Deflation

Abstract

The demonization of deflation has drawn attention away from the key problem of productivity. It arises from the two errors that deflation causes recessions and that investment responds to real interest rates. Deflation can be a symptom of inadequate demand but it can also occur when demand is strong. The fallacy depends on ignoring history and the importance of inflationary expectations. These were low in the late nineteenth century, allowing output to grow strongly while prices declined. Low expectations today have allowed stable prices to be combined with falling unemployment. But such expectations are very volatile. Should they rise a sharp increase in interest rates will be needed to prevent stagflation. This will be more dangerous today that it was on the previous occasion in 1982, as asset prices are now overvalued and were then cheap and debt levels were low.