What Makes Deflation Good?

Earlier this week, there was a piece in the Financial Times by Michael Heise, chief economist at Allianz SE, arguing that the recent dip in Eurozone inflation to near zero is not a sign of economic weakness, but a sign of recovery reflecting increased competitiveness in the Eurozone periphery. Scott Sumner identified a systematic confusion on Heise’s part between aggregate demand and aggregate supply, so that without any signs that rapidly falling Eurozone inflation has been accompanied by an acceleration of anemic growth in Eurozone real GDP, it is absurd to attribute falling inflation to a strengthening economy. There’s not really much more left to say about Heise’s piece after Scott’s demolition, but, nevertheless, sifting through the rubble, I still want to pick up on the distinction that Heise makes between good deflation and bad deflation.

Nonetheless, bank lending has been on the retreat, bankruptcies have soared and disposable incomes have fallen. This is the kind of demand shock that fosters bad deflation: a financial crisis causes aggregate demand to shrink faster than supply, resulting in falling prices.

However, looking through the lens of aggregate supply, the difficulties of the eurozone’s periphery bear only a superficial resemblance to those plaguing Japan. In this case, falling prices are the result of a supply shock, through improved productivity or real wage reduction.

Low inflation or even deflation is testament to the fact that (painful) adjustment through structural reforms is finally working.

In other words, deflation associated with a financial crisis, causing liquidation of assets and forced sales of inventories, thereby driving down prices and engendering expectations of continuing price declines, is bad. However, the subsequent response to that deflationary shock – the elimination of production inefficiencies and the reduction of wages — is not bad, but good. Both responses to the initial deflationary contraction in aggregate demand correspond to a rightward shift of the aggregate supply curve, thereby tending to raise aggregate output and employment even while tending to causes a further reduction in the price level or the inflation rate.

It is also interesting to take note of the peculiar euphemism for cutting money wages adopted by Heise: internal devaluation. As he puts it:

The eurozone periphery is regaining competitiveness via internal devaluation. This could even be called “good deflation.”

Now in ordinary usage, the term “devaluation” signifies a reduction in the pegged value of one currency in terms of another. When a country devalues its currency, it is usually because that country is running a trade deficit for which foreign lenders are unwilling to provide financing. The cause of the trade deficit is that the country’s tradable-goods sector is not profitable enough to expand to the point that the trade deficit is brought into balance, or close enough to balance to be willingly financed by foreigners. To make expansion of its tradable-goods sector profitable, the country may resort to currency devaluation, raising the prices of exports and imports in terms of the domestic currency. With unchanged money wages, the increase in the prices of exports and imports makes expansion of the country’s tradable-goods sector profitable, thereby reducing or eliminating the trade deficit. What Heise means by “internal devaluation” in contrast to normal devaluation is a reduction in money wages, export and import prices being held constant at the fixed exchange.

There is something strange, even bizarre, about Heise’s formulation, because what he is saying amounts to this: a deflation is good insofar as it reduces money wages. So Heise’s message, delivered in an obscure language, apparently of his own creation, is that the high and rising unemployment of the past five years in the Eurozone is finally causing money wages to fall. Therefore, don’t do anything — like shift to an easier monetary policy — that would stop those blessed reductions in money wages. Give this much to Herr Heise, unlike American critics of quantitative easing who pretend to blame it for causing real-wage reductions by way of the resulting inflation, he at least is honest enough to criticize monetary expansion for preventing money (and real) wages from falling, though he has contrived a language in which to say this without being easily understood.

Actually there is a historical precedent for the kind of good deflation Heise appears to favor. It was undertaken by Heinrich Bruning, Chancellor of the Weimar Republic from 1930 to 1932, when, desperate to demonstrate Germany’s financial rectitude (less than a decade after the hyperinflation of 1923) he imposed, by emergency decree, draconian wage reductions aimed at increasing Germany’s international competitiveness, while remaining on the gold standard. The evidence does not suggest that the good deflation and internal devaluation adopted by Bruning’s policy of money-wage cuts succeeded in ending the depression. And internal devaluation was certainly not successful enough to keep Bruning’s government in office, its principal effect being to increase support for Adolph Hitler, who became Chancellor within less than nine months after Bruning’s government fell.

This is not to say that nominal wages should never be reduced, but the idea that nominal wage cuts could serve as the means to reverse an economic contraction has little, if any, empirical evidence to support it. A famous economist who supported deflation in the early 1930s believing that it would facilitate labor market efficiencies and necessary cuts in real wages, subsequently retracted his policy advice, admitting that he had been wrong to think that deflation would be an effective instrument to overcome rigidities in labor markets. His name? F. A. Hayek.

So there is nothing good about the signs of deflation that Heise sees. They are simply predictable follow-on effects of the aggregate demand shock that hit the Eurozone after the 2008 financial crisis, subsequently reinforced by the monetary policy of the European Central Bank, reflecting the inflation-phobia of the current German political establishment. Those effects, delayed responses to the original demand shock, do not signal a recovery.

What, then, would distinguish good deflation from bad deflation? Simple. If observed deflation were accompanied by a significant increase in output, associated with significant growth in labor productivity and increasing employment (indicating increasing efficiency or technological progress), we could be confident that the deflation was benign, reflecting endogenous economic growth rather than macroeconomic dysfunction. Whenever output prices are falling without any obvious signs of real economic growth, falling prices are a clear sign of economic dysfunction. If prices are falling without output rising, something is wrong — very wrong — and it needs fixing.


11 Responses to “What Makes Deflation Good?”

  1. 1 Tom November 21, 2013 at 1:37 pm

    “If observed deflation were accompanied by a significant increase in output, associated with significant growth in labor productivity and increasing employment..we could be confident that the deflation was benign”

    David, it’s worth bearing in mind you sometimes see a lag before increasing productivity growth leads to more employment. Rising productivity growth can initially create rising unemployment until higher incomes lead to rising demand and job creation once again.


  2. 2 marksadowski November 21, 2013 at 2:55 pm

    Michael Heise:
    “However, looking through the lens of aggregate supply, the difficulties of the eurozone’s periphery bear only a superficial resemblance to those plaguing Japan. In this case, falling prices are the result of a supply shock, through improved productivity or real wage reduction.”

    yoy HICP October 2013
    Ireland (-0.1)
    Greece (-1.9)
    Spain (-0.0)
    Italy (+0.8)
    Cyprus (-0.5)
    Portugal (-0.0)

    yoy Nominal ULC 2013Q2
    Ireland (+2.1)
    Greece (NA)
    Spain (-2.4)
    Italy (+1.5)
    Cyprus (-4.2)
    Portugal (+2.1)


    yoy Real Labour Productivity per Hour Worked 2013Q2
    Ireland (-3.8)
    Greece (NA)
    Spain (+0.7)
    Italy (-0.5)
    Cyprus (-0.0)
    Portugal (-0.3)


    I can see the falling wages in Spain and Cyprus. But where’s this improved productivity of which he speaks?


  3. 3 David Glasner November 22, 2013 at 9:29 am

    Tom, Valid point. Nevertheless, although good deflation would not necessarily cause an immediate increase in employment, it should generate an immediate increase in output — the mechanism by which prices are being reduced. Employment increases would follow.

    Mark, Good question. Thanks for all your data crunching.


  4. 4 Benjamin Cole November 23, 2013 at 8:10 am

    Excellent blogging.
    I also appreciate your take on the peculiar use of language so common in economics.
    I wonder if any sustained deflation can be good in the modern economy, as debts are nominal. Real estate tied to debt…real estate depreciates, loans go sour, banks stop lending….
    Moderate inflation is not utopia but it works better than deflation. ..


  5. 5 W. Peden November 24, 2013 at 8:18 am

    Great post. Insofar as the failure of the “wage-cutting” approach during the 1920s and 1930s in Britain (and the 1930s in the US) was the salient cause of the rise of Keynesianism and subsequent post-war inflation, the (fair or foul weather) deflationists have a lot to answer for.

    (Of course, as you’ve cogently argued, much of the British interwar unemployment was structural, but this would have been easier for contemporary economists identify had there not been a large amount of cyclical unemployment as well.)


  6. 6 W. Peden November 24, 2013 at 8:19 am

    * to identify.


  7. 7 marksadowski November 25, 2013 at 1:46 pm

    Off Topic.

    I’ve been doing a lot of Granger causality tests on monthly data over the period since December 2008 (since ZIRP) and have some results that I thought my be of particular interest to you, because of your paper that found a correlation between inflation expectations and the S&P 500 index since 2008.

    I find that there is bidirectional Granger causality between the S&P 500 and 5-year inflation expectations as measured by TIPS at the 1% significance level, that the S&P 500 Granger causes the PCEPI at the 5% significance level, that inflation expectations Granger causes Nondefense Capital Goods Excluding Aircraft Industries (ANXAVS) spending at the 5% significance level, and finally that the monetary base Granger causes inflation expectations, the S&P 500 and the PCEPI at the 1%, 5% and 10% significance levels respectively.

    Just thought you might be interested.


  8. 8 David Glasner November 25, 2013 at 3:43 pm

    Benjamin, Thanks. If we could get at least 3% growth with deflation and keep interest rates from falling below 2%, I would say that the deflation was not harmful. But those are pretty big “ifs.”

    W. Peden, Good point.

    Mark, Interesting. Certainly consistent with my results. Thanks for sharing.


  9. 9 NeighbourhdEconomist (@NeighbourhdEcon) November 26, 2013 at 4:18 am

    The moves by the ECB (and the central bank in Japan) to weaken the currency through looser monetary policy seem like part of measures to bolster inflation by increasing the prices of imports. This is just creating inflation for inflation’s sake and is likely to be worse than any deflation which is necessary for some countries in Europe to regain competitiveness. For more, see http://yourneighbourhoodeconomist.blogspot.com/2013/11/good-deflation-better-than-bad-inflation.html


  10. 10 David Glasner November 30, 2013 at 8:32 pm

    In April 1933 FDR created inflation for inflation’s sake by devaluing the dollar against gold and immediately started a recovery from the Great Depression after almost four years of continuous declines in prices, output and income. So there is some pretty impressive evidence that inflation can trigger a recovery from a deep recession or depression.


  11. 11 Joey Kay January 26, 2014 at 6:23 am

    All nonsense. Inflation is bad for most everybody but bankers/ investment industry, deflation is good for most people in population. Purposely devalue ing a currency ? Great idea if you are not a wage earner and trying to save some of your salary. Economists are as accurate as voodoo witch doctors and tarot card readings…. Hog Waller.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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