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Table of Contents
October 20, 1997

Deflation Is Bullish


For most of this year producer (or wholesale) prices have been slowly declining in the U.S. Economists wedded to the Keynesian belief that low unemployment generates rising prices have reacted with disbelief, puzzlement and concern. But history suggests that their expectations--not the booming economy--are out of step with reality. A modest dose of deflation should be no surprise. Indeed, it should be welcomed.

Sadly, modern economic thinking has been colored by the high inflation rates of the 1970s, and many observers have come to doubt that falling prices are consistent with rapid economic growth. While some prices may fall, they may argue, surely a broad-based price index will not. But not only is deflation possible; it was commonplace when currencies were more directly linked to gold. These misconceptions arise from the myth that falling prices are always due to a lack of "demand." This assumption in turn leads investors to see deflation as a harbinger of economic contraction.

While fear of inflation is the heritage of the 1970s, fear of deflation was the heritage of the 1930s. Although deflation certainly preceded and accompanied the Great Depression, subsequent experience has been quite different. Indeed, during the past half-century, far from being a sign of contraction, deflation (measured in terms of producer prices) has been followed by significantly better economic performance than has inflation.

If, as Milton Friedman contends, inflation is a monetary phenomenon, deflation is a monetary phenomenon too. Inflation represents a cheapening currency; deflation, an appreciating currency. As the population becomes more confident that the dollar is a safe asset to hold, its purchasing power increases.

This process is most readily evident in the prices of precious metals. Modern scholars have shown that gold and silver are the only stores of value whose long-run purchasing power remains stable across the ages. This stability will far outlive the so-called demonetization of these metals during the present century.

The precious-metals indicator explains why Federal Reserve Chairman Alan Greenspan and others who have been expecting an upsurge of inflation have been wrong. The dollar prices of gold and silver are down sharply from a year ago. If the prices of gold and silver go down over time, the dollar's purchasing power must be on the increase.

Deflation often goes unrecognized because of the reliance placed on official measures of the general price level that distort the facts. And outright decline in the consumer price level is unlikely to be registered because (for well-publicized reasons) government indexes greatly overstate inflation. But inflation by any measure has been ebbing even while economists committed to the mistaken belief that inflation results from "excessive" growth continue to predict the contrary.

Movements in the price of gold are excellent leading indicators of changes in the general price level. They also forecast movements in interest rates. With gold down 15% or more from a year ago, mild deflation and slowly declining interest rates are in the cards.

Since deflation allows interest rates to fall, it is bullish for bond markets. Most investors recognize this, but very few of them understand that deflation is also bullish for stock markets and economic growth. It is a common assumption, but an illogical one, that if deflation is good for bonds, it must be bad for stocks and the economy.

On four other occasions since 1954 the U.S. producer price index fell from one year to the next: 1961, 1963, 1985 and 1986. There have been other periods during which it hardly moved at all. Although the years of actual deflation have been few, they provide enough information to explore the financial consequences. Each was followed a year later by excellent stock market performance (an average rise of 18%) and an acceleration in economic growth (an average of 2.8 percentage points in terms of industrial production).

Other statistical tests further confirm these results: The greatest improvement in economic performance and the best stock market performance follow periods of deflation in the PPI. As would be expected, the reverse is true following periods of high inflation.

Evidence from abroad corroborates the U.S. experience. There have also been occasional episodes of deflation in Germany and Japan in the past 50 years. During and immediately after these brief periods, economic performance improved in these countries as well.

My purpose is not to advocate deflation as an economic policy. Any unanticipated change in the price level is an economic friction, because it capriciously redistributes wealth among borrowers and lenders. But if completely stable prices are an unattainable ideal, a modest dose of deflation is better than any amount of inflation.

Mr. Ranson is president of H.C. Wainwright & Co. Economics, an investment research firm in Boston.

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