Good versus Bad Deflation: Lessons from the Gold Standard Era

Historically, the negative view of deflation may be attributed to the fact that deflation had been largely unanticipated. The negative view of deflation in the United States, no doubt, was reinforced by farmers who believed that the prices of the commodities they produced had fallen faster than the manufactured goods they consumed.

In Good Versus Bad Deflation: Lessons from the Gold Standard Era (NBER Working Paper No. 10329), authors Michael Bordo, John Landon Lane, and Angela Redish look back at deflationary periods of the late 19th century. These economists find that, contrary to conventional wisdom, deflation may well be more positive than negative.

Bordo, Landon Lane, and Redish focus on the price level and growth experience of the United States, Britain, and Germany during the late 1800s. This period, not unlike the present era, was notable for low inflation or even deflation, for rapid expansion resulting largely from technological innovation, and for a credible and internationally accepted gold standard. The researchers work from the premise that deflation might be good, bad, or even neutral. Good deflation, they maintain, occurs when aggregate supply of goods (say from technological advances, improved productivity, and the like) increases faster than aggregate demand, resulting in falling prices. Bad deflation in turn occurs when aggregate demand falls faster than any growth in aggregate supply. Negative money shocks, for example, that are non-neutral over a significant period - such as occurred later during the Great Depression -- would generate "bad" deflation. Indeed, the authors say, such might be the case in Japan today. A neutral impact of deflation, meanwhile, might occur where monetary neutrality holds despite negative money shocks.

The researchers identify separate "supply shocks," "money supply shocks," and "non-monetary demand shocks" on output and prices. Their analysis is grounded in a model of money supply under the international gold standard. Their results indicate that deflation in the three leading industrial nations in the late 19th century reflected both positive aggregate supply shocks and negative money supply shocks. Yet the latter had only a minor effect on output. The evidence thus suggests that deflation in the 19th century was primarily good, or at the very least neutral.

Bordo, Landon Lane, and Redish believe their findings have relevance for today's economies, even though differences between the environment of their study and that of the modern era must be borne in mind. Three such differences are significant. First, the 19th century was the classical gold standard regime, during which all three countries adhered to the gold standard convertibility rule and all faced a common money shock - the fluctuations in the demand and supply for gold. Second, aggregate supply appears to have been a significant source of the shocks in the 19th century. This stands in contrast to the deflation that occurred in 1920-1, as well as later following the stock market crash of 1929, and in the economic woes that beset Japan in the 1990s, which were demand driven. Third, the negative demand shocks that occurred only had minimal effects on output. This, the analysts note, contrasts sharply with the experience of 1929-33, a period in which many observers attribute the declines in output in the face of monetary contraction to nominal rigidities, such as wages.

Bordo, Landon Lane, and Redish further acknowledge that their study does not deal with several issues in the current debate about the possible onset of deflation. Unlike today, for example, in the era before 1914 central banks rarely used monetary policy to stimulate national economies. Moreover, Bordo, Landon Lane, and Redish do not explicitly distinguish between the effects of actual versus expected price level changes. It is unexpected deflation, they stress, which produces negative consequences.

Finally, Bordo, Landon Lane, and Redish stress that although 19th century deflation was chiefly of the good variety, people hardly perceived it as good. The common view at the time in the United States, Britain, and Germany was that deflation was a clear sign, if indeed not a direct cause, of economic depression. Such a position in fact accounts for the concern about deflation that persists today in the United States, Europe, Japan, and China. Yet the researchers believe that, " historically, the negative view of deflation may be attributed to the fact that deflation had been largely unanticipated. The negative view of deflation in the United States, no doubt, was reinforced by farmers who believed that the prices of the commodities they produced had fallen faster than the manufactured goods they consumed." The re-emergence of deflation today, the researchers conclude, would no doubt be equally unpopular.

-- Matt Nesvisky