Deflation Has Got To Be Good For You

Gareth MorganEconomics

Gareth Morgan, Director of Gareth Morgan Investments

Producer prices have fallen for five months in a row in the US, a cumulative 2% drop in prices so far this year. This is a streak unmatched since 1952 and is great news for that economy.

So ingrained in our psyche has become the equivalence of price deflation with economic depression, that there is a shortage of explanation for this current US experience. Nobody would suggest the US is in a depression right now. Indeed it's quite the opposite – a booming economy and falling prices ! Why ?

Over the decades of permanent inflation we seem to have forgotten that there can be a range of circumstances which deliver a fall in the price level. Not all of these are symptomatic of an imploding economy, as say was the case during the 1930's Depression. Arguably the advent of the Industrial Revolution last century with its technological revolution of mechanised production, led to many decades of falling prices as the productivity benefits were captured.

Such circumstances of productivity-inspired price declines can present headaches for a central bank as it tries to maintain overall price stability. In particular, under conditions of rapid and widespread technological change, prices can drop generally and at such a pace that monetary authorities fail to adjust their policy sufficiently. The net result is that the central bank keeps untoward pressure on the interest and exchange rates, forcing the economy to grow below its potential, or non-inflationary rate. I am not suggesting this is happening in New Zealand at present.

So a strong economy, one where competition and productivity improvement is delivering benefit to households in the form of cheaper goods, can be expected to experience widespread price falls, even to an extent that these show up in general price indexes. This is what is happening in the US. The information and communications technology revolution is the driver of the change and it offers that economy and the world an enormous opportunity to lift living standards.

The US, being the most free and competitive market on earth is getting the deflationary fruits of this revolution rapidly and its households are benefiting. Central to the rapid dispersion of the benefits are deregulated and deep markets which enable the competitive processes of "creative destruction' to vent their wrath on the economic structure. Industries which no longer have any comparative advantage are allowed, in fact encouraged, to die and free up resources (labour and capital) for more productive use.

So how are we doing in New Zealand on this score ? With our deregulated international borders there are few barriers presented to rapid infusion of the benefits of the technology age into our society. Once here though there are significant impediments to those fruits spreading rapidly. Regulated markets and a large government (central and local) sector which is not responsive to market pricing, present a formidable drag on realising our potential.

To boot, our central bank has not done a great job in reducing inflationary expectations as is witnessed by the reality that it has been conspicuous in sponsoring inflation outcomes above the mid-point of its so-called target (which was 1.0 and is now by virtue of ill-informed and misguided political influence, 1.5). So throughout our productive sector there is still a tendency to raise prices rather than lower them. How often do we see the following sort of communication from firms.

" We have not raised our prices for more than two years, but we regret we are unable to hold the line any longer, and as a consequence from April 10 we will be lifting prices by 3%'.

It's as though they expect congratulations for holding their price rises off . Such an admission is evidence that our firms still operate on a cost plus mentality and see pass-through as a profitable practice. If the Reserve Bank had succeeded in its mission, firms would not have this attitude – they would be too scared of substantial loss of revenue. Rather, they would as an alternative concentrate on productivity as the source of greater profits. Until that day arrives the Reserve Bank still has not succeeded in stabilising prices. The move to 0-3% has frustrated that task.

One day, if and when price stability is achieved, the Reserve Bank will perhaps face a different challenge – easing monetary conditions to prevent productivity-driven price falls undermining an overall stable price level. Clearly this is some way away yet.

Deflation Has Got To Be Good For You was last modified: December 15th, 2015 by Gareth Morgan
About the Author

Gareth Morgan

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Gareth Morgan is a New Zealand economist and commentator on public policy who in previous lives has been in business as an economic consultant, funds manager, and professional company director. He is also a motorcycle adventurer and philanthropist. Gareth and his wife Joanne have a charitable foundation, the Morgan Foundation, which has three main stands of philanthropic endeavour – public interest research, conservation and social investment.