Perils of Price Deflations: An Analysis of the Great Depression.

In the last two decades, central banks within the industrialized world have been remarkably successful at lowering inflation rates. For example, in 1980 the U.S. rate of inflation was 9.3 percent, while in 2000 it was 2.3 percent. [1] This success has led to a new concern--could deflation be a problem?

A deflation is a decline in the level of prices, that is, a negative inflation rate. Two decades ago, worrying about deflation was like worrying about a shortage of pigeons in Trafalgar Square. But now that inflation rates are near zero, periodic deflations are much more plausible. Some think that a policy of price stability requires that the monetary authority walk a tight rope between the danger of letting inflation reignite and the threat of allowing possible deflation. In this Economic Commentary, we review some of the potential perils of price deflations. We do this by examining how price deflation contributed to the worst economic calamity of the twentieth century--the Great Depression.

Deflations make central bankers nervous, and history tells us why. In their monumental A Monetary History of the U.S., 1867-1960, Milton Friedman and Anna Schwartz note that every example of significant real output decline in the United States was associated with a decline in nominal prices. [2] The most famous episode is the Great Depression. Nominal prices fell 24 percent while real GDP fell nearly 40 percent during 1929-33 (see table 1 for the figures used throughout). Furthermore, both output and prices stayed below their 1929 levels for the rest of the decade. Did the deflation contribute to the decline in output?

Economic theory suggests that deflations potentially pose three main dangers. First, because nominal interest rates cannot fall below zero percent, deflations can increase real interest rates. High real rates tend to discourage investment spending and decrease real economic activity. Second, if employers are unable to reduce nominal wages, price deflations will increase the real wage, which tends to discourage employment growth. Finally, price deflations can lead to large redistributions of wealth from borrowers to lenders. To the extent that firms are net borrowers, this reallocation of wealth will have additional indirect effects. As their balance sheets deteriorate, firms have more trouble acquiring external financing.

Would periodic deflations that may be experienced by a central bank pursuing a zero inflation target likely wreak such economic havoc? To what extent? …

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