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|  | MAY 14, 2004
By Christopher Farrell The Roots of Deflation [Page 2 of 2] THE PAYOFF Deflation is not synonymous with depression. The conventional notion that a persistent decline in prices is always a disaster, an economic disease to be avoided at all costs, a depression in the making, is wrong. University of Minnesota economist Timothy Kehoe examined the record of deflation in 15 countries over 100 years. There were indeed a number of episodes when nations experienced both deflation and depression. But it was more common for economies to grow during periods of deflation. Hyper-deflation, say a 1930s deflation rate of 5% to 10%, is ruinous. Period. The record is mixed when it comes to mild deflation, say a rate of 1% to 2% a year. Sometimes, mild deflation signals a vigorous, healthy economy. What matters are why are overall prices persistently falling. Bad deflation stems from a "demand shock" perhaps a bankrupt banking system or some other trauma that pushes a weak economy into a downward deflationary spiral. Good deflation can co-exist with strong economic growth when the primary cause is a "supply shock" coming from a string of major technological innovations that push costs and prices down, strong productivity improvements, consumer and business gains from freer international trade, and the like. "Such benign productivity-driven deflation was a common occurrence during the last part of the nineteenth century, when people routinely looked forward to goods getting cheaper," says George Selgin, economist at the University of Georgia. You have to go back to the 1800s to find examples of persistent supply side deflation, especially in the late 19th century. Like now, the last third of the 19th century and the early years of the 20th century were defined by the rapid emergence of an integrated world economy. International trade flourished. The volume of world foreign trade per capita was more than 25 times greater at the end than at the beginning of the 19th century. It was an era of astonishing technological and organizational innovation. Immigrants crossed borders in astonishing numbers. This was also the period of the international gold standard. A shared belief, a commitment to the economic and political benefits of the gold anchor, facilitated international commerce and investment, and kept the price level stable to down. Deflation and better everyday circumstances went together in America. The wholesale price level fell about 1.5% annually between 1870 and 1900. Living standards improved as real incomes rose by 85%, or about 5% a year. The U.S. economy grew threefold as America went from an agricultural republic to an industrial empire. In the 1860s, America's industrial output lagged behind Germany, France, and Great Britain. By 1900, the U.S. had became the world's leading industrial power with a combined output greater than its main European rivals. The supply side of the economy, including trade, technology, business organization, and immigration, put enormous downward pressure on prices. Writes George Edward Dickey in Money, Prices, and Growth, The American Experience, 1869-1896: "Such a supply or cost-induced deflation does not have the same deleterious effects as a demand-induced fall in prices.... Deflation in this case is a direct result of the rapid growth of output and is not an inhibitor to growth.... The nineteenth century American experience demonstrated that economic growth is compatible with deflation." What about stock and bond returns? Stocks returned an average of 8.5% a year and bonds 6.6% from 1870 to 1900. Hardly a disastrous return on investment considering that the long-term return on stocks averages 7% and bonds 3.5% since 1802, according to data compiled by Jeremy Siegel, professor of finance at the Wharton School. THE DARK SIDE OF DEFLATIONARY DYNAMISM Innovation, creativity, and risk taking are the essence of capitalist growth. The most famous proponent of this way of looking at economic life is Joseph Schumpeter, one of the 20th century's intellectual giants. Schumpeter is best known for his evocative metaphor "creative destruction." It captures the process by which new technologies, new markets, and new organizations supplant the old. The economic return from the forces driving price level toward deflation is showing up in the productivity statistics. Productivity measures output per hour of work. It is the number economists really care about because the productivity growth rate is the foundation of higher living standards. Strong productivity growth translates over time into more output and lower prices. Productivity growth has averaged 3% a year since 1995 and 3.6% over the past five years—that's more than double the productivity performance of 1973 to 1995. Companies have plenty of leeway to maintain profit margins and keep selling prices stable to down even if management does raise wages. "Ultimately, productivity growth is what determines our living standards, the competitive advantage of companies, and the wealth of nations," says Erik Brynolfssohn, economist at MIT. But Schumpeter also emphasized the destructive side of his famous metaphor. The dynamism of capitalist competition is devastatingly painful. While 17th century textile makers in Britain built the factory system, middle-class weavers in Yorkshire sank into poverty. In the 1800s, the spread of railroads devastated communities without a rail link. The 1950s and 1960s were an era of U.S. economic dominance, but many industrial laborers never recovered from losing the well-paying manufacturing jobs thousands of them held before industrial companies moved from the Northeast and Midwest to cheaper sites in the South and West. Today, highly educated 24/7 technology workers are losing jobs to lower paid 24/7 peers in the developing world. In the 19th century, many farmers and laborers bitterly protested against the evolving global economy, despite widespread gains in living standards. There were many reasons, but the basic problem was job insecurity. Much like the 19th century, today's souped-up economy translates into intense job insecurity from the warehouse floor to the white-collar office. Restructuring, downsizing, reengineering -- whatever term you prefer -- is now a routine part of management's strategic and tactical toolkit. The insecurity doesn't just stem from spells of unemployment or reduced wages. No, America's health care system for working age families is employer based. So, when a worker loses their job they -- and their families -- also lose their health care coverage. The same goes with their pension. The current safety net is woefully inadequate for an intense competitive, high-tech, globally integrated world economy. The most important reform is to attach health care and pension benefits to the worker rather than the company. This way, if the worker loses his or her job, their family doesn't suffer on the health or retirement savings side. The government could also create insurance policies modeled on disability insurance that could provide displaced workers with transition income to a new job. Major investments in boosting the supply side of the economy—knowledge, education, technological advances, the free flows of capital, people and goods and services—are also needed. The payoff from supply side investments and a worker better safety in an economy of rapid growth and a falling price level is a high standard of living than many people believe possible. Indeed, ever since Robert Malthus, the first economist, economics has been about scarcity, savings, and other puritanical notions. Yet the stunning fact ever since the Industrial Revolution has been how much material wealth has grown and by how much scarcity has been relaxed, although not banished. Given time, in the high-tech, global economy the bounty that was once largely confined to the modern industrial nations should be shared by the entire world -- bringing everyone on the planet hope for a better life.
 Adapted from Deflation: What Happens When Prices Fall , published by HarperCollins, May, 2004. Copyright 2004 by Christopher J. Farrell. Farrell is BusinessWeek's contributing economics editor, as well as economics editor at Minnesota Public Radio nationally syndicated Sound Money and a regular commentator for MPR's Marketplace. His previous book, Right on the Money: Taking Control of Your Personal Finances, was published in 2000. Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | |
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