Dean Baker – China Doesn’t Need to Fear Deflation

In the wake of the Great Recession there was a spate of news articles warning of the menace of deflation. The story was that something really bad would happen if the rate of inflation went from a modest positive rate to a modest negative rate. This means something really bad would happen if the rate of inflation was -0.5 percent, as opposed to 0.5 percent. This made zero sense then and it also makes zero sense now.

To understand the issue, it is important to realize there is a grain of truth to the story. In principle, when companies are considering an investment, they will look at the real rate of interest they have to pay. This is the rate of interest they pay in the market, say 6.0 percent on a bond they issue to borrow money, minus the expected rate of inflation in the product they expect to produce.

That means that, if they are producing cars, and they expect the price of cars to rise at a 2.0 percent annual rate over the period of time their investment will be operating, they will effectively be looking at a 4.0 percent real interest rate (6.0 percent minus 2.0 percent equals 4.0 percent). In this story, if the rate of inflation in car prices falls, say to 1.0 percent, then the real rate of interest will rise, in this case to 5.0 percent. At this higher real rate of interest, businesses will be less likely to invest.

The general story is that other things equal (yes, this is a huge qualifier), the lower the rate of inflation, the higher the real rate of interest. This means that lower inflation (and more importantly lower expected inflation), will discourage investment.

So, what’s the deal with deflation? First, it is important to recognize that a lower inflation rate means a higher real interest rate. From this perspective, any drop in the rate of inflation is bad news, there is no special magic to crossing zero. The drop in the rate of inflation from 0.5 percent to -0.5 percent is not qualitatively different from the drop from 1.5 percent to 0.5 percent. Both declines have the effect of raising the real rate of interest and reducing investment.

The other point is simply definitional. The consumer price index, or whatever inflation measure we use, is simply an average of the rates of inflation across thousands of different items. When the rate of inflation gets near zero it means that the prices of many items are already falling. It just means that price rises in other items outweigh the declines in the items with falling prices.

When the overall index crosses zero and goes negative, it just means that the weight of the items with falling prices now exceeds the weight of the items with rising prices. This is not a crisis, it doesn’t really mean anything.

There is a story where deflation can become self-perpetuating, but this is not a case where we edge below zero, it’s a case where there is a sudden economic collapse that sends prices plummeting, as happened at the start of the Great Depression. In that case, we were talking about double-digit price declines, not rates of inflation that were just slightly less than zero.

And no, edging downward does not threaten a deflationary spiral. Japan had several periods of deflation in the last three decades. There was no tendency for the rate of deflation to accelerate. It is reasonable to assume that China is in the same situation.

This doesn’t mean China’s economy doesn’t face problems. Its pattern of growth based on booming exports seems to have to come to an end, due to competition from lower wage countries and protectionist measures from the United States. Its government has also hampered its tech sector by imposing stronger controls.

Nonetheless, its economy is still growing much faster that of the U.S. and other rich countries, so no one should imagine that it is now dead in the water. In any case, its problem is not deflation. Contrary to what you read in the paper, if China’s rate of inflation crosses zero and turns negative, it really doesn’t matter.

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