Does Deflation Lead to Depression? Who Sold Us This Theory?

In a well written article at Bloomberg.com, Matthew Lynn challenges the notion of price deflation risk, and the widely held belief that deflation leads to economic depression.

First, is there really a risk of deflation anymore?

U.K. Chancellor of the Exchequer Alistair Darling said in a speech earlier this year that the Bank of England must be “prepared to act” to prevent price deflation.

“We are very keen on avoiding deflationary risk,” said European Central Bank President Jean-Claude Trichet in an interview this month. Much the same message has been pumped out around the world by economic leaders.

Nor have they been slow to put their freshly minted money where their mouth is. The Bank of England has embarked on a program of “quantitative easing,” or creating new money, to stave off the threat.

The trouble is, the theory doesn’t stack up.

Deflation, after all, has already arrived.

Is deflation killing the Eurozone?

So the “deflating” euro area is disappearing over an economic precipice, right? Not quite. It is leading the world out of recession. Figures released last week showed Germany and France were hauling the region out of the global decline -- both expanded 0.3 percent in the three months through June after four consecutive quarters of contraction.

Not much sign of the dangers of deflation there.

Deflation did not prevent some of the most expansionary periods in history, e.g. the Industrial Revolution:

In other words, there were plenty of deflationary years. Yet over that period, the U.K. became the greatest economic power in the world: Its relative decline only started once inflation took hold. Deflation didn’t stop the Industrial Revolution, one of the most sustained times of economic creativity ever seen.

Likewise, a 2004 study by the Federal Reserve Bank of Minneapolis looked at the data on deflation across 17 countries over 100 years. It found that although the Great Depression of the 1930s was linked with falling prices, that wasn’t true of any other historical period. There was, it said, “virtually no evidence” that deflation caused a depression.

Why should it? We are constantly told that deflation is bad because it makes consumers hold off from buying things, thinking they will be cheaper tomorrow. But that is just silly.

The Bottom Line: Matthew Lynn is arguing that there are numerous times in history when deflation and depression were mutually exclusive c0nditions and only one time, The Great Depression, when the two were linked. Therefore the consensus that deflation leads to depression may be flawed. Lynn is not saying that a depression is not possible, just that it is not necessarily preceded by deflation. In addition, another important point Lynn makes is that we should not fear deflation, when in fact, we are already in a deflationary economic period.

Read the complete article here.

Source: Deflation Theory is a Lemon We Have All Been Sold, Matthew Lynn, Bloomberg, August 17, 2oo9