Stop obsessing over prices

It is one of the most bewildering discussions in a confusing area. Deflation is welcomed by some economists but condemned by others as a grave threat. Some basic distinctions are necessary to understand the debate.

Let’s start by outlining recent developments. The eurozone’s inflation rate fell by 0.2 per cent in the year to December according to a flash estimate from Eurostat. For many commentators the drop signaled the possibility that the region was descending into a protracted period of stagnation akin to Japan’s painful experience since the 1980s. For other pundits, particularly in Germany, the slight downturn in prices was no cause for alarm.

Shortly after the eurozone estimate was released the Office for National Statistics in Britain said that the consumer prices index (CPI) had risen by only 0.5 per cent in the year to December 2014 – the lowest level since records began.  In response David Cameron tweeted that: “The fall in #inflation is good news for families. Our long term economic plan is on track and helping hardworking taxpayers.”

Mark Carney, the governor of the Bank of England, said that the dip was nothing to worry about. It was caused by a fall in global fuel and food prices rather than a generalised slowdown of the economy. In his view this sort of low inflation could grease the wheels of economic activity.

The pessimists typically point out that deflation is often associated with stagnation. In other words falling prices and sluggish economic performance often coincide. This phenomenon was common in the western economies in the 1930s and has often prevailed in Japan in recent years. Indeed the term “deflation” is used in two different ways: to simply mean falling prices or alternatively to refer to a downward economic spiral.

Typically the pessimists go on to suggest ways in which falling prices and stagnation could be linked. One popular line of argument is that the economy can get caught in a liquidity trap: consumers are reluctant to buy goods today as prices could be lower tomorrow. Another common claim is that falling prices increase the real burden of debt that economies are suffering.

Deflation optimists, in contrast, often argue that there is no correlation between lower prices and economic stagnation. From that perspective they are challenging one of the key premises of the doomsters.

But the differences between deflation pessimists and deflation optimists are often less than first appears. For example, Carney simply claimed that at present falling prices are confined to niche areas of the economy. If deflation became more widespread, with the overall price level falling, he would no doubt identify it as a problem.

It is also worth noting the all too common tautology used by Carney and many others. He said falling fuel and food prices caused the inflation rate to drop. But this is simply saying that falling prices cause falling prices. It fails to identify the underlying driver.

It would be better to pay much less attention to changing price levels. Instead a more fundamentalist approach to the economy is necessary.

Although it is true that falling prices can coincide with stagnation they can also be a sign of strength. The rapid improvements in information technology in recent years provide an example of the latter trend. Consider how much it costs to buy one kilobyte of computer storage compared with, say, 20 years ago. In effect the price of computers has fallen rapidly. Yet it is a symptom of innovation in this particular sector rather than, on the contrary, a sign of stagnation.

If falling prices can be both a symptom of economic weakness and of strength they have little value as indicators. It is far better to try to discern what is happening in the underlying economy rather than draw illegitimate conclusions from the changing price level.

Analysts should focus on the state of the productive economy rather than the inflation rate. Key statistics to consider include the levels of business investment and productivity growth.

The huge attention paid to the price level – both inflation and deflation – in the past two decades has corresponded with a narrowing view of the economy. Most discussion has focused on relatively superficial questions, including the state of the financial sector, rather than grapple with the underlying dynamics of the economy. It is not that inflation or finance are unimportant but they should be understood in relation to developments in the real economy.

This narrowing of intellectual horizons is the paradoxical effect of the end of the Cold War in the late 1980s. In the earlier era the battle between socialism and capitalism forced individuals to have more fundamental discussions on the nature of the economy. Each side was anxious to prove that their side knew best.

There is no going back to the past but it should be possible to recapture some of the better elements of the earlier discussion. Those who argue the world is facing economic stagnation should start from an examination of the real economy rather than become preoccupied with changing prices.

This column first appeared in the February issue of Fund Strategy.