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Take a razor to the deflation debate Samuel Brittan: Financial Times 04/07/03 The fashionable shock-horror word is now "deflation". The European Central Bank in particular is often accused of pursuing deflationary policies. Faithful readers will know that I was intensely suspicious of this language long before the bond market shake-out indicated second thoughts in the financial markets on the deflation spectre. Some years ago it was mostly the political and academic left that accused governments and central banks of following excessively deflationary policies. Today, however, the war cry is heard more loudly from some sections of the business community and the political right. It is difficult to suppress the unworthy thought that some of those behind the clamour are looking for a way out of unwise debts they have previously contracted. It is as well to know just what we are talking about. Just as inflation is a general rise in the price levels, so deflation is a general fall. Apart from Japan, the industrial world has not seen deflation for 70 years. Once there is a single currency and a single monetary authority, inflation and deflation refer to movements of the price level of the whole area. To raise the alarm about possible German deflation, because the rate of inflation in that country has fallen to 0.6 per cent - against a euro area rate of 1.9 per cent - is simply to ignore the advent of the new currency. To talk about German deflation makes as much sense as to talk about deflation in Texas or Cornwall, unless you believe monetary union is premature or still immature. In any case it seems inherently absurd to believe that a ¼ per cent annual increase in prices is satisfactory, while a ¼ per cent decrease spells catastrophe. Very often the difference between these low rates of inflation and deflation will depend mainly on the price index used. A ½ per cent rate of deflation based on the European Union's Harmonised Consumer Price Index usually translates into a ¼ per cent rate of inflation on the British Retail Prices Index. The problem is how to combat unhelpful deflationary panic without endorsing the assurances of monetary authorities that world output will stage a gradual recovery in the course of 2003 and move back towards trend in 2004. There is a real danger ahead, but it is badly described by the deflationary war cry. It is that of a recession or slump in which nominal short-term interest rates are already near zero and cannot go any lower, even though the economy needs stimulation. It is this that has triggered a discussion, led by the US Federal Reserve, of "unconventional policies". These policies may be required to prevent a decline or abnormally low increase in output and employment, irrespective of whether prices are slightly falling or slightly rising, as they often have been in past recessions. There have been periods, such as the 1880s in the UK, when prices fell by 0.6 per cent per annum, yet output grew by a highly respectable 2.2 per cent. Less happily, in the US in the years 1933 to 1937, after the Great Depression, the stimulatory effects of monetary expansion were syphoned off into wage and price increases by mistaken New Deal policies, thus retarding the recovery in output. When J.M. Keynes invented the "liquidity trap", he made no mention of deflation but simply analysed the difficulty in some circumstances of getting interest rates low enough to stimulate output and employment. The principle that is required for cutting through these complexities was provided by William of Occam, a 14th-century British philosopher. The principle, known as Occam's razor, states: "Entities are not to be multiplied beyond necessity." This is usually extended to mean that the simplest explanation should be preferred to more complex ones and that single encompassing hypotheses should be sought. The simplest inclusive statement of the problem that may be facing monetary policy is that of the zero interest rate bound (ZIRB). This problem encompasses both the case when the need for stimulus is associated with falling prices and when it is not. It also excludes periods when prices are falling slightly owing to productivity improvements and there is no need for stimulus. I have discussed how central banks might deal with ZIRB in previous articles. The most thorough analysis has been provided by Ben Bernanke of the US Federal Reserve. Possible instruments range all the way from extending central bank operations to longer-dated securities to the finance of budget deficits by monetary creation, which Mr Bernanke regards as the practical equivalent of the economist Milton Friedman's helicopter drop of money from the sky. The bond market may now think it less likely that these devices will be tried; but fashions in financial markets change very quickly. Let us suppose that nominal demand - or the national income in nominal terms - is rising by 3 per cent. Would you rather have a 4 per cent increase in output offset by a 1 per cent fall in prices? Or no increase in output but a 3 per cent rise in prices? The deflation-mongers implicitly assume the latter outcome would be better because there is a positive rate of inflation. This is no way to conduct a sensible debate.
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