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"Deflation is not synonymous with depression. The conventional notion that a persistent decline in prices is always a disaster, an economic disease to be avoided at all costs, a depression in the making, is wrong. University of Minnesota economist Timothy Kehoe examined the record of deflation in 15 countries over 100 years. There were indeed a number of episodes when nations experienced both deflation and depression. But it was more common for economies to grow during periods of deflation.

Hyper-deflation, say a 1930s deflation rate of 5% to 10%, is ruinous. Period. The record is mixed when it comes to mild deflation, say a rate of 1% to 2% a year. Sometimes, mild deflation signals a vigorous, healthy economy. What matters are why are overall prices persistently falling. Bad deflation stems from a "demand shock" perhaps a bankrupt banking system or some other trauma that pushes a weak economy into a downward deflationary spiral. Good deflation can co-exist with strong economic growth when the primary cause is a "supply shock" coming from a string of major technological innovations that push costs and prices down, strong productivity improvements, consumer and business gains from freer international trade, and the like. "Such benign productivity-driven deflation was a common occurrence during the last part of the nineteenth century, when people routinely looked forward to goods getting cheaper," says George Selgin, economist at the University of Georgia.

You have to go back to the 1800s to find examples of persistent supply side deflation, especially in the late 19th century. Like now, the last third of the 19th century and the early years of the 20th century were defined by the rapid emergence of an integrated world economy. International trade flourished. The volume of world foreign trade per capita was more than 25 times greater at the end than at the beginning of the 19th century. It was an era of astonishing technological and organizational innovation. Immigrants crossed borders in astonishing numbers. This was also the period of the international gold standard. A shared belief, a commitment to the economic and political benefits of the gold anchor, facilitated international commerce and investment, and kept the price level stable to down.

Deflation and better everyday circumstances went together in America. The wholesale price level fell about 1.5% annually between 1870 and 1900. Living standards improved as real incomes rose by 85%, or about 5% a year. The U.S. economy grew threefold as America went from an agricultural republic to an industrial empire. In the 1860s, America's industrial output lagged behind Germany, France, and Great Britain. By 1900, the U.S. had became the world's leading industrial power with a combined output greater than its main European rivals. The supply side of the economy, including trade, technology, business organization, and immigration, put enormous downward pressure on prices. Writes George Edward Dickey in Money, Prices, and Growth, The American Experience, 1869-1896: "Such a supply or cost-induced deflation does not have the same deleterious effects as a demand-induced fall in prices.... Deflation in this case is a direct result of the rapid growth of output and is not an inhibitor to growth.... The nineteenth century American experience demonstrated that economic growth is compatible with deflation."

What about stock and bond returns? Stocks returned an average of 8.5% a year and bonds 6.6% from 1870 to 1900. Hardly a disastrous return on investment considering that the long-term return on stocks averages 7% and bonds 3.5% since 1802, according to data compiled by Jeremy Siegel, professor of finance at the Wharton School .. ". MORE "Deflation". Posted by Greg Ransom | TrackBack