Jun 16, 2019 | Updated: 11:54 AM EDT

Why Economists Still Can't Agree on Whether Deflation is Good or Not

Mar 24, 2015 07:32 PM EDT

Falling consumer prices
(Photo : Getty) A clothing sale sign stands outside of a store in Manhattan on March 12, 2015 in New York City. For a third straight month in February U.S. retail sales unexpectedly fell according to a report by the Commerce Department released on Thursday. The report said that retail sales dropped 0.6 percent, with receipts falling in almost all categories.

Although the current global trend of falling prices may seem like good news to consumers, economists worldwide are beginning to wring their hands at the possibility of economies succumbing to sustained deflation, which can be very hard to get out of.

Defined as a decrease in the general price level of goods and services, deflation is everywhere nowadays. Fifteen of the 19 members of the euro zone, for example, are in deflation. Even in the United States and Canada, inflation is well below target. In Britain, inflation dropped to near zero for the first time on record last month, as falling oil prices and a supermarket price war push the country toward its first spell of deflation in 50 years.

While the idea of falling prices may sound attractive - after all, what consumer would reject the notion of being able to buy more for less? -, deflation is a disturbing problem for economists because of its immediate economic implications. Academics and policymakers agree that deflation - of the bad kind, if it is sustained - discourages spending and investment because consumers and businesses begin to expect prices to continue falling and, therefore, postpone purchases in order to pay lower prices at a later date. Less spending leads to a decline in company sales and profits, which in turn increases unemployment in the long run.

Or so we thought?

Expert voices are now attempting to debunk this widely held view. According to the Financial Times, a thought-provoking article published in the latest Quarterly Review of the Bank for International Settlements by Claudio Borio, among others, makes the case for the common sense notion that falling prices should make people spend more, leading to greater business profits and an increase in employment.

After analyzing figures going back to 1870 from 38 countries, Borio concludes that declines in consumer prices are not actually the problem. He argues that the negative effects associated with deflation are in reality caused by huge declines in real estate prices and equity values. All this time, he posits, economists have been deceived by the fact that prices for goods and services have at times decreased at the same time that asset prices have gone down, especially during the Great Depression.

After controlling for sustained asset price deflations and growth rates for each country over the sample period, persistent declines in the prices of goods and services are not associated in a statistically significant way with slower growth. On the other hand, the positive association between property and equity price deflations and slower growth is a statistically significant one.

If Borio and his colleagues are right, then policy makers, economists and especially central bankers should certainly rethink their strategies, and be more concerned with the interaction between asset prices and growth than with controlling the price of goods and services.

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