III Historical Experiences of Deflation and Policy Lessons
- Taimur Baig, Jörg Decressin, Tarhan Feyzioglu, Manmohan Kumar, and Chris Faulkner-MacDonagh
- Published Date:
- June 2003
In view of the discussion in the previous section of the determinants and costs of deflation, an examination of the empirical evidence regarding persistent deflation is useful. Prior to the onset of deflation in Japan from the mid-1990s onward, there had been few sustained deflationary episodes in the post–World War II period in the major economies. Among industrial countries, Canada, Norway, and Sweden had small and short-lived declines in aggregate measures of prices in the late 1980s; and the private consumption deflator fell in Germany in 1986 (mainly due to a supply shock) and in Japan in 1988. Several Scandinavian countries experienced a bursting of an asset price bubble, a sharp decline in output, and severe banking sector distress in the late 1980s and early 1990s. However, these were not generally accompanied by falling aggregate prices. A number of emerging market and developing countries also experienced declines in prices up to the mid-1990s. But the declines were generally short-lived, reflecting natural disasters or severe declines in terms of trade of commodity exporters (IMF, 1999; the CFA Franc Zone countries have experienced similar price shocks). Nonetheless, as noted earlier, the frequency of price declines in both industrial and emerging market countries has been clearly increasing over time.
For an assessment of periods of pronounced and sustained declines in prices, one needs to consider the pre–World War II period. The discussion below focuses on two periods: the last quarter of the nineteenth century, when mild but persistent deflation in industrial countries in the first half of the period was followed by inflation in the second half; and the 1930s, when severe deflation lasted for a shorter period, but was accompanied by far more severe consequences. The paper examines the United States, Japan, and Sweden during this period.9
A review of the historical episodes yields three main conclusions: first, deflation and deflationary expectations can take root surprisingly quickly; second, deflation can impose severe economic costs, unless it reflects primarily positive supply shocks; and third, determined and vigorous policies can make a critical difference to ending deflation effectively and relatively quickly.10
Deflation in the Nineteenth Century
From a broader historical perspective, secular increases in the aggregate price level are very much a phenomenon of the second half of the twentieth century.11 For much of recorded history, prices rose because of supply shocks, including military conflicts or harvest failures, but abstracting from these factors, prices were as likely to increase as decline: there were few episodes of sustained inflation. Over the nineteenth century as a whole, there was a marked decline in the aggregate CPI in several major economies (see Appendix Figure A6). In the United States, the CPI index in 1900 was around half its value in 1800; in the United Kingdom, it was a third lower.12
Prices declined in large part because of the constraints imposed by the gold standard in an environment in which there was a significant excess demand for gold. Increasing demand for money was being driven by technological change and population growth. At the same time, the supply of gold was largely fixed. The constraints imposed by the limited supply of gold manifested in part in the deflationary episodes and relatively weak growth: despite the extraordinary technological revolution, annual U.S. real GDP growth per capita was just above 1½ percent over the entire century; in the United Kingdom it was just under 1 percent.
Although there is some debate on the precise effects of deflation specifically during the last quarter of the nineteenth century, there is a broad consensus on the following: (1) periods of deflation were generally associated with significant social and political unrest as producers (especially farmers) faced rising debt burdens and bankruptcies; (2) there was considerable volatility in output growth, with deflationary periods marked by frequent financial crises; and (3) periods of inflation, such as the last decade of the nineteenth century, had generally higher growth than periods of sustained deflation during the decade of the 1870s and early 1880s (Lindert and Williamson, 1985; Frieden, 1993; and Bordo and Redish, 2003).
Nonetheless, GDP growth was on average positive in periods of deflation. There are two main explanations for this: First, periods of declining prices occurred at times of relatively favorable supply shocks. These included major episodes of diffusion of new technologies, including the spread of railways and electrification. Second, prices did not fall long, or far, enough to lead to expectations of a deflationary spiral becoming entrenched. This hypothesis is supported by the behavior of long-term interest rates that did not fall during deflationary episodes. Furthermore, financial intermediation played a less crucial role in the nineteenth century, and nominal rigidities likely were less entrenched than today (Bordo, Erceg, and Evans, 2000).
Deflation in the Early Twentieth Century
Deflation in the late 1920s and early 1930s was qualitatively and quantitatively different than that during the nineteenth century. In the United States, the consumer price index (and the GDP deflator) declined by 24 percent from August 1929 to March 1933, after having been virtually flat from 1921 to 1929. This decline was accompanied by a fall in real GDP of almost 30 percent. Similar price declines occurred in other countries; from 1929 to 1933, prices fell by 25 percent in Japan and 20 percent in Sweden.
In contrast to the nineteenth century, a collapse in aggregate demand and credit channels, along with policy mistakes, drove deflation of the late 1920s and early 1930s. There is broad agreement that monetary factors played a crucial role both in the onset and prolongation of deflation and in the accompanying Great Depression. Friedman and Schwartz (1963) show that the initial downturn in August 1929 and the length and severity of the Great Depression were due to restrictive monetary policy that resulted in a drastic decline in money supply. Bernanke (1995) has emphasized disruptions to the bank intermediation channel—and Eichengreen (1992) the international financial channels. These factors are now generally reckoned to be more important than the stock market crash per se.13
Obstfeld and Rogoff (1996) emphasize that there is a broad consensus that the Depression was caused by an “exogenous world-wide contraction, originating mainly in the United States and transmitted abroad by a combination of policy errors and technical flaws in the interwar gold standard.” This conclusion is also supported by the clear divergence in economic performance between countries that abandoned the gold standard early in the Depression and others that stubbornly clung to gold.
In the United States, the Federal Reserve made two policy mistakes. First, it saw the initial collapse in prices and demand as “necessary” to correct excesses of the 1920s. It regarded the collapse as a result of nonmonetary forces—including creation of excess capacity in the late 1920s—and beyond the influence of monetary policy. The large number of bank failures in 1930 were, according to the Federal Reserve, the result of poor management and lending for speculative equity and land deals. Second, the Federal Reserve tried to maintain the gold standard. While the Federal Reserve did ease monetary policy, it paid no attention to the money supply. The discount rate fell from 6 percent in early 1930 to ½ percent in the first part of 1931.14 However, bank lending had virtually stopped, and along with the high rate of deflation, real interest rates rose sharply. The gold standard was maintained until 1933.
Sweden and to some extent Japan provide examples of countries that were able to break deflationary forces through strong policy action.15 Sweden experienced similar, although somewhat less pronounced, deflation as the United States in the late 1920s. Consumer prices had been falling gradually, and wholesale prices sharply, since late 1928 as the gold standard transmitted deflationary pressures to Sweden. Industrial production declined by 21 percent during 1929–31, compared to a fall of 46 percent in the United States. In late 1931 Sweden left the gold standard, the Swedish central bank explicitly adopted a price level target, and implemented a policy that included open market operations to achieve that target. The abandonment of the gold standard itself was a boost to confidence and a signal that the government was not prepared to allow deflation to continue. This was supported by the price level targeting framework underlining the government’s determination to end deflation. As Berg and Jonung (1999) show, there was a clear recognition that the Riksbank’s commitment to price stability would anchor expectations.
Japan was also able to stop deflation by adopting strong measures. It had temporarily returned to the gold standard in 1929, but by 1930–31, there were sharp declines in Japanese exports, resulting in output declines and rapid deflation. Wholesale prices declined by about 30 percent in 1930–31. The gold standard was abandoned in December 1931, followed by exchange rate depreciation, a marked easing in monetary policy, and large-scale government deficit spending. The Bank of Japan underwrote a substantial proportion of the government’s bond issuance. These measures led to a sharp rebound in Japanese domestic demand and an end to deflation; wholesale prices rose substantially during 1932–33. However, in the absence of a clear commitment to price level targeting—as in Sweden—and the rapid increase in government spending and monetization of deficits driven by war mobilization, inflation accelerated markedly in the second half of the 1930s.