Yet it is shocking that, with Asia and Latin America mired in deep recession, the otherwise healthy European economy should be choosing to run a large trade surplus, thus subtracting economic activity from the rest of the world.
Since 1990, the EMU countries have piled up a cumulative trade surplus of $320 billion (pounds 200bn), while the US has amassed a cumulative trade deficit of $1,370bn. The US should be telling Europe in no uncertain terms that the EMU bloc must ease demand policy aggressively, and soon, to alleviate the risk of global deflation.Reuse content