The Risk of Deflation in the US Economy

I was asked to explain deflation, and why there was a chance that it would become a serious economic problem for the U.S.  I thought my answer would make a good christening post for this blog:


  • Deflation is a self-reinforcing decline in average prices across a whole economy.
  • Once started, it is very difficult to stop, because customers and investors hoard cash instead of buying and investing, causing demand to drop and the economy to spiral downward.
  • The US is flirting with deflation or is now experiencing mild deflation.
  • Because the US is the largest economy and the dollar is the world’s reserve currency, if deflation gets out of hand in the US, it will trigger a global depression.


Deflation is defined as an economy not having enough money to buy all the goods and services available (at their old prices), leading to a fall in prices.  Deflation can be caused by some combination of two things:  1) a decrease (or insufficient increase) in the supply of money; 2) an increase in the quantity and/or quality of goods and services.  Deflation is often characterized as negative inflation.  That is, an inflation rate of -2% is the same thing as a deflation rate of 2%.

Another way to view deflation is as a broad increase in the value of the currency.  We are used to the opposite – $1,000 in 1980 bought less than half as much as the same $1,000 would have bought in 1970. In deflation, the reverse is true.  During deflation, the dollar actually gains in purchasing power over time.  While this might seem desirable for those holding currency or safe bonds, the effect is disastrous for the economy as a whole.  For most people, having their savings grow in value will not matter much if their income disappears.

One chronic problem with determining the current rate of inflation or deflation is that the Bureau of Labor Statistics grossly underestimates the value of increases in quality when it calculates the Consumer Price Index.  In a period of rapid technological innovation and competition, characterized by rapid increases in quality at the same or lower prices, the economy can be experiencing true deflation even though the CPI is positive.


To get a good idea of what deflation does to an economy, look at the US during the 19th century, when the money supply was essentially fixed to the supply of gold (and sometimes silver).  Since the underlying productive capacity of the US increased rapidly in that century, with the growth in population, capital investment, and productivity, the output of goods should have increased rapidly as well.  And in some periods it did.  But when the supply of goods and services outpaced the growth in monetary stocks of gold/silver in the money supply, there wasn’t enough money in circulation to buy all the goods at the old prices.

This made prices drop, which made people and businesses start to hoard cash – if you can buy 10 yards of cloth today, or wait a month and get 11 yards for the same money, and so on, it makes sense to wait as long as possible.  But that reduces the velocity of money (the rate at which the average dollar circulates), which reduces the money supply even more.  And if everyone starts doing that, demand falls rapidly, creating a vicious circle of dropping prices that drives people who supply non-essential goods and services out of business.

It’s even worse when you look at how this affects credit.  If you borrowed money to buy a farm or build a factory, you now have to produce and sell more and more goods at lower and lower prices just to pay the interest on the loan in ever-more-valuable dollars.  As deflation continues, you soon get to the point where you have no hope of paying the interest, much less repaying the loan, so you close the doors and walk away.

When that happens to enough growers and manufacturers, the total value of goods and services at the now-depressed prices drops below the supply of available money, prices stabilize and even start to creep back up a little, people start to expand production, the depression ends, and all is fine for a while.   As optimism returns, people borrow money, build factories (or reopen old ones), and crank up production.  Yay!

Unfortunately, the metal-based money supply then typically fails to keep pace with this new growth, and pretty soon the economy is back where it started, in that old deflation/depression nightmare spiral.  If you look back at the economic history of the US, you’ll see a string of deflationary depression cycles right through the 19th and into the early 20th century. The only period that was not so afflicted was between 1840 and 1860, when the money supply was expanded sharply by the California gold rush.


Deflation was good for creditors, bad for everyone else, and horrible for debtors, which included many farmers as well as businesses.  Gradually, as people figured this out, there were a variety of efforts to expand the money supply.  The discovery of gold in California in 1849 gave us a boost, but as it played out, less and less new gold came into the banks.

If a nation is on the gold standard, the only way to increase its money supply is to obtain more gold and convert it to currency, either as coins or as gold certificates.  It can either mine more gold or sell things to other nations for gold or both.  And it has to do so faster than goldsmiths, dentists, and other people take gold out of the money supply and use it for other things.  Even if monetary gold stocks increase, if the net increase is less than the population growth rate, there will be less and less money available per person over time, a situation that severely hampers economic growth, especially when the population is booming.

One very appealing idea for trying to escape this trap is to use more than one precious metal, but unfortunately it doesn’t work. The US originally used both gold and silver for its monetary base, but soon found out why it fails.  Keeping the ratio of value between the two metals exactly right is impossible with shifting market demand, and Gresham’s law applies: whichever metal is undervalued will disappear from the monetary base.  For example, if the fixed ratio undervalues gold relative to silver, people will trade silver dollars for gold dollars, melt the gold dollars down, and sell the gold for more silver dollars (or sell the gold abroad for other gold-backed currencies), and repeat the process until all the gold dollars are gone

A lot of the political strife in the late 19th century was about monetary policy, and in spite of the repeated failure of “bimetallism,” there were strong efforts to reintroduce silver as part of the monetary base (thus greatly expanding the money supply).  After a devastating depression that began in 1893 and ruined many Americans, William Jennings Bryan accused those who opposed bimetallism of wanting to “crucify mankind on a cross of gold!”  This will give you a sense of the depth of passion that this issue inspired:

Bryan’s “Cross of Gold” Speech: Mesmerizing the Masses

The most famous speech in American political history was delivered by William Jennings Bryan on July 9, 1896, at the Democratic National Convention in Chicago. The issue was whether to endorse the free coinage of silver at a ratio of silver to gold of 16 to 1. (This inflationary measure would have increased the amount of money in circulation and aided cash-poor and debt-burdened farmers.) After speeches on the subject by several U.S. Senators, Bryan rose to speak. The thirty-six-year-old former Congressman from Nebraska aspired to be the Democratic nominee for president, and he had been skillfully, but quietly, building support for himself among the delegates. His dramatic speaking style and rhetoric roused the crowd to a frenzy. The response, wrote one reporter, “came like one great burst of artillery.” Men and women screamed and waved their hats and canes. “Some,” wrote another reporter, “like demented things, divested themselves of their coats and flung them high in the air.” The next day the convention nominated Bryan for President on the fifth ballot.


The effort to add silver back into the monetary base failed, but new supplies of gold alleviated problems for a while.  Meanwhile, policy makers looked for another solution.  One candidate, fractional-reserve banking has long been known as a way to increase the money supply to some multiple of the monetary base.  Unfortunately, it is wildly unstable without a government guarantee of some kind.

Simply put, banks can lend out most of their deposits as long as most depositors don’t ask for their money back at the same time.  If banks everywhere lend 80% and keep 20% in reserve, the money supply is multiplied 5-fold.  But as soon as there is a sign of economic trouble or instability, depositors rush to the bank to get their money back because they know that only the first 20% of the deposits can be repaid.  This unwinding of deposits dramatically reduces the money in circulation, so bank runs and bank failures can play a big role in turning a mild deflation into a severe deflationary depression.  This happened time and again until finally most societies realized that some kind of government control or guarantee was necessary to stop the cycle.


Central banks were gradually and haltingly given powers to regulate money and banks, but without any clear idea of the importance of matching the growth of the money supply to the growth of the total productive capacity of the nation.  When the stock market crashed in 1929, the Federal Reserve believed that the right way to respond to the problem was to restrict the money supply, which they proceeded to do.

Most modern economists now believe that the Federal Reserve’s active deflationary policy in response to the economic chaos of 1929 was the key mistake that turned a severe recession into the decade-long Great Depression.  Since then, it has been the policy of central banks everywhere to avoid deflation if at all possible, by taking whatever steps are necessary to increase the money supply in step with growth in output of the economy.

The problem is that this is a “Goldilocks problem” – too much monetary growth is almost as bad as too little.  It leads to inflation, which can feed on itself in much the same way deflation does, and runaway inflation destroys savings, impoverishes lenders, and wrecks the economy.  So the goal is to provide a balance.  Like Goldilocks, we need to get it “just right.”


For technical reasons, the optimum level of monetary growth in an economy is slightly higher than the amount needed to keep prices exactly stable.  Deflation is more dangerous and harmful than inflation, and a low level of inflation acts as a mild tax on idle cash, which encourages people to spend it or invest it instead of stuffing it under a mattress.  Since both spending and investment encourage economic growth, a little bit of inflation is a good thing.

Most economists believe that the target should be the amount of growth in the money supply that is needed to keep inflation at an average rate over the long term of around 2-3%.  The US Federal Reserve has had a recent target of 2% inflation and in spite of expansionary policies has consistently averaged less than that, leaving us in chronic danger of sliding into deflation.

Or are we already there?   If the chronic overstatement of the CPI is taken into account, the economy has actually been experiencing at least a mild deflation since 2008.


The problem we face is that measuring inflation is not simple.  If a gallon of milk cost $3 one year, and $3.30 the next year, we can say that the price of milk rose 10%.  But what if the price of bread went down 8%?  And housing went up 2%?  And gas stayed unchanged?

One solution is to make up a standard “market basket” of goods, which is what the CPI or consumer price index is based on.  Because it is used to determine increases in social security payments, among other things, it is heavily weighted toward the costs of necessities and ignores most goods in the economy, especially goods purchased primarily by businesses, not consumers.  It is, after all, a consumer price index, not a general price index.  (The Fed actually uses a somewhat more restrictive measure of personal consumption, but one that still ignores deflation in large parts of the economy that affect business.)

Most of the time, inflation affects everything in the economy about the same, so the difference doesn’t matter too much.  But there are good reasons to believe that this is no longer true, and that consumer prices have been rising while prices in other large parts of the economy are in fact falling rapidly, which means that the CPI grossly overstates the average inflation rate for the economy as a whole.  If the overestimate is 3 percentage points, for example, that means that the Fed, in trying to keep CPI inflation under 2%, may unwittingly be keeping the nation at less than MINUS 1%.  Or, to put it differently, a deflation rate of more than 1%.


The reason that inflation can progress differently in different parts of the economy is that there’s a chronic problem in measuring inflation when the quality of goods is rapidly changing.  A gallon of milk today is pretty much the same as a gallon of milk in 1960.  But the average family four-door sedan of today is a totally different beast from the average family four-door sedan in 1960!  Today’s car is much more reliable, more comfortable, more efficient, less polluting, and vastly safer.  It handles better, brakes faster, has A/C and high-quality audio, and includes many other features barely imagined in 1960.

If you could take the modern car back to 1960, what would it be worth?  You could make a pretty good case that it would have been worth at least ten times what an average 1960-era car was worth.  It’s that much better, in so many different ways.

Thought experiment:  if bread cost 30 cents a loaf in 1960 and $3 a loaf in 2010, it would seem that the dollar lost 90% of its value in 50 years.  But if the 2010 sedan would have been worth $30,000 in 1960 (in 1960 dollars) and still cost $30,000 in 2010 (in 2010 dollars), it would appear that the dollar still has 100% of its old value – that inflation has been zero!

My numbers were chosen to keep the arithmetic simple, and you can certainly argue with my estimate of the increased value of a family sedan, but the point should be clear: steady improvements in science, technology, and manufacturing can make inflation estimates based on slow-changing, low-tech items (like bread, milk, and housing) wildly misleading.

Right now, we base our inflation estimates mostly on food, apartment rent, transportation, clothing, and medical care, without taking much account of the improvements in quality.  Transportation is not the only area to improve dramatically in quality.  How, for example, do we account for the rising cost of medical care, when today it might include a medicine or procedure that cures what would have been a fatal or crippling condition 50 years ago?  We don’t.

This is not to say that medical costs haven’t been going up much faster than other prices.  They have.  But all the Bureau of Labor Statistics sees is that medical bills are going up, and it treats the increase in cost as if the product being purchased has stayed the same.

Surely not dying is a major increase in value!

Of course, all you have to do is look at communication and entertainment to see how seriously hard the quality problem gets.  In 1960, a really primitive 21” analog color TV got typically 3-5 low-resolution channels with poor reception and cost $495.  Today, you can buy a crystal clear hi-def 50” TV with 700 channels for … yes, that’s right! … $495.  That’s not zero inflation.  When you get a vastly better product for the same price, that’s deflation!  The same amount of money can now buy something of much greater value, so in this particular case the purchasing power of the dollar has increased substantially.  If you would say, conservatively, that the new TV is 100 times better than the old one, then that would mean a deflation rate of more than 8% per year for the past 53 years!  (.92^53 > 1%)

And what do you compare the Internet to?  Or a modern computer or gaming console?  Or a smart phone?  In many respects, a person making a very modest income today is able to enjoy luxuries that not even the richest person in the world could have afforded half a century ago, but none of this is – or realistically can be – included in the government figures.


Right now, one of the big economic puzzles is why businesses in the US are sitting on huge piles of cash even though labor is cheap and plentiful and interest rates are at historic lows.  Why aren’t they investing and hiring and expanding production?

A look back at history suggests the answer.  When has that happened before?  During every major deflation.  When has it happened outside of a deflation?  Never.

Businesses are currently facing the classic deflationary dilemma.  They can invest their money today in new factories and new technology.  Or they can wait until next year, and get more for their money.  In many cases, a lot more.  Just consider data storage or any other computer-intensive application, where value per dollar is roughly doubling every 18 to 30 months.  That’s a 30-40% annual return on investment for NOT spending anything today that you don’t absolutely have to spend to stay in business.

It’s actually worse than that.  Suppose you are a CEO in a competitive industry and you have the opportunity to invest $4 billion in a new plant that can turn out 10 million widgets a year for a marginal cost of $100 per widget.  Widgets currently sell for $200, so this looks like a no-brainer:  you can recover your investment in 4 years and then make big profits as long as the market holds.

However, you know the technology you rely on is getting better and cheaper every year.  If your major competitors wait just one more year, they can build factories for the same investment that will produce twice as many widgets and cost only $75 each to make.  If you build your plant first, you’ll be stuck almost immediately with the worst plant and the highest cost of goods in your industry, which means you’re out of business.

So what do you do?  You wait for your competitors to go first.  Let them build the soon-to-be-obsolete white elephants.  After they commit themselves, you can build the most productive plant with the newest technology, become the low-cost producer, and grab both market share and higher profits per sale.

Unfortunately, you and your competitors studied all the same cases in B-school, so they won’t move until you do.  It becomes a case of Alphonse and Gaston.

  • Rule 1:  When the first-mover stands to win big, investment moves forward rapidly and the economy grows.
  • Rule 2:  When it pays to be the last to move, no one invests and the economy stagnates.

Businesses that depend heavily on computer technology – which includes almost all growth industries in the US today – are all operating in a strong deflationary environment.  Meanwhile, the Fed is worried about inflation and can’t seem to understand why their supposedly aggressive program of “quantitative easing” is not causing inflation.

There are parts of the economy that look highly inflationary – like health care and higher education – but they are primarily premium service industries that depend on the relatively inefficient use of very expensively trained professionals.  And there are large parts of the economy in a deep, technology-driven, deflationary spiral.  The CPI is hopelessly inadequate as a measure of what is happening to the whole economy, and using it to guide national monetary policy is seriously misleading.


If we want average long-term GDP growth of 4% and a true inflation rate of 2%, one viable strategy is for the Fed to set a target of 6% growth in NOMINAL GDP.  That’s current GDP as we actually measure it in today’s dollars, divided by last year’s GDP, measured in last year’s dollars, minus 1.  In other words, it’s the raw number, without the very dubious adjustment for inflation.

In practical terms, targeting nominal GDP would automatically mean higher monetary stimulus during recessions and much lower inflation (or none at all) during boom times, which is in fact what the Fed is supposed to be doing anyway.  The advantage of this approach is that it eliminates the confusion and the potential for error that results from misestimating the inflation rate

An alternative is to recognize that the current target of 2% annual increase in the CPI is too low for current circumstances, and to reset the target at something like 2.8 or 2.9%.  Even better, set it at an average of 2.5%, but require the Fed to compensate for going under (and over).  Every time they miss on the low side, they need to raise the target (and vice versa) until the average is back on track.  Right now, the Fed effectively treats the 2% number as a ceiling, not a target, guaranteeing that the long-term increase in the CPI will be less than that, and in this economy, that means deflation

The problem with arguing for any increase in the inflation target is that it puts you in temporary alliance with certain extremely vocal left-wing nuts who long for unrestrained growth in government spending and who therefore think that high inflation is a good thing, or at least a tolerable price to pay.  As a result, there are people on the right for whom ANY adjustment in the inflation target means a victory for the pro-inflation lobby, which will put us on a slippery slope toward Zimbabwean inflation rates.

This subject is being argued at high decibels among the macroeconomists, so I will leave the argument to those who have better credentials than I do.  But the key to any Goldilocks problem is finding a way to move to the optimum point in the middle without going from one bad extreme to the other.  Think of standing in the shower, adjusting the temperature.  Experimental adjustments should be small and gradual, and should be made with a clear understanding that just because a little more of something is good, that does NOT mean that a lot more of it would be better!

Update 11/15/13:

*Ahem*  I have something to show you.


Did I call this, or what?

The Economist made this subject their cover article in their 11/9-15 issue.  Three articles (“The perils of falling inflation“, “The price is a blight,” and “Renouncing stable prices“) focus on the dangers of low inflation and the possibility of slipping into deflation.  Their take on it is that Europe is in more danger of doing so than the US – a scary thought, considering how precarious Europe’s economic situation is already…


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