November 29, 2013
The NYT perpetuated nonsense about the magic of zero in a piece discussing recent measures of inflation and unemployment in the euro zone. It told readers;
“Deflation is considered even worse than runaway inflation, because consumers delay purchases in anticipation of ever lower prices, undercutting corporate profits and causing companies to stop investing in new plants and equipment. The result is rising unemployment and further downward pressure on prices.
“Economists at the advisory firm Oxford Economics calculate that, if the euro zone suffered deflation, unemployment would rise to 16.5 percent of the work force by 2018, or 25 million people. At the same time, countries like Greece would have even more trouble paying back debts, because economic output would shrink and tax receipts would dwindle.”
There is no link to the Oxford Economics analysis cited here, but on its face the idea that the inflation rate falling from 0.5 percent to -0.5 percent would have a devastating impact on employment and output is absurd. The inflation rate is an amalgamation of the prices of hundreds of thousands of different goods and services. At any point in time some prices are rising and some are falling. When the inflation rate goes from a small positive to a small negative it means that the percentage of items with falling prices has increased relative to the percentage of items of rising prices. The notion that this leads to economic disaster is more than a bit far-fetched. (Imagine the shift is from 45 percent of items having falling prices to 55 percent having falling prices.)
Furthermore, since the inflation indices measure quality adjusted prices we could get a shift from a modest rate of inflation to a modest rate of deflation simply because the quality of goods like computers and cell phones is increasing more rapidly. Does that sound like the basis for economic disaster?
The idea that consumers will delay purchases in any notable way due to a shift to deflation is absurd on its face. Computer and cell phone prices have been falling sharply for the last two decades yet people seem to be buying plenty of both. If we just applied an aggregate deflation rate of 0.5 percent to an item like an $800 television set, it would mean that a person could save $4 by waiting a year to buy a television set. Does that have you scared about the impact on consumption?
The point about investment is right, but the crossing of zero, from a small positive inflation rate to a small negative inflation rate is of no real consequences. Businesses invest in the present to sell more goods and/or services in the future. If those goods and services are expected to sell for higher prices then it makes investment more profitable. If they sell for lower prices then it makes investment less profitable.
However there is no particular importance to crossing zero in this story. If the inflation rate falls from 1.5 percent to 0.5 percent, this will make investment look less profitable. The same is true if it falls from 0.5 percent to -0.5 percent. The problem faced by euro zone countries (as well as Japan and the United States) is that it would be desirable to have a higher inflation rate to make investment more profitable. This is just as true when the inflation rate is a very low positive number as when it is a negative number and countries face deflation. The problem is simply too low a rate of inflation.
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