Don't Worry About Deflation


When an acquaintance of mine hired a personal trainer to help enforce his diet and exercise regimen, the results were impressive. Still, I can't help wondering how long his svelte new figure will last. Based on my own experience with middle-age spread, I wouldn't be at all surprised if two years from now his spare tire is back.

But I would be very surprised to see my friend's weight loss continue to the point that he becomes excessively thin. After all, for every Kate Moss who declares that "food is boring," there are thousands of us who rank eating way up there in terms of short-term gratification (No. 2 for me. How about you?). My point is, being overweight and being underweight are not equally difficult problems to fix. Dealing with one requires that you resist temptation. Dealing with the other requires only that you give in.

Why am I telling you this? To explain why I cannot take seriously the pronouncements, which we hear more and more often from Wall Street gurus, that the age of inflation has given way to a new age of deflation in which prices will fall more often than they will rise. There's surface plausibility in these claims: Inflation has more or less steadily trended downward since about 1980. And now, mainly because of the rising dollar and the crisis in Asia, the prices of quite a few goods (but not services) are falling. To some analysts, this looks like the beginning of a period in which excess capacity and global competition will consistently push prices downward--in other words, an era of deflation to match the inflationary '60s and '70s. But I don't believe it--because deflation, like being underweight (and unlike inflation), tends to be a relatively easy problem to fix.

Consider why we had an inflation problem in the first place. Milton Friedman once said, "Inflation is always and everywhere a monetary phenomenon." Like many of Friedman's dictums, this is too simple an explanation but mainly right. Prices have almost always and everywhere risen, not fallen, during the past 50 years because governments have encouraged money supplies to expand faster than the production of goods and services. Why? Increasing the money supply, like eating too much dessert, feels good while you're doing it. It produces an initial period of economic exhilaration, low unemployment, and rising profits. The bill comes later--and if a politician is lucky, during the next guy's Administration. Then, curbing inflation tends to be painful. The big disinflation in the U.S. in the early '80s, when inflation went from 9% to the 4% range, was accompanied by a severe recession and prolonged high unemployment. Of course, we chose to accept the pain. But it didn't come easy. In fact, the rehabilitation wouldn't have been possible if we hadn't retained the services of a tough personal trainer, a fellow named Paul Volcker.

So far, the results of our economic fitness program have endured. Indeed, keeping the weight off seems to have gotten easier over time, at least in the U.S., where wage increases have remained surprisingly subdued despite tight labor markets. But while our economy may be less inflation-prone than it used to be, this is no reason to believe that deflation is about to become a problem. After all, if you start to get too skinny, there's an easy answer: Just relax and enjoy life a little. In fact, Coach Greenspan, concluding that America's metabolism has increased, has lately been cutting his client some slack, letting the economy boom for a while without raising interest rates. This is why our unemployment rate is at a 25-year low.

Granted, there have been epochs of deflation in the past. But the more you know about them, the less relevant they seem to the modern world. For example, there was sustained deflation in the late 19th century. That was because we were on the gold standard, and the supply of gold couldn't keep up with rising world output. There was also a short but vicious spell of deflation in the early 1930s. The U.S. banking system collapsed then, thanks in large part to the eerie passivity of the Fed in the face of a financial panic. Other countries didn't have to follow us down, but because they insisted on staying with gold, they did. Really, I can't see anything in today's world producing sustained 19th-century-type deflation. And a 1931-style collapse would require not only that everything that can go wrong actually does, but also that Alan Greenspan and his German counterparts behave with completely uncharacteristic stupidity.

I don't care how bad the news from South Korea gets or what happens to next month's producer price index. I'd still find it hard to imagine a world in which deflation becomes a trend. While Asia's woes may put temporary downward pressure on the prices of some goods, we are mainly a service economy--and anyway, Greenspan can handle any short-run deflationary pressure by serving us an extra monetary helping or two. On the other hand, if someone offered me an option on the possibility of a return to, say, 4% inflation three years from now, I'd be prepared to buy it on general principles. No matter how much we vow to battle indulgence, that extra dessert is all too tempting. In fact, I think I'm ready for a snack right now.

Originally published, 2.2.98