Matthew Lynn: Deflation theory just doesn't stack up

Deflation is good news for savers, who get richer by holding on to their cash. Photo / Wairarapa Times-Age

For much of the past year, central bankers, industrial leaders and politicians have been warning us about deflation.

Falling prices, they tell us, will create another 1930s-style depression. The only answer is to print money furiously.

Now it turns out the theory is a lemon.

Deflation is no threat at all.

It doesn't prevent an economy from functioning, and it doesn't stop it from recovering either.

The evidence suggests a period of sustained deflation might be what indebted economies need to get them back on the right track.

UK 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 programme 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.

In the euro region, prices fell a record 0.7 per cent in July from a year earlier, after declining 0.1 per cent in June, according to the European Union's statistics office.

In Germany, Europe's largest economy, consumer prices posted their first annual drop in more than 22 years in July. Wholesale prices plunged almost 11 per cent.

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 per cent in the three months through June after four consecutive quarters of contraction.

Not much sign of the dangers of deflation there.

In reality, anyone with a sense of economic history would have been aware that the whole deflation story was oversold.

In the UK, the House of Commons Library publishes data on prices going back to 1750. From 1814 to 1914, prices rose a bit in some years, and dropped a bit in others, so there was no real change in the price level over the century.

In other words, there were plenty of deflationary years. Yet over that period, the UK 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. Everyone knows that a computer or an iPod will be both better and cheaper in six months. And people really want one right now.

Torn between those two impulses, plenty of shoppers go out and buy computers and music players. It is true in the electronics industry and, once they get used to falling prices, it will be true for other industries as well.

Deflation may be bad for particular interest groups, which happen to be very powerful. It is bad for chief executives. It is easier to keep your profits rising in a mildly inflationary environment. You can just jack up your prices a bit, and you can often cut workers' wages by stealth by holding wages steady.

The banking industry, which has come to rely on inflation to make highly leveraged loans sustainable, also dislikes deflation. Likewise, it is bad for governments, which use inflation to reduce the value of their debts.

On the other hand, deflation is good news for savers, who get richer just by hanging on to their cash.

And it is beneficial for consumers, who get cheaper prices. It is usually good for workers as well, as they can generally hold the value of their wages, even while prices fall.

There are winners and losers, just as there are from most economic developments. The important point is that the people who lose are more powerful than the people who gain. That might explain why we hear about the dangers of deflation, and not about its advantages. It still doesn't make them right.

There is no threat from deflation. It may even be desirable if it encourages a balance between saving and consumption, and discourages governments and banks from taking on debt.

- BLOOMBERG