Gary H. Stern - President, 1985-2009
Published September 1, 2003 | September 2003 issue
Editor's note: The following commentary is based on President Stern's opening address to participants at the June 2003 Supply, Demand & Deadlines economics workshop for journalists.
I am pleased to have this opportunity to talk with you about a topic that, once considered the purview of economic history, has become one of the most cited economic concerns of todaydeflation. As I do so, I should caution that I'm speaking only for myself and not for others in the Federal Reserve.
When I speak of deflation, I am using the economist's definition: a sustained period of decline in a broad measure of prices, that is, a persistent decline in broad price indices. By persistent I mean not just a decline for one or two months or even one or two quarters but a sustained decline in prices. And by a broad price measure, I mean something like the consumer price index or the personal consumption deflator. This description is what most economists mean by deflation.
As best I can judge, from looking at a variety of reports, commentary and analysis about deflation, the conventional wisdom is that while the probability of deflation in the United States is low, the consequences are possibly severe. The question I will address is the following: Based on what we know about deflation, should this be the conventional wisdom? In other words, does economic history, economic theory, our understanding of financial markets and the stance of policy lead to these concerns about deflation? My answer is, not entirely. I will argue that the conventional wisdom about the real economic consequences of deflation is questionable.
Let's start with what we can learn about deflation from history. Probably the first thing that comes to mind, at least in the U.S. experience when deflation is mentioned, is the Depression of the 1930s. Between 1929 and 1933 prices declined by roughly 25 percent, while over that same period real (inflation-adjusted) gross domestic product (also known as real economic activity) in the United States declined nearly 40 percent. Clearly, this is an episode where deflation was accompanied by a significant decline in real economic activity. We don't call it the Great Depression for nothing. It was a very difficult economic time. And if you use that bit of history, obviously that's an experience that nobody wants to repeat.
A more recent economic experience that has raised concerns about deflation's impact on real economic activity is Japan. The Japanese economy has essentially stagnated over the last 10 or 12 years, and some of those years have been characterized by modest declines in overall price levels. This is perhaps a particular concern if you put yourself back in the environment of the late 1980s and early 1990s. Japan had not only become the second largest economy in the world, but also there seemed to be a consensus that the Japanese had the "right economic model" and that they would soon become the largest economy in the world. That was not the first grandiose forecast to go awry and no doubt not the last, but I think that was a good characterization of expectations at the time.
Historical experiences with deflation accompanied by a decline in economic activity, however, are not the only ones we have had with deflation. During the last quarter of the 19th century, roughly 1870 to 1900, prices on average went down modestly. Yet, that was a period characterized by appreciable economic growth on average in the United States.
And many other countries around the world over those years had a similar experience. The last quarter of the 19th century was a period of modest deflation accompanied by, on average, appreciable economic growth and rising per capita incomes. Now admittedly, that was over 100 years ago, and one might wonder about the relevance of that experience given when it occurred, given its age so to speak. It would be nice to have an example that was relevant and that was closer in time to the present. And we do.
Consider the recent experience in China. Over the last five years deflation in China has been accompanied by substantial economic growth. And I think there's little doubt that China has been the beneficiary of what we economists would call a positive supply shock or a positive productivity shock, which simply means you get more output of goods and services with the same inputs. It's easy to see why that's happening in China because they're moving to a market economy. Before this move, they had a serious resource misallocation problemthey had all sorts of resources doing very unproductive things.
Well, that's a quick summary of what I've been able to glean from looking at several deflation episodes. I would have to say that the historical picture is fuzzy and that without economic theory to guide us, it will remain a blur. So now I would like to discuss what economic theory might have to say about deflation.
Let me start with this: I think one thing theory says is that unanticipated changes in inflation or deflation are likely to create more serious problems than anticipated changes. And unanticipated disinflation, which would just mean a decline in the rate of inflation, would be a larger problem than anticipated disinflation. And in fact there are many similarities between disinflation and, ultimately, deflation. The 2002 annual report of the Federal Reserve Bank of Cleveland goes to some length to point out that many of the issues and problems that people point to when they discuss deflation prevail in a world of unanticipated disinflation equally well. I think that's something important to bear in mind.
Now, why would unanticipated deflation (or disinflation or inflation, but I'll confine myself to deflation for the most part) be a more serious problem than anticipated deflation? One area where unanticipated changes in rates of deflation can cause problems is in the labor market, particularly if wages are sticky. History suggests that wages frequently are slow to adjust, especially on the downside. That is, nominal wages, current dollar wages, are rarely reduced. If prices fall unexpectedly but firms cannot cut wages, then they may lay off workers as a result.
But we have recently seen some downward wage adjustments in the airline and steel industries, and I suspect that wages are more flexible than they used to be. The reason is that variable pay contracts, for example, those that include bonuses and commissions, have become an important part of today's compensation packages.
What does that imply? Well, it implies that compensation is not as sticky as it once was. And that means that unanticipated deflation should not have as large an adverse consequence for employment as it might have formerly. If that is true, it is an important observation. The problem with wage stickiness is it's great for the people who remain employed because they're pretty well compensated. But wage stickiness puts the burden on the people who become unemployed, or who already are unemployed, because it makes landing a new job more difficult. Flexible compensation packages mitigate these problems.
Another negative effect of unanticipated deflation, and one that is talked about a great deal, is that it results in arbitrary redistributions of income and wealth. And what in fact happens, of course, is that deflation transfers income to creditors from borrowers. Another way of putting it, borrowers ex post find themselves paying higher real interest rates than they expected to, and creditors find themselves receiving higher real interest rates than they expected to.
Let me leave aside the question of how such unanticipated transfers could affect the real economy (what borrowers lose, creditors gain; there is no net loss), and just assert that they will. What I think is interesting and important is that today financial markets work sufficiently well to basically eliminate many of these arbitrary redistributions.
For example, think about how the mortgage market works in the United States today. It looks like you can almost always refinance or recontract in that market. And what the effect of that refinancing or recontracting is, is people wind up paying and receiving the "same old" real interest rate, although nominal rates clearly have come down. So you don't get in today's mortgage markets the same kind of arbitrary redistribution effects, even if the deflation or the disinflation is unanticipated, that you would get in a different institutional framework.
Does this always work? Well of course not. For it to work pretty well, home prices have to be stable or rising, otherwise refinancing is pretty difficult. The second condition is you have to avoid the zero boundthat is, mortgage rates falling to zero or close to zerobecause once that happens your ability to recontract is probably ended. But mortgage rates today are well above that. So it's interesting that the mortgage market at least seems to have the characteristics that enable borrowers and creditors to deal with unanticipated changes in prices.
If you think about the market for consumer credit more broadly, and I'm now thinking of credit cards, practices are somewhat similar. You know you're always getting mailings that, if you've got credit outstanding at 9.9 percent, you can refinance it at 7.9 percent, or 7.9 percent at 5.9 percent or 5.9 percent at 3.9 percent. Last year, I received several mailings where you could pay a $50 upfront fee, and you had no interest expense for six months. Now, I didn't calculate what the effective rate of that was, but it had to be pretty low, especially if you had a large balance.
So it looks like on the consumer side, some of the things that we typically worry about with regard to unanticipated deflation have been mitigated. However, that seems to be less true in the markets for corporate debt or corporate credit. If you issued corporate notes or bonds without a call provision and you get surprised by deflation, there's not a heck of a lot you can do about it until that paper matures. We also know, or at least it's my strong impression, that certainly the market for credit for small and medium-sized business borrowers is nowhere near as well developed and as flexible as the mortgage market I was describing earlier.
So that means that in the corporate market, it is harder to refinance or recontract, at least for small and medium-sized borrowers. It means if you misjudge the rate of price change and if you misjudge the prospective rate of growth of revenues, top-line growth, you may indeed find yourself with a debt burden that's more difficult to service than you had anticipated. And this may be the intuition behind the concern over the so-called debt overhang or debt deflation. It seems to apply mostly to, at least as I survey the financial markets, the corporate market and more likely the markets for credit for small and medium-sized business. And maybe this is one reasonand anecdotally there is some support for thisthat capital spending has been sluggish even though the economy has been growing over the last six quarters or so. By the way, if my description is more or less accurate, it suggests that the solution should rely upon structural and institutional changes in the market for corporate credit. It's not much a matter of monetary policy, and there have been efforts from time to time to standardize that market to a greater extent than it has been so far.
There is another thing that I think economic theory tells us. It is that the underlying cause of the deflation matters. If, on the one hand, the deflation is a result of a positive supply shock, positive productivity growth, then it's benign. And we need not worry about it, and we need not think about policies to offset it. If, on the other hand, deflation is a consequence of a negative shock to aggregate demand, so that the demand for goods and services unexpectedly falls below what had been anticipated, that could be a more serious problem.* Consequently, before we act, we need to identify and understand the cause of the unanticipated deflation.
What about anticipated deflation? Let me make another observation that comes from economic theory. The size of the deflation matters. In virtually all well-developed theories of money, anticipated, small deflations are optimal; that is, a small deflation is the best we can do, even in the presence of rigidities and wage stickiness. However, anticipated, large deflations are suboptimal, because they lower economic growth as savers invest in the high-return assetmoneyrather than invest in real capital. My point is that, according to theory, magnitudes matter.
What do these various observations from history and from theory and about how markets work suggest for the U.S. economy today? Obviously the reason I'm talking about this is that deflation has become an issue of the moment. As I suggested earlier, there is a conventional wisdom, which I hope I've characterized reasonably, that suggests that the probability of deflation in the United States is low, but the consequences of deflation, should we experience it, are possibly severe. Now the phrase "probability of deflation is low" is obviously imprecise; it's not very rigorous and I'm not going to try to clarify that this evening. But what I will say is I think that judgment is probably correct in our current circumstances.
I think it's likely correct for a variety of reasons, some of which I've already described. First, by most measures that matter, monetary policythe policy that we at the Federal Reserve have been pursuinghas been accommodative. That's evidenced by the way interest rates have behaved, and also by growth in the broad measures of money, which has been reasonably rapid. Clearly we have had stimulus coming from fiscal policy and more is on the way. And whatever you may think of the long-run budget situation, in our immediate circumstances stimulative fiscal policy seems appropriate. Third, we have had in the United States continued growth in income and improvement in wealth, certainly coming from appreciation in house prices and from improvement in equity values at least in recent months. All of those things suggest that deflation in the near future is unlikely.
Let me move on to the second part of the conventional wisdom, namely, that the consequences of deflation, should we experience it, could be severe. Well, if you looked at the Depression for your "inspiration," you would answer yes, the consequences could well be severe. And Japan might provide the same answer, although I think it's important to note that really all that Japan has experienced as far as I can judge is stagnation and occasional bouts of deflation. It's certainly nothing rivaling the Depression of the '30s. Further, Japan's recent problems may be due to rigidities and resource misallocation. Too many resources are devoted to declining or contracting industries. The Japanese have been unwilling to make or encourage or facilitate the resource reallocations that need to occur for the economy to thrive.
In any event, the U.S. economy does not, in my opinion, suffer from the rigidities, resource misallocations and financial problems of the Japanese economy. And so I don't think Japan presents us with a particularly relevant example of what can happen. It seems to me the two economies are fundamentally so different that I would be remiss if I didn't point that out.
I also want to point out, and I think this is pretty well recognized by now, that beginning in the 1990s the U.S. economy experienced a positive productivity shock, one that has persisted to this day. It certainly has not been of the size of the supply-side shock that has occurred in China as best I can judge. Nevertheless, these are two large economiesours and China'sthat have had significant positive supply shocks.
And finally, if we go back to the Depression of the '30s, it's still a subject of intense economic analysis and research even though it occurred 70-plus years ago. There is not a consensus about the causes of the Depression or what could have been done about it. But one thing that most people agree about is that one of the causes of the Depression was a mistake in monetary policya mistake by the Federal Reservethat allowed the money supply to contract. And that was a serious error and one that we will certainly not repeat.
So to try to sum this up: I agree with the conventional wisdom that the probability of deflation is low. The severity question to me is murky, whether you come at it from the historical side or you come at it from the theoretical side, or if you come at it from the more practical institutional side. But as a policymaker, of course, I have to worry about what can really go wrong. And for that reason, even if the evidence were more preponderant one way or the other, I think deflation is a subject that is well worth our attention and well worth our concern.
* An issue I did not address at the journalism workshop but one worthy of serious reflection is the potentially limited effectiveness of monetary policy if the economy experiences a negative demand shock and interest rates are already quite low.