John Cochrane has a new piece in the WSJ, criticizing the widespread concern over deflation risks, especially in Europe. I have mixed feelings about this whole enterprise. I’ve repeatedly argued that inflation doesn’t matter, and that economists should just stop talking about inflation (and deflation.) But they obviously won’t stop, and hence I guess I can’t blame Cochrane for responding to the often incoherent discussion. He lists 4 reasons to be skeptical about deflation fears:
1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.
Sticky wages would be a problem for a sharp 20% deflation. But not for steady 2% deflation. A typical worker’s earnings rise around 2% a year as he or she gains experience, and another 1%—hopefully more—from aggregate productivity growth. So there could be 3% deflation before a typical worker would have to take a wage cut. And the typical worker also changes jobs, and wages, every 4½ years. Moreover, “typical” is the middle of a highly volatile distribution of wage changes among a churning job market. Ultimately very few additional workers would have to take nominal wage cuts to accommodate 2% deflation.
Curiously, if sticky wages are the central problem, why do we not hear any loud cries to unstick wages: lower minimum wages, less unionization, less judicial meddling in wages such as comparable worth and disparate-impact discrimination suits, fewer occupational licenses and so forth?
2) Monetary policy headroom. The Federal Reserve wants a 2% inflation rate. That’s because with “normal” 4% interest rates, the Fed will have some room to lower interest rates when it wants to stimulate the economy. This is like the argument that you should wear shoes two sizes too small, because it feels so good to take them off at night.
The weight you put on this argument depends on how much good rather than mischief you think the Fed has achieved by raising and lowering interest rates, and to what extent other measures like quantitative easing can substitute when rates are stuck at zero. In any case, establishing some headroom for stimulation in the next recession is not a big problem today.
3) Debt payments. The story here is that deflation will push debtors, and indebted governments especially, to default, causing financial crises. When prices fall unexpectedly, profits and tax revenues fall. Costs also fall, but required debt payments do not fall.
Again, a sudden, unexpected 20% deflation is one thing, but a slow slide to 2% deflation is quite another. A 100% debt-to-GDP ratio is, after a year of unexpected 2% deflation, a 102% debt-to-GDP ratio. You’d have to go decades like this before deflation causes a debt crisis.
Strangely, in the next breath deflation worriers tell governments to deliberately borrow lots of money and spend it on stimulus. This was the centerpiece of the IMF’s October World Economic Outlook antideflation advice. The IMF at least seemed to realize this apparent inconsistency, claiming that spending would be so immensely stimulative that it would pay for itself.
4) Deflation spiral. Keynesians have been warning of a “deflation spiral” since Japanese interest rates hit zero two decades ago. Here’s the story: Deflation with zero interest is the same thing as a high interest rate with moderate inflation: holding either money or zero-interest rate bonds, you can buy more next year. This incentive stymies “demand,” as people postpone consumption. Falling demand causes output to fall, more deflation, and the economy spirals downward.
It never happened. Nowhere, ever, has an economy such as ours or Europe’s, with fiat money, an interest-rate target, massive excess bank reserves and outstanding government debt, experienced the dreaded deflation spiral. Not even Japan, though it has had near-zero inflation for two decades, experienced the predicted spiral.
He’s right about point 4, there’s very little risk of a deflationary spiral. And of course he’s right about the insanity of borrowing money to try to overcome deflation. Point 2 is a lousy metaphor, which doesn’t capture the logic of higher inflation as a way of avoiding a liquidity trap. If Cochrane insists on shoe metaphors, here’s the right one:
Suppose you occasionally have to go out and shovel snow when it’s 40 below. You should have one set of shoes that is 2 sizes too large, so that you can wear 4 pairs of socks with it.
Points one and three are examples how conservatives (except for the great Milton Friedman) have an unfortunately tendency to minimize the impact of demand shocks. It’s true that inflation itself doesn’t matter, and that almost all Phillips Curve models perform really poorly. But that’s a side issue. When economists worry about deflation they are actually worried about falling NGDP, they just don’t realize it. Obvious lower prices, ceteris paribus, are perfectly fine. But when NGDP growth comes in 10% or 20% lower than workers or borrowers expected when they signed labor and debt contracts, then you have big problems. Conservatives tend to have a blind spot for that problem (except for Milton Friedman, obviously.)
PS. I hereby issue “loud cries to unstick wages.”
PPS. Notice to my international readers. Keep in mind that 40 below zero fahrenheit is equivalent to 40 below zero centigrade.
HT: Ramesh Ponnuru