Download Historical Experience with Low Inflation

America's Historical Experience with
Low Inflation
J. Bradford DeLong1
October 7, 1999
[email protected]
http://econ161.berkeley.edu
I. Introduction
The burst of inflation that struck the United States in the 1970s still shapes
much American thought about macroeconomic policy. The decade of the
1970s saw GDP-deflator inflation rates peak at nearly ten percent per year,
and saw consumer price inflation peak at rates three or four percent higher.
Such a rate of inflation was high enough to potentially induce significant
distortions in investment as a result of the interaction of inflation with our
tax system, which is unable to adequately adjust for the difference between
nominal and real income. Such a rate of inflation transfered substantial
wealth from creditors to debtors. And it rendered accounting statements
1
I would like to thank Barry Eichengreen, Christopher Hanes, and Robert Waldmann for helpful
discussions.
2
constructed according to standard accounting principles thoroughly
untrustworthy.
Moreover, the inflation of the 1970s has cast its shadow upon forecasts of
the likely future of the American economy. Practically everyone's
3
expectations of what inflation might be in the future are to some degree or
other influenced by the experience of the 1970s. During the 1970s, after all,
the American price level rose by more than eighty percent.
Yet a look back at history reveals that the sustained inflation of the 1970s
was an anomaly in American history.
It is certainly true that there had been previous peaks of inflation higher than
or as high as was reached in the 1970s. But the two biggest peaks had come
during the emergencies of World Wars I and II. One expects considerable
inflation while one's country is engaged in a total war. The third peak--the
last one during which inflation peaked at levels higher than reached in the
1970s--took place during the recovery from the mammoth deflation of 19291933. It did not rapidly and substantially raise the price level above marks
that had previously been considered normal. Instead, it restored prices to
levels that had been considered normal before the coming of the Great
Depression.
In addition these spikes of inflation had been transitory. They had lasted for
a couple of years, or at most for half a decade, not for the decade-plus of the
1970s.
4
Moreover, these episodes of total wartime and deflation-rebound inflation
were exceptional. For the entire century between the end of the Civil War
and the late 1960s inflation had been always below five percent per year
(and usually below three percent per year) in non-wartime non-Great
Depression years.
The century before 1968 reveals that in peacetime the United States is
typically a hard-money country. It is the inflation of the 1970s that is the
significant exception. The causes of the inflation of the 1970s were unique,
and are unlikely to be repeated.2 And William Jennings Bryan lost the
election of 1896 when he campaigned on the platform of free coinage of
silver at a rate of 16-to-1.3 Neither the Republican nor the Democratic Party
sought at the end of 1970s to run on a platform of tolerating the "head cold"
of ten percent per year's worth of inflation in order to achieve the benefits of
a high-pressure economy.4 Both political parties today--save at their fringes-
2
See J. Bradford DeLong (1997), "America's Peacetime Inflation: The 1970s," in Christina Romer and
David Romer. eds., Reducing Inflation: Motivation and Strategy (Chicago: University of Chicago Press);
Herbert Stein (1984), Presidential Economics (New York: Simon and Schuster); Edward Tufte (1978),
Political Control of the Economy (Princeton: Princeton University Press); Donald Kettl (1986), Leadership
at the Fed (New Haven: Yale University Press); Alan Blinder (1982), “The Anatomy of Double-Digit
Inflation,” in Robert Hall, ed., Inflation: Causes and Effects (Chicago: University of Chicago Press).
3
See Lawrence Goodwyn (1978), The Populist Moment (Oxford: Oxford University Press).
4
Although there are some who believe that running on such a platform would have led to overwhelming
political victory. See William Grieder (1987), Secrets of the Temple (New York: Simon and Schuster).
5
-are eager to praise senior Federal Reserve officials who have pursued
monetary policies that have successfully minimized inflation.
Thus it is probably best to think of the current relatively low rate of inflation
as a return to a typical American pattern. Anyone forecasting the future from
today has to be willing to give long odds that the low levels of inflation
America has experienced since the early 1980s will continue.
If it is the case that we are likely to be entering a prolonged era of very low
inflation, what should we expect that era to bring? What potential dangers
does history tell us that low inflation brings to the forefront?
In this paper I want to review the lessons of history--in the hope that by
remembering history, we will be able to avoid repeating the bad parts of it.
There seem to be four sets of issues where America's long-run historical
experience with low inflation might be of help in forecasting the future, or at
least in aiding those of us who want to play the role of Cassandra in pointing
out potential dangers.
The first set of issues revolves around low inflation and the credit channel.
The current leading theory of the causes of the Great Depression stresses the
6
destruction of the web of financial intermediation by deflation between 1929
and 1933: the Great Depression appears from today's perspective to be more
of a credit than a monetary phenomenon. Low inflation raises the chance
that at some point the turning of the wheel of the business cycle will
generate deflation. How great is this danger? How is it to be guarded
against?
The second set of issues revolves around low inflation and real interest rates.
All economists believe deep in their bones in the theory of the Fisher effect:
theory tells us that if one changes the average trend rate of inflation, and if
one then waits long enough, nominal interest rates will adjust point-for-point
(or possibly more than point-for-point given the interaction of inflation and
the tax system) to the change in the rate of inflation, and real interest rates
will return to equilibrium. Is this in fact the case? Or does low inflation pose
a danger in terms of being likely to generate persistently high real interest
rates?
The third set of issues concerns inflation and productivity growth. The idea
behind low inflation is to remove some sand from the wheels of the price
mechanism. In an effectively-zero-inflation climate, people can have more
trust that the real prices they see are likely to persist near their current levels
7
rather than being always in motion as some (s, S) mechanism recurrently
ratchets real prices of individual commodities to levels that are temporarily
high and then temporarily low. In an effectively zero-inflation climate,
people don't have to worry about inflation. Instead, they can devote their
mental attention to worrying about other things--and we hope that some of
that worry about other things will translate into improvements in
productivity.
But does low inflation in fact produce faster productivity growth? And if it
doesn't what is the rationale behind pursuing policies to guarantee low
inflation--policies that may incur substantial costs in terms of other
objectives sacrificed?5
II. Low Inflation and the Credit Channel6
Deflation and the Credit Channel
Does the absence of significant inflation increase the chance of significant
5
See Olivier J. Blanchard and Lawrence H. Summers (1986), "Hysteresis and the European Unemployment
Problem," NBER Macroeconomics Annual 1, pp. 15-78.
6
For a more extended version of the argument of this section, see J. Bradford DeLong (1999), "Should We
Fear Deflation?" Brookings Papers on Economic Activity (Spring).
8
deflation? The price level no longer has a noticeable upward trend. Does this
absence of inflation mean that the chances of a sharp downward movement
in prices--a deflation--are increased?
Certainly people who write articles for newspapers and magazine believe
that it does. In the first six months of 1999 major newspapers printed 467
articles that fall within the scope of the keyword "deflation." A similar
search records only 36 such articles in the first six months of 1997, and only
10 in the first half of 1990.7
John Maynard Keynes8 set out what was perhaps the first analysis of the
damaging effects of deflation working through the credit channel. Keynes
argued that deflation was damaging because entrepreneurs were inevitably
short nominal assets:
…the business world as a whole must always be in a position
where it stands to gain by a rise… and to lose by a fall in
prices…. [The] regime of money-contract forces the world
always to carry a big speculative position, and if it is reluctant
7
Moreover, many of the mentions back in 1990 are ironic: consider the last Financial Times Lex column in
1990. It talks of how in the year just past: "Recession and deflation were hardly on the agenda." See
Financial Times, December 31, 1990, Section I, page 12.
8
John Maynard Keynes (1924), A Tract on Monetary Reform (London: Macmillan).
9
to carry this position the productive process must be
slackened…. The fact of falling prices injures entrepreneurs;
consequently the fear of falling prices causes them to protect
themselves by curtailing their operations; yet it is upon the
aggregate of their individual estimations of the risk, and their
willingness to run the risk, that the activity of production and of
employment mainly depends…9
It was Irving Fisher, however, who argued that it was not the fear of falling
prices but the fact that prices had fallen that was the principal source of
danger.10 Fears that past price declines meant that the banks in which you
placed your money were insolvent decreased monetary velocity. Corporate
bankruptcies also disrupted Fisher's equation of exchange. Thus any decline
in prices carried a severe decline in velocity along with it.
Others disagreed. Academics like Joseph Schumpeter and policy makers like
U.S. Treasury Secretary Andrew Mellon argued that periodic deflations were
9
John Maynard Keynes (1924), A Tract on Monetary Reform (London: Macmillan), pp. 40-42.
See Irving Fisher, "The Debt-Deflation Theory of Great Depressions," Econometrica Vol. 1, No. 4
(October, 1933), pp. 337-57. Irving Fisher (1926), "A Statistical Relationship Between Unemployment and
Price Changes," International Labour Review. Reprinted in the Journal of Political Economy 81:2,1
(March-April 1973), pp. 496-502. Fisher's language provokes occasional culture shock: consider his
statement that "…during the last three years in particular I have had at least one computer in my office
working almost constantly on this problem…" (p. 497).
10
10
necessary for economic growth. After all, anyone could make money during
an inflation: only during deflation could the collection of the economy's
entrepreneurs be pruned through bankruptcy which would release factors of
production that could then be re-employed by more skillful entrepreneurs
during the next boom.11
Deflation was so dangerous in previous eras before World War II--or so we
now think--because of the side effects of the principal-agent problem that
confronts investors who commit their funds to enterprises. The investor has
very limited ability to monitor and assess what is going on at the level of the
operating business. Thus investors need to structure their relationships with
entrepreneurs so that they are forced to monitor the progress of the business
as little as possible, and a good way to do that is through debt. In such a debt
contract the investor receives a fixed sum negotiated ex ante in all states of
the world in which the entrepreneur can pay, and in those states of the world
in which the entrepreneur cannot pay his or her rights are extinguished in
bankruptcy.12
11
See J. Bradford DeLong (1997), "American Fiscal Policy in the Shadow of the Great Depression", in
Michael Bordo, Claudia Goldin, and Eugene White, eds., The Defining Moment: The Great Depression and
the American Economy in the Twentieth Century (Chicago: University of Chicago Press, 1997).
12
See Robert Townsend (1979), "Optimal Contracts and Competitive Markets with Costly State
Verification," Journal of Economic Theory 21:5 (October), pp. 265-93; Douglas Gale and Martin Hellwig
(1985), "Incentive-Compatible Debt Contracts I: The One-period Problem," Review of Economic Studies
52:5 (October), pp. 647-63.
11
In economic theory there is no reason that a debt contract has to be a
nominal debt contract, unconditioned on macroeconomic signals of
production, price levels, and unemployment. But in practice the economy
has and has long had a lot of nominal debt contracts.
Deflation destroys the ability of entrepreneurs to service their nominal debt
obligations. The existence of nominal debt contracts means that to the
financial system deflation appears to be a signal that entrepreneurs have
failed, and that their enterprises need to be liquidated. This makes deflation
destructive: valuable organizations and webs of intermediation are
eliminated for no fundamental purpose. And there is significant evidence
that deflation has been at work, both before and since World War II.13
Kinds of Deflation
This credit-channel analysis of the macroeconomic dangers of deflation
leads immediately to the conclusion that declining goods and services price
indexes are not the only potential source of macroeconomic danger. A large13
See Ben Bernanke, "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great
Depression," American Economic Review Vol. 73, No. 2 (June 1983), pp. 257-76; Ben Bernanke and Mark
Gertler, "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review Vo. 79, No. 1
(March 1989), pp. 14-31; and Ben Bernanke and Mark Gertler, "Financial Fragility and Economic
Performance," Quarterly Journal of Economics Vol. 105, No. 1 (February, 1990), pp. 87-114.
12
scale asset price decline can have similar destructive consequences for the
credit channel and the web of financial intermediation. This is one theory of
the source of Japan's macroeconomic difficulties over the past decade.
Another source of potential deflationary effects is harder-currency
borrowing by banks, companies, and governments with transactions are
denominated in currencies that lose value. When demand for a private
business's products falls, it is natural for the business to cut its price. When
demand for a country's products--either its exports or its properties--falls, it
is natural for the country to cut its price by letting its exchange rate
depreciate.
But if its banks and corporations have borrowed abroad in harder currencies,
then depreciation looks like deflation: it writes up the home-currency value
of their debts, erodes entrepreneurial net worth, and sets the destructive
credit channel in motion. The credit channel effects we fear from deflation
have more potential sources than simply a fall in broad goods-and-services
price indexes alone.
Thus the conclusion has to be that low inflation increases the risks of a debtdeflation credit-channel downward spiral, but it presumably does not
13
increase these risks by very much. Other sources of pressure on the web of
financial intermediation--from asset price or exchange rate declines-continue to exist even in the presence of goods-and-services price index
inflation. Moreover, to the extent that inflation alone14 or the interaction of
our tax system and inflation encourage leverage, the potential danger from
these other sources of pressure will be higher in the presence of inflation
than in times of price stability.15
III. Low Inflation and Real Interest Rates
The end of moderate inflation in the United States in the early 1980s also
saw a substantial increase in real interest rates. The figure below shows real
interest rates on three-month and ten-year U.S. Treasury securities since
1960. The real interest rate is estimated by subtracting the rate of inflation
over the previous twelve months from the nominal interest rate. It is thus a
very imperfect measure of changes in real interest rates in the short term. To
the extent, however, that investors believe that changes in inflation are
14
See William English (1996), "Inflation and Financial Sector Size" (Washington DC: Federal Reserve
Fiannce and Economics Discussion Series 96/16).
15
Martin S. Feldstein (1983), Inflation, Tax Rules, and Capital Formation (Chicago: University of Chicago
Press).
14
persistent and are unforecastable, it will provide a reasonable guide to
changes in real interest rates across decades.
The three most striking features of the figure are (i) the downward trend in
real interest rates from the 1960s into the inflationary 1970s, (ii) the upward
jump in real interest rates to what were (for the United States) extraordinary
levels during the Volcker disinflation, and (iii) the continued high level of
real interest rates since. Real interest rates today are some one hundred basis
points higher at the short end and at least one hundred fifty basis points
higher at the long end than in the early 1960s.
15
The Fisher Effect
Back in 1984 when economists first noted this rise in interest rates, Olivier
Blanchard and Lawrence Summers attributed it to an increase in the return
on capital springing from deregulation and reductions in marginal tax rates.16
But the increase in economic growth over the following decade that one
would have expected to result from an investment boom driven by an
16
See Olivier J. Blanchard and Lawrence H. Summers (1984), "Perspectives on High World Interest
Rates," Brookings Papers on Economic Activity (Fall), pp. 323-74.
16
increase in the return on capital did not happen. Thus today it seems much
more likely that relatively high real interest rates in financial markets are a
result of some failure of the Fisher effect: investors appear to believe that
there is a significant chance of a renewal of inflation like that of the 1970s.
Historical experience tells us that such failures of the Fisher effect for
prolonged periods of time--generations--are not at all uncommon. Lawrence
Summers (1983) argued that there was essentially no evidence for the
existence of a response of nominal interest rates to changes in long-term
trend rates of inflation back before World War II, and only a partial response
to changes in long-term trend rates of inflation since World War II.
In response to the criticism that pre-World War I rates of inflation were
essentially unforecastable--and hence that there was no predictable
component to shifts in pre-World War I inflation--Barsky and DeLong
(1991) pointed out that the link under the gold standard between mining and
prices did provide a way to forecast pre-World War I inflation. Although the
log of the pre-World War I price level is almost a random walk), there is a
component of future price changes that is forecast by changes in the world
stock of gold. The smooth gold production series pick ups an important and
17
forecastable low-frequency component of inflation which is masked in
univariate analyses.
Worldwide gold production was a well-known and closely-followed quantity
at the time. The correlation between pre-World War I rates of inflation and
rates of increase in the world gold stock was significant. Financial markets
back before World War I could have used the information implicit in gold
mining to forecast in the years immediately after 1896 that the world
economy was shifting from a regime of slow deflation to one of slow
inflation. Yet they do not appear to have done so.
18
Instead of a Fisher Effect, we have a pre-World War I Gibson Paradox.
Interest rates respond to the turnaround of the direction of movement of the
price level around 1896 so slowly and hesitantly that the nominal interest
rate is correlated not with the inflation rate but with the integral of the
inflation rate, the price level.17
Irving Fisher himself attempted to reconcile his point-for-point adjustment
of nominal interest rates to inflation, and concluded that the failure of the
nominal interest rate to rise after 1896: "…must, in all probability, have been
17
See Shiller and Siegel (1977).
19
due to inadvertence. The inrushing streams of gold caught merchants
napping. They should have stemmed the tide by putting up [nominal]
interest… two or three percent[age] points higher…"18
It is clear that long-run historical experience gives us no reason to be
confident that the Fisher effect would hold. So why should we be surprised
when the Volcker disinflation of the early 1980s turns out to have had a
significant and long-lasting effect on the level of real interest rates?
Implications for Investment
Yet has the persistent rise in real interest had significant economic effects?
Has it led to a reduction in real investment below its counterfactual path? It
is not at all clear that it has had any such effect. Untangling the causes of
secular changes in savings and investment rates is next to impossible
because the changing composition of the capital stock has been shortening
its average lifetime. Gross investment as a share of GDP has certainly not
18
See Barsky and DeLong (1991), who note that this assessment by Fisher fits awkwardly with his
(earlier) arguments in The Rate of In terest for the Fisher effect:
"Foresight is clearer and more prevalent to-day than ever before. Multiples of trade
journals and investors’ reviews have their chief reason for existence in supplying data on
which to base prediction. Every chance for gain is eagerly watched for. An active and
keen speculation is constantly going on which, so far as it does not consist of fictitious
and gambling transactions, performs a well-known and provident function for society. Is
it reasonable to believe that foresight, which is the general rule, has an exception as
applied to falling or rising prices?"
20
fallen since 1980. Net investment as a share of GDP may have fallen. And it
is not even clear which way we would expect a rise in the ex ante real
interest rate to shift the savings rate.
Thus the lesson of history for the effect of an age of low inflation on the real
interest rate is double-edged. First, do not expect the Fisher effect to hold:
expect the real rate of interest in low-inflation times to be relatively high.
Second, do not expect this failure of the Fisher effect to have any significant
effect on the level of investment: the failure of expectations to adjust fully to
the low-inflation environment is, presumably, present on both sides of the
market. (There are, of course, substantial effects on the relative wealth of
debtors and creditors.
IV. Low Inflation and Productivity Growth
V. Conclusion
21
There is, moreover, one additional reason to look forward to an era of low
inflation. People do not seem to like inflation. They vote against political
parties that preside over governments that experience inflation.
22
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23
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24
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25
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26
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