Japan, under Prime Minister Shinzo Abe, has gone hell for leather to create 2 per cent inflation. Photo: Reuters

As with so many illnesses, focus only on deflation as a state and you will end up more likely to get it and to mis-treat it when it happens.

Scarred by the lessons of the Great Depression, where an exceptional and self-reinforcing deflation, or general fall in prices, took hold, central bankers have fought signs of it since the financial crisis with everything they have.

This ignores several truths, some of them argued in a recent study by the Bank for International Settlements on deflations over the past 140 years.

The fall in the prices of goods and services has only a weak link with growth. Asset price deflations, such as the bursting of the property bubble, are more damaging.

Monetary policy leading up to a property bubble, rather than simply mopping up after one, is key. And to a central banker with a mop everything looks like a puddle.

To a central banker with a mop everything looks like a puddle

The emphasis on fighting deflation with monetary policy is strong precisely because it becomes so politically difficult to stimulate with government spending in the aftermath of a debt-fuelled bubble. Just because someone confiscated your shovel doesn’t mean you ought to dig a trench with a hammer.


“It is misleading to draw inferences about the costs of deflation from the Great Depression, as if it was the archetypal example,” write Claudio Borio, Magdalene Erdem, Andrew Filardo and Boris Hofman of the BIS.

“The episode was an outlier in terms of output losses; in addition, the scale of those losses may have had less to do with the fall in the price level per se than with other factors, including the sharp fall in asset prices and associated banking distress.”

The study looked at a sample of leading economies over 140 years and found that, in aggregate, they’ve been in deflation 18 per cent of the time, though only 5 per cent of the time since the second world war. High debt levels matter, according to the BIS, but because they amplify property price deflations rather than magnifying falls in the prices of goods and services.

And yet here we are, fighting deflationary threats in the euro zone, United States and Japan in some respects as if we still risked a re-run of the 1930s, while being totally willing to look through the impact of the falls in energy and some manufactured goods prices.


Euro zone core inflation has been in the 0.6 to 1.0 per cent range for the past several months, well below the European Central Bank’s 2.0 per cent target. This is admittedly low but not in and of itself full justification for quantitative easing (QE).

“It may, rather, represent normality in a post-crisis world where employees in the advanced economies lack the bargaining power to enforce higher wages,” economist Stephen Lewis of ADM Investor Services in London wrote in a note to clients.


“In such conditions, any attempt, through monetary policy, to push up the rate of consumer price inflation could only be temporarily successful. Higher prices would squeeze real household incomes, choke off consumer demand and thereby, ultimately, undermine producers’ pricing power.”

Look at Japan, both in recent history and now. Many argue that the persistent deflation in Japan is the main underlying cause of the ongoing malaise, an analysis which underestimates the impact of declining population. Real gross domestic product grew in Japan by 9 per cent between 2000 and 2007, compared to 11 per cent in the supposedly healthy US. But measure that as real GDP growth in terms of working-age population and Japan grew 15 per cent, against just 8 per cent in the US.

Japan under Abenomics has gone hell for leather to create 2 per cent inflation, driving down the yen and undertaking massive quantitative easing. The main result, at least so far, is a squeeze on living standards, as price rises are not matched by increases in wages. Oh, and a nice fillip for corporate profits as Japanese corporations opt not to increase production to sell more in newly cheap yen but just to cream off the higher margins that makes possible.


To be sure, there are huge differences between deflations now and during the period when the money supply was limited by the gold standard, rather than adjusted by a central bank. This flexibility is one of the principal arguments for fiat money central banking.

Having a tool is good, but using it for the right job is better.