Should We Accept the Conventional Wisdom About Deflation?


This is the title of an article written seven years ago by -guess who?- Gary H. Stern, the president and chief executive officer of the Federal Reserve Bank of Minneapolis from 1985 through 2009.

He has several interesting insights arguing (mildly) against the conventional wisdom about deflation, especially considering his professional role. According to this conventional wisdom, deflation is a phenomenon that monetary authorities should avoid whatever it takes, a  nightmare which is much more feared than inflation itself. In a previous post I showed Donald Luskin’s position on this.

The question I will address is the following: Based on what we know about deflation, should this be the conventional wisdom? In other words, does economic history, economic theory, our understanding of financial markets and the stance of policy lead to these concerns about deflation? My answer is, not entirely. I will argue that the conventional wisdom about the real economic consequences of deflation is questionable.

An interesting answer, coming from a Fed guy.

Robert Higgs writes about this issue, too:

The modern fear of deflation is irrational. Gradual deflation that reflects ongoing improvements in productivity is for the most part a desirable condition. Between 1865 and 1897 gradual deflation reduced consumer prices by about 50 percent. During the same years, the United States experienced very rapid growth of real GDP per capita. Prices fell greatly between 1920 and 1922 and would have fallen further, had the Fed not acted (unwisely) to stabilize the commodity price level for the rest of the 1920s. However, rapid unexpected deflation caused by changes in the demand for or supply of money are not desirable and may cause substantial harm, as they did in the United States between 1929 and 1933. Nevertheless, constantly erring on the side of inflation, as the Fed has done since the 1930s, is bad policy because it results in secular loss of the dollar’s purchasing power. Since the Fed’s creation in 1913, the dollar has lost more than 95 percent of its purchasing power.

As Joseph Salerno argues in this paper, we should be careful on the issue of deflation: there various types of deflation, depending their origins, and not all are bad.