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Thursday, March 13, 2003

Why All the Fuss About Deflation

Deflation is a generalised and sustained fall in prices, with the emphasis on generalised and sustained. At any given time, especially in a low-inflation economy like that of our recent times, prices of some goods and services will be falling. Price declines in a specific sector may occur because productivity is rising and costs are falling more quickly in that sector than elsewhere or because the demand for the output of that sector is weak relative to the demand for other goods and services. Sector-specific price declines, uncomfortable as they may be for producers in that sector, are generally not a problem for the economy as a whole and do not constitute deflation. Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.

The above more-or-less is the now commonly accepted definition of deflation. However worrying about deflation is one thing (all thinking economists are now worried about it). Knowing why it is happening, and having something useful to say about what to do about it is another. We can all get interest rates down to the zero limit, and then start dropping our currencies 1930's style - but will it work, or will we only succeed in going round in circles?

Even while there is a growing consensus that the problem of deflation is real, my feeling is we are quite short on analysis. This was also my initial impression when I read the writings of two deflation stalwarts: Paul Krugman and Steven Roach . Importantissimo as their work is in drawing attention to the problem, too much weight in my view has been placed on the debt deflationary dynamics of the burst bubble, and not enough attention has been paid to getting to grips with why this impact has been so deep, and why it is happening now?

Why, for example, is Japan so ill? Certainly we have the boom-bust cycle story (and thanks a lot to Stephen Roach and Larry Summers for this), but are things really so unstable that you cross over a little white line and bingo, you're stuck. This, incidentally, cuts across all those arguments to the effect that we've actually got better at handling economic and financial problems.And why is today's Japan deflation of the chronic, slow-burn variety, which is very different from the dramatic and acute deflation of the 1930's. Again what is the significance for policy of this difference?

My question then is, is there something more important going off? I personally think so: I tend to use the expression 'phase transition' - or regime switch - to describe this move from an inflationary to a deflationary environment, but it's only a metaphor.

So far, I've come up with three candidates:

Firstly the secular decline in the unit price of INFORMATION (ie not just IT equipment, but eg human genome string etc, for more on this see Kurzweil's exponential over exponential, or law of accelerating returns - another thing some people just don't seem to get).

Secondly the changing demography of the developed countries: aging, changing support ratios, changing patterns of saving and consumption etc. Jeffrey Williamson and Angus Deaton, for example, have some interesting material on the growth of the so called Asian tigers that makes very interesting reading here.

Thirdly the changing structure of international production through globalisation, and in particular the entry of China into the WTO. Again Williamson and O'Rourke show how the opening of the New World changed structurally the European economies and facilitated industrial growth. It is only reasonable to expect that the take-off of China and then India will have similarly dramatic consequences in the twenty first century. These three pointers are only a start, my point of departure for an ongoing investigation. I have set up a page on my website and it is my attention to use this page to take this analysis further, and to continue digging until in Wittgenstein's famous phrase, my spade is turned. Anyone else who's interested is welcome to join me there, and mail me if you have anything interesting to contribute.

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