Can Deflation Be Good?

Can Deflation Be Good?

By Rakesh Sharma | November 17, 2015 AAA |

Consumer prices have been going down in Switzerland for the last four years. And, the economy is doing just fine. Typically, deflation is a sign of a weakening economy. Prices fall due to less consumer demand. In turn, this leads to an increase in unemployment numbers. Deflation can also tip an economy into recession. The ratio of public debt to GDP increases as the government is forced to increase spending on social welfare programs. (For more, see: Why Is Deflation a Central Bank’s Worst Nightmare?)

But, economists are beginning to revise their opinion about the ill effects of deflation. This article will examine the case for good deflation by highlighting the recent Swiss economy as an example.

The Swiss Case

Japan is a textbook case of deflation. The Asian country’s economy has been wracked by deflation for the last 20 years. Economic and population growth has stalled. At 227%, the country’s government debt to GDP ratio is also the highest in the world. Other countries that make up the list of countries with high government debt are, again, countries whose economies have been battered in recent times.

But, Switzerland has proved to be an exception. Earlier this year, Switzerland’s central bank mandated negative interest rates for certain investments to stem an investor tide into the Swiss Franc from a rapidly devaluing Euro. In the aftermath of the introduction of the negative interest rate, economists expected the Swiss economy to go into a recessionary tailspin. (For more, see: How Negative Interest Rates Work.)

But, that has not happened. The country has a low unemployment rate (3.4%) numbers and its economy is expected to grow by between 1% to 1.5%. Wages have declined by 0.6% on an annualized basis but have been offset by the drop in prices. In fact, there has been a net increase in spending power, when wage gains are compared to the fall in prices.

Switzerland’s achievement is even more remarkable, when you compare and contrast it with that of its neighbors in Europe. For example, Sweden’s economy, which witnessed a slide into deflation for much of last year, is on the cusp of a housing bubble, thanks to the availability of cheap credit due to zero-bound interest rates. The country’s central bank is caught in a bind as increasing interest rates would further depress inflation rates and lead to a local version of the 2008 U.S. housing crisis.

Is There Such a Thing as Good Deflation?

All of this leads to the more general question of whether Switzerland is a one-off case or whether deflation occurs independent of other economic indicators. The general consensus around deflation has veered around to the view that it is bad for the economy. Economic research is divided on the issue.

For example, an NBER paper distinguishes between good and bad deflation. According to the paper, good deflation occurs when aggregate supply outstrips aggregate demand, due to advances in technology or improved productivity. Bad deflation occurs when aggregate demand falls faster than supply. The researchers cite Japan and the Great Depression of the 1930s as examples of bad deflation.

The Swiss case seems to be an example of the former. Separately, in a March 2015 article, a team of researchers at the Bank of International Settlements concluded that the link between output economic growth and deflation is statistically weak or insignificant. According to the researchers, this view (which is largely prevalent in economic theory) is a product of the Great Depression. Further proof of this phenomenon is offered by research published by George Selgin, a director at the Cato Institute, in a paper at the Institute of Economic Affairs in 1997. In that paper, Selgin proves that Britain’s Great Depression of 1873 to 1896, when British wholesale prices fell by about a third, was also a time of rising real income.

That said, deflation can be pernicious in combination with other economic indicators. For example, the BIS team concluded that there is a stronger link between output growth and asset price deflation. “The most damaging interactions appear to be between property price deflations and private debt,” they write. In simple words, this means the effect of a corresponding increase in property prices and private debt can deflate the economy into a recessionary spiral. Sweden’s housing problems seem to be an illustration of this problem.

The Bottom Line

Deflation has gotten a bad rap in recent times. However, as economic research and the Swiss economy example shows that view may not be true in all cases.

Read more: Can Deflation Be Good?
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