Deflation: that sinking feeling

Deflation is a word that is continually misused and misunderstood both inside and outside the economics profession. It was misused after the Global Financial Crisis when austerity policies were described as leading to deflation. It will be misused again as we move towards another period of stagflation. This is exactly what happened in the UK in the 1970`s. I wrote an article in 1976 which was largely ignored as it did not fit the narrative but it explained why the word is misunderstood and misused. The article has the same relevance now as it did then.

To understand why government policies can be described as deflationary during a period of inflation we need to look at an economist`s definition. Paul Samuelson offered us this definition “Deflation is a period when most prices and costs are falling” He did however add the following footnote “Deflation sometimes has a secondary meaning too, namely, a drop in real output and an increase in unemployment regardless of price behaviour”.

It is this second definition of deflation that gives rise to an obvious problem if a drop in real output and a rise in unemployment occurs during a period of inflation. This occurred during the 70`s and is about to occur again now in the aftermath of the coronavirus pandemic. To avoid any misunderstanding it is necessary to deal with this confusion. By the first definition deflation (a fall in the average level of prices) is the opposite of inflation (a rise in the average level of prices), but by the second definition deflation can occur alongside inflation which is logically impossible given the first definition.

We ushered in the Keynesian era after 1945 and this obvious confusion was never exposed because slowly rising prices were, if anything, associated with growth and job creation while all previous deflations were linked to rising unemployment. There had been no experience of what might happen to employment levels if average prices started to accelerate towards and above double digit inflation. Up to this point the fact that deflation had always caused a rise in unemployment led some misguided economists to the mistaken view that every rise in unemployment must be the result of deficient demand and deflation.

Academic views were polarised on this observation. Keynesians always, and still do, support the view that a rise in unemployment must be the result of insufficient demand for goods and services and they request a reversal of the deflationary policies that have caused this to happen. Also should inflation occur at the same time as rising unemployment then it must be caused by cost push pressures such as labour costs, energy prices etc. (I have dispelled this myth of cost push inflation in other articles on this blog).

In contrast monetarists argue correctly that inflation is always caused by excessive monetary demand and therefore whenever we have inflation it must have been preceded by too much demand in the economy. On the contrary unemployment has many causes, one of which can be high and accelerating inflation where volatile prices disturb market signals and misallocate resources.

Despite the fact that we have had inflation every year of this century there are still many economists explaining that the government has been using deflationary policies that have created austerity and even any policy that slows the rate of inflation (which should be described as disinflationary as it is slowing the rate) is described as deflationary given the following reasoning: we have deficient demand and cost push inflation and therefore we need to expand monetary demand to accommodate the same number of transactions at these higher prices and if we want to bring unemployment down we need to expand demand even further. This reasoning is exactly what caused inflation to rise to 27% pa during the 70`s and we are treading the same path now. Politicians and economists are telling us we need to spend more. With talk of an impending deflation and rising unemployment the Treasury are sanctioning unprecedented increases in spending at a time when tax revenues are falling, the yearly public sector borrowing requirement will be the largest in peacetime, the National Debt will reach ￡2.5 trillion and all this is being financed by the Bank of England printing (creating electronic) money through its QE programme and Open Market Operations.

It is important to clarify the meaning of deflation and separate it completely from rising unemployment and slowing growth. Deflation is always and only ever a fall in the average level of prices and “a drop in real output and an increase in unemployment” can occur during periods of deflation, inflation or disinflation. If we accept this then it is easier to analyse the problems of this century. For the last twenty years we have had excessive monetary demand that has caused continuing inflation at higher and lower rates. There was and is no sign of deflation on the horizon and our attempts at overcoming the rising unemployment caused by lockdown and what may eventually be seen as a panic response to the pandemic will cause inflation to accelerate over the next two years. We are moving towards another period of stagflation.

John Hearn 3/9/2020