The burst of inflation that struck the United States in the 1970s still shapes much American thought about macroeconomic policy. The decade of the 1970s saw GDP-deflator inflation rates peak at nearly ten percent per year, and saw consumer price inflation peak at rates three or four percent higher. Such a rate of inflation was high enough to potentially induce significant distortions in investment as a result of the interaction of inflation with our tax system, which is unable to adequately adjust for the difference between nominal and real income. Such a rate of inflation transfered substantial wealth from creditors to debtors. And it rendered accounting statements constructed according to standard accounting principles thoroughly untrustworthy.
Moreover, the inflation of the 1970s has cast its shadow upon forecasts of the likely future of the American economy. Practically everyone's expectations of what inflation might be in the future are to some degree or other influenced by the experience of the 1970s. During the 1970s, after all, the American price level rose by more than eighty percent.
Yet a look back at history reveals that the sustained inflation of the 1970s was an anomaly in American history.
It is certainly true that there had been previous peaks of inflation higher than or as high as was reached in the 1970s. But the two biggest peaks had come during the emergencies of World Wars I and II. One expects considerable inflation while one's country is engaged in a total war. The third peak--the last one during which inflation peaked at levels higher than reached in the 1970s--took place during the recovery from the mammoth deflation of 1929-1933. It did not rapidly and substantially raise the price level above marks that had previously been considered normal. Instead, it restored prices to levels that had been considered normal before the coming of the Great Depression.
In addition these spikes of inflation had been transitory. They had lasted for a couple of years, or at most for half a decade, not for the decade-plus of the 1970s.
Moreover, these episodes of total wartime and deflation-rebound inflation were exceptional. For the entire century between the end of the Civil War and the late 1960s inflation had been always below five percent per year (and usually below three percent per year) in non-wartime non-Great Depression years.
The century before 1968 reveals that in peacetime the United States is typically a hard-money country. It is the inflation of the 1970s that is the significant exception. The causes of the inflation of the 1970s were unique, and are unlikely to be repeated.2 And William Jennings Bryan lost the election of 1896 when he campaigned on the platform of free coinage of silver at a rate of 16-to-1.3 Neither the Republican nor the Democratic Party sought at the end of 1970s to run on a platform of tolerating the "head cold" of ten percent per year's worth of inflation in order to achieve the benefits of a high-pressure economy.4 Both political parties today--save at their fringes--are eager to praise senior Federal Reserve officials who have pursued monetary policies that have successfully minimized inflation.
Thus it is probably best to think of the current relatively low rate of inflation as a return to a typical American pattern. Anyone forecasting the future from today has to be willing to give long odds that the low levels of inflation America has experienced since the early 1980s will continue.
If it is the case that we are likely to be entering a prolonged era of very low inflation, what should we expect that era to bring? What potential dangers does history tell us that low inflation brings to the forefront?
In this paper I want to review the lessons of history--in the hope that by remembering history, we will be able to avoid repeating the bad parts of it. There seem to be four sets of issues where America's long-run historical experience with low inflation might be of help in forecasting the future, or at least in aiding those of us who want to play the role of Cassandra in pointing out potential dangers.
The first set of issues revolves around low inflation and the credit channel. The current leading theory of the causes of the Great Depression stresses the destruction of the web of financial intermediation by deflation between 1929 and 1933: the Great Depression appears from today's perspective to be more of a credit than a monetary phenomenon. Low inflation raises the chance that at some point the turning of the wheel of the business cycle will generate deflation. How great is this danger? How is it to be guarded against?
The second set of issues revolves around low inflation and real interest rates. All economists believe deep in their bones in the theory of the Fisher effect: theory tells us that if one changes the average trend rate of inflation, and if one then waits long enough, nominal interest rates will adjust point-for-point (or possibly more than point-for-point given the interaction of inflation and the tax system) to the change in the rate of inflation, and real interest rates will return to equilibrium. Is this in fact the case? Or does low inflation pose a danger in terms of being likely to generate persistently high real interest rates?
The third set of issues concerns inflation and productivity growth. The idea behind low inflation is to remove some sand from the wheels of the price mechanism. In an effectively-zero-inflation climate, people can have more trust that the real prices they see are likely to persist near their current levels rather than being always in motion as some (s, S) mechanism recurrently ratchets real prices of individual commodities to levels that are temporarily high and then temporarily low. In an effectively zero-inflation climate, people don't have to worry about inflation. Instead, they can devote their mental attention to worrying about other things--and we hope that some of that worry about other things will translate into improvements in productivity.
But does low inflation in fact produce faster productivity growth? And if it doesn't what is the rationale behind pursuing policies to guarantee low inflation--policies that may incur substantial costs in terms of other objectives sacrificed?5
II. Low Inflation and the Credit Channel6
Deflation and the Credit Channel
Does the absence of significant inflation increase the chance of significant deflation? The price level no longer has a noticeable upward trend. Does this absence of inflation mean that the chances of a sharp downward movement in prices--a deflation--are increased?
Certainly people who write articles for newspapers and magazine believe that it does. In the first six months of 1999 major newspapers printed 467 articles that fall within the scope of the keyword "deflation." A similar search records only 36 such articles in the first six months of 1997, and only 10 in the first half of 1990.7
John Maynard Keynes8 set out what was perhaps the first analysis of the damaging effects of deflation working through the credit channel. Keynes argued that deflation was damaging because entrepreneurs were inevitably short nominal assets:
…the business world as a whole must always be in a position where it stands to gain by a rise… and to lose by a fall in prices…. [The] regime of money-contract forces the world always to carry a big speculative position, and if it is reluctant to carry this position the productive process must be slackened…. The factof falling prices injures entrepreneurs; consequently the fear of falling prices causes them to protect themselves by curtailing their operations; yet it is upon the aggregate of their individual estimations of the risk, and their willingness to run the risk, that the activity of production and of employment mainly depends…9
It was Irving Fisher, however, who argued that it was not the fear of falling prices but the fact that prices had fallen that was the principal source of danger.10 Fears that past price declines meant that the banks in which you placed your money were insolvent decreased monetary velocity. Corporate bankruptcies also disrupted Fisher's equation of exchange. Thus any decline in prices carried a severe decline in velocity along with it.
Others disagreed. Academics like Joseph Schumpeter and policy makers like U.S. Treasury Secretary Andrew Mellon argued that periodic deflations were necessary for economic growth. After all, anyone could make money during an inflation: only during deflation could the collection of the economy's entrepreneurs be pruned through bankruptcy which would release factors of production that could then be re-employed by more skillful entrepreneurs during the next boom.11
Deflation was so dangerous in previous eras before World War II--or so we now think--because of the side effects of the principal-agent problem that confronts investors who commit their funds to enterprises. The investor has very limited ability to monitor and assess what is going on at the level of the operating business. Thus investors need to structure their relationships with entrepreneurs so that they are forced to monitor the progress of the business as little as possible, and a good way to do that is through debt. In such a debt contract the investor receives a fixed sum negotiated ex ante in all states of the world in which the entrepreneur can pay, and in those states of the world in which the entrepreneur cannot pay his or her rights are extinguished in bankruptcy.12
In economic theory there is no reason that a debt contract has to be a nominal debt contract, unconditioned on macroeconomic signals of production, price levels, and unemployment. But in practice the economy has and has long had a lot of nominal debt contracts.
Deflation destroys the ability of entrepreneurs to service their nominal debt obligations. The existence of nominal debt contracts means that to the financial system deflation appears to be a signal that entrepreneurs have failed, and that their enterprises need to be liquidated. This makes deflation destructive: valuable organizations and webs of intermediation are eliminated for no fundamental purpose. And there is significant evidence that deflation has been at work, both before and since World War II.13
Kinds of Deflation
This credit-channel analysis of the macroeconomic dangers of deflation leads immediately to the conclusion that declining goods and services price indexes are not the only potential source of macroeconomic danger. A large-scale asset price decline can have similar destructive consequences for the credit channel and the web of financial intermediation. This is one theory of the source of Japan's macroeconomic difficulties over the past decade.
Another source of potential deflationary effects is harder-currency borrowing by banks, companies, and governments with transactions are denominated in currencies that lose value. When demand for a private business's products falls, it is natural for the business to cut its price. When demand for a country's products--either its exports or its properties--falls, it is natural for the country to cut its price by letting its exchange rate depreciate.
But if its banks and corporations have borrowed abroad in harder currencies, then depreciation looks like deflation: it writes up the home-currency value of their debts, erodes entrepreneurial net worth, and sets the destructive credit channel in motion. The credit channel effects we fear from deflation have more potential sources than simply a fall in broad goods-and-services price indexes alone.
Thus the conclusion has to be that low inflation increases the risks of a debt-deflation credit-channel downward spiral, but it presumably does not increase these risks by very much. Other sources of pressure on the web of financial intermediation--from asset price or exchange rate declines--continue to exist even in the presence of goods-and-services price index inflation. Moreover, to the extent that inflation alone14 or the interaction of our tax system and inflation encourage leverage, the potential danger from these other sources of pressure will be higher in the presence of inflation than in times of price stability.15
III. Low Inflation and Real Interest Rates
The end of moderate inflation in the United States in the early 1980s also saw a substantial increase in real interest rates. The figure below shows real interest rates on three-month and ten-year U.S. Treasury securities since 1960. The real interest rate is estimated by subtracting the rate of inflation over the previous twelve months from the nominal interest rate. It is thus a very imperfect measure of changes in real interest rates in the short term. To the extent, however, that investors believe that changes in inflation are persistent and are unforecastable, it will provide a reasonable guide to changes in real interest rates across decades.
The three most striking features of the figure are (i) the downward trend in real interest rates from the 1960s into the inflationary 1970s, (ii) the upward jump in real interest rates to what were (for the United States) extraordinary levels during the Volcker disinflation, and (iii) the continued high level of real interest rates since. Real interest rates today are some one hundred basis points higher at the short end and at least one hundred fifty basis points higher at the long end than in the early 1960s.
The Fisher Effect
Back in 1984 when economists first noted this rise in interest rates, Olivier Blanchard and Lawrence Summers attributed it to an increase in the return on capital springing from deregulation and reductions in marginal tax rates.16 But the increase in economic growth over the following decade that one would have expected to result from an investment boom driven by an increase in the return on capital did not happen. Thus today it seems much more likely that relatively high real interest rates in financial markets are a result of some failure of the Fisher effect: investors appear to believe that there is a significant chance of a renewal of inflation like that of the 1970s.
Historical experience tells us that such failures of the Fisher effect for prolonged periods of time--generations--are not at all uncommon. Lawrence Summers (1983) argued that there was essentially no evidence for the existence of a response of nominal interest rates to changes in long-term trend rates of inflation back before World War II, and only a partial response to changes in long-term trend rates of inflation since World War II.
In response to the criticism that pre-World War I rates of inflation were essentially unforecastable--and hence that there was no predictable component to shifts in pre-World War I inflation--Barsky and DeLong (1991) pointed out that the link under the gold standard between mining and prices did provide a way to forecast pre-World War I inflation. Although the log of the pre-World War I price level is almost a random walk), there is a component of future price changes that is forecast by changes in the world stock of gold. The smooth gold production series pick ups an important and forecastable low-frequency component of inflation which is masked in univariate analyses.
Worldwide gold production was a well-known and closely-followed quantity at the time. The correlation between pre-World War I rates of inflation and rates of increase in the world gold stock was significant. Financial markets back before World War I could have used the information implicit in gold mining to forecast in the years immediately after 1896 that the world economy was shifting from a regime of slow deflation to one of slow inflation. Yet they do not appear to have done so.
Instead of a Fisher Effect, we have a pre-World War I Gibson Paradox. Interest rates respond to the turnaround of the direction of movement of the price level around 1896 so slowly and hesitantly that the nominal interest rate is correlated not with the inflation rate but with the integral of the inflation rate, the price level.17 Irving Fisher himself attempted to reconcile his point-for-point adjustment of nominal interest rates to inflation, and concluded that the failure of the nominal interest rate to rise after 1896: "…must, in all probability, have been due to inadvertence. The inrushing streams of gold caught merchants napping. They should have stemmed the tide by putting up [nominal] interest… two or three percent[age] points higher…"18 It is clear that long-run historical experience gives us no reason to be confident that the Fisher effect would hold. So why should we be surprised when the Volcker disinflation of the early 1980s turns out to have had a significant and long-lasting effect on the level of real interest rates?
Implications for Investment
Yet has the persistent rise in real interest had significant economic effects? Has it led to a reduction in real investment below its counterfactual path? It is not at all clear that it has had any such effect. Untangling the causes of secular changes in savings and investment rates is next to impossible because the changing composition of the capital stock has been shortening its average lifetime. Gross investment as a share of GDP has certainly not fallen since 1980. Net investment as a share of GDP may have fallen. And it is not even clear which way we would expect a rise in the ex ante real interest rate to shift the savings rate.
Thus the lesson of history for the effect of an age of low inflation on the real interest rate is double-edged. First, do not expect the Fisher effect to hold: expect the real rate of interest in low-inflation times to be relatively high. Second, do not expect this failure of the Fisher effect to have any significant effect on the level of investment: the failure of expectations to adjust fully to the low-inflation environment is, presumably, present on both sides of the market. (There are, of course, substantial effects on the relative wealth of debtors and creditors.
There is, moreover, one additional reason to look forward to an era of low inflation. People do not seem to like inflation. They vote against political parties that preside over governments that experience inflation.
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1 I would like to thank Barry Eichengreen, Christopher Hanes, and Robert Waldmann for helpful discussions.
2 See J. Bradford DeLong (1997), "America's Peacetime Inflation: The 1970s," in Christina Romer and David Romer. eds., Reducing Inflation: Motivation and Strategy (Chicago: University of Chicago Press); Herbert Stein (1984), Presidential Economics (New York: Simon and Schuster); Edward Tufte (1978), Political Control of the Economy (Princeton: Princeton University Press); Donald Kettl (1986), Leadership at the Fed (New Haven: Yale University Press); Alan Blinder (1982), “The Anatomy of Double-Digit Inflation,” in Robert Hall, ed., Inflation: Causes and Effects (Chicago: University of Chicago Press).
3 See Lawrence Goodwyn (1978), The Populist Moment (Oxford: Oxford University Press).
4 Although there are some who believe that running on such a platform would have led to overwhelming political victory. See William Grieder (1987), Secrets of the Temple (New York: Simon and Schuster).
5 See Olivier J. Blanchard and Lawrence H. Summers (1986), "Hysteresis and the European Unemployment Problem," NBER Macroeconomics Annual 1, pp. 15-78.
6 For a more extended version of the argument of this section, see J. Bradford DeLong (1999), "Should We Fear Deflation?" Brookings Papers on Economic Activity (Spring).
7Moreover, many of the mentions back in 1990 are ironic: consider the last Financial Times Lex column in 1990. It talks of how in the year just past: "Recession and deflation were hardly on the agenda." See Financial Times, December 31, 1990, Section I, page 12.
8John Maynard Keynes (1924), A Tract on Monetary Reform (London: Macmillan).
9John Maynard Keynes (1924), A Tract on Monetary Reform (London: Macmillan), pp. 40-42.
10See Irving Fisher, "The Debt-Deflation Theory of Great Depressions," Econometrica Vol. 1, No. 4 (October, 1933), pp. 337-57. Irving Fisher (1926), "A Statistical Relationship Between Unemployment and Price Changes," International Labour Review. Reprinted in the Journal of Political Economy 81:2,1 (March-April 1973), pp. 496-502. Fisher's language provokes occasional culture shock: consider his statement that "…during the last three years in particular I have had at least one computer in my office working almost constantly on this problem…" (p. 497).
11See J. Bradford DeLong (1997), "American Fiscal Policy in the Shadow of the Great Depression", in Michael Bordo, Claudia Goldin, and Eugene White, eds., The Defining Moment: The Great Depression and the American Economy in the Twentieth Century (Chicago: University of Chicago Press, 1997).
12See Robert Townsend (1979), "Optimal Contracts and Competitive Markets with Costly State Verification," Journal of Economic Theory 21:5 (October), pp. 265-93; Douglas Gale and Martin Hellwig (1985), "Incentive-Compatible Debt Contracts I: The One-period Problem," Review of Economic Studies 52:5 (October), pp. 647-63.
13 See Ben Bernanke, "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression," American Economic Review Vol. 73, No. 2 (June 1983), pp. 257-76; Ben Bernanke and Mark Gertler, "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review Vo. 79, No. 1 (March 1989), pp. 14-31; and Ben Bernanke and Mark Gertler, "Financial Fragility and Economic Performance," Quarterly Journal of Economics Vol. 105, No. 1 (February, 1990), pp. 87-114.
14 See William English (1996), "Inflation and Financial Sector Size" (Washington DC: Federal Reserve Fiannce and Economics Discussion Series 96/16).
15 Martin S. Feldstein (1983), Inflation, Tax Rules, and Capital Formation (Chicago: University of Chicago Press).
16 See Olivier J. Blanchard and Lawrence H. Summers (1984), "Perspectives on High World Interest Rates," Brookings Papers on Economic Activity (Fall), pp. 323-74.
17 See Shiller and Siegel (1977).
18 See Barsky and DeLong (1991), who note that this assessment by Fisher fits awkwardly with his (earlier) arguments in The Rate of In terest for the Fisher effect:
"Foresight is clearer and more prevalent to-day than ever before. Multiples of trade journals and investors’ reviews have their chief reason for existence in supplying data on which to base prediction. Every chance for gain is eagerly watched for. An active and keen speculation is constantly going on which, so far as it does not consist of fictitious and gambling transactions, performs a well-known and provident function for society. Is it reasonable to believe that foresight, which is the general rule, has an exception as applied to falling or rising prices?"