Wednesday, 30 May 2012

Where's the Deflation?


I think it’s time to throw my fedora into the ring regarding the inflation debate. One of the most interesting things about the economic crisis has been the conspicuous absence of deflation. With large output gaps pretty much everywhere, even today, it’s strange that inflation remains around or above target in most advanced economies (ignoring for a moment the internal devaluation taking place in countries like Ireland and Spain). One would expect that, with large excess capacity, prices would fall. Britain is the starkest example of this not being the case; consumer price inflation is still running at 3% year-on-year, having peaked at over 5% in 2011. There are a few different explanations for this phenomenon.

One is that output gaps simply aren’t as large as we think they are. Perhaps the financial crisis seriously damaged potential GDP. There has been quite a lot of focus on hysteresis effects recently – the effect of a reduction in GDP on potential GDP. Estimates of maximum capacity have been revised significantly down pretty much across the board, including in the US and UK. Certainly, if the economy was running at above capacity before the crisis, and potential GDP has been almost flat since then, the output gap might be a lot smaller than estimated, and so might not be exerting nearly as much downward pressure on prices as previously assumed.

This has disturbing implications, because it implies that the high unemployment and low growth that we see today have become permanent structural problems within the economy rather than being symptoms of a reversible shortfall in demand. Rising rates of long-term unemployment and falling labour-force participation support this conclusion. The structural hypothesis basically surmises that unemployment is high not because employers are unwilling to hire, but because they can’t find workers with the right skills and experience.

Fortunately, it is unlikely that our structural problems are quite this bad. For one thing, the economy might not have been running too far above capacity prior to the crisis. After all, inflation was fairly close to target in 2006 and 2007. So, even if there has been low growth in potential GDP over the past few years, there’s still likely to be a sizeable output gap, at least in the UK, where actual GDP is still 4% below its pre-crash peak. Further, there is some evidence suggesting that the woes of the economy are more to do with demand than structural problems. Employment hasn’t fallen only in specific declining industries – every sector has seen significantly reduced payrolls. Moreover, this chart suggests that most UK employers would be able to find workers with the right skills, if only they were actually looking to hire at all. Ultimately the buck stops with the demand side; any structural issues are actually being created and reinforced by a persistent lack of demand. This means that, while structural problems are an issue, fiscal and monetary stimulus would help remedy the problem, by increasing actual GDP and preventing the structural problems from getting worse.

Meanwhile, if there is a large output gap, then something else must be to blame for high inflation. Some economists, notably Paul Krugman, have attributed the lack of deflation to sticky prices, specifically the downward nominal rigidity of wages. It’s not especially counterintuitive a concept; most people understand, if they think about it, that it is very difficult to cut people’s wages in nominal terms. If people aren’t getting wage rises (and so losing out in real terms), that’s one thing. But an actual wage cut has different implications and employers are very reluctant to reduce wages. The upshot of this is that wages haven’t fallen despite high unemployment; in fact, most people’s wages have remained completely flat, with small rises for some earners, leading to an overall rise in wages. This chart from Krugman illustrates this trend nicely. Rising nominal wages exert upward pressure on prices, and so deflation is prevented and inflation remains stubbornly high.

This story is convincing and sticky wages have, in my view, contributed to high inflation. But there’s something deeper at work here, too. The current crisis has been compared to the Great Depression ad infinitum over the last five years. Interestingly, one initial response to the Depression in America was to prevent wage cuts in what was arguably a much more flexible labour market than today’s. This, it was hoped, would prevent prices from falling and so stop the debt deflation spiral which was ravaging America’s economy. But it didn’t work. Wholesale prices, especially, continued to tank and the result was the worst depression in modern history.

What had happened, of course, was deflationary pressure not from wages but from elsewhere. Reduced demand and the consequent fall in production in every industrial economy meant a collapse in commodity prices and this was a deflationary shock which policy was unable to offset. The million-dollar question, of course, is this – what’s changed since then?

One of the major differences is in monetary policy. In the early years of the Great Depression, America was on the Gold Standard and so didn’t have control over the money supply. This meant that they could do very little to discourage hoarding, because money was effectively guaranteed to maintain its value. Thus deflation became self-reinforcing, as people hoarded cash because it would be worth more following expected further deflation in the future. By contrast, the modern response to the depression and to the threat of deflation was massive monetary stimulus. Reduced interest rates and quantitative easing have meant that there has been an increase in the money supply that has offset reduced monetary velocity. You can debate endlessly the influence – or lack of it – that central banks have when interest rates are at the zero lower bound, but it seems likely that monetary policy at least contributed significantly to staving off deflation.

The other difference between today and the 1930s is globalisation. The world economy is increasingly integrated and there are a lot more industrial economies. In the Great Depression, steel prices collapsed because almost all of the demand for steel came from industry in America and Europe. Prices didn’t recover until industry did. In the modern crisis, commodity prices did drop, as the financial crash reverberated around world markets. But then something strange happened. Even though output was still severely depressed in the developed world, especially in Europe, commodity prices began to increase again. It wasn’t because of any isolated incident. Floods in Asia, the Libyan Civil War and so on may have disrupted the production of particular commodities, raising their prices. But the trend was present across the board, from corn to oil to copper, and the main reason for this is that demand is now global. Demand for these commodities might have fallen in the developed world, but it has increased massively in fast-growing China, India and Brazil. Countries like the USA and especially the UK, which buy large amounts of commodities from abroad, are particularly vulnerable to imported inflation from global market price increases. This is an important factor in considering why deflation has failed to materialise. Demand is rising in other places, and that’s having an effect on prices here in a way that it wasn’t during the Great Depression.

In the 1970s, ‘stagflation’ was a structural issue. Growth was low because potential GDP growth was low and the economy was running above full employment. Today this phenomenon occurs for different reasons. Large output gaps and low growth should and are be causing deflationary pressure, but this is being offset by commodity price rises as a result of increased emerging-market demand. And that’s an important part of the story, which sticky-wage-emphasising Keynesians too often fail to account for.

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