The preposterous deflation scare Part III – The empirical data: When has deflation really been dangerous?

There have been different stages of varying levels of inflation in world economic history, but also long periods of price stability. The present period, which is characterised by relatively moderate and constant inflation rates of about 2% p.a., is relatively unusual from a historical perspective. Historically, there is only one other comparable period — that of the “price revolution” in the 16th Century, a time when changes in the money circulation and gold imports from the Spanish colonies permanently eroded the gold-based value of money throughout Europe.

As far as history can be reconstructed (there is very little meaningful data for many ancient cultures and the Middle Ages up until circa 1270), three phases of “genuine monetary stability” can be identified. In these phases, the value of money remained constant for an extended period of time and phases of inflation and deflation alternated.

• The pre-Christian Roman Republic and the first decades of the Empire.
• The age of Venetian gold ducats in the 14th and the 15th Centuries.
• Great Britain in the 18th and 19th Centuries.

All of these periods were characterised by the following:

• Money was issued by countries that were substantially more powerful — from both a military and economic perspective — than the others and had relatively efficiently organised state systems.
• The driving political force was a commercially oriented and successful elite in all nations. Roman patricians, Venetian merchants and early British capitalists all had one thing in common – they apparently recognised the benefits of a stable currency for their own trading. Venice and London established credible currencies, making them the leading financial centres of the times. London has continued to enjoy this status, even 100 years after the end of the stable pound.
• The currencies were backed by precious metals in all countries. The lasting scarcity of these metals was, however, a prerequisite for maintaining monetary stability. The military super powers of the time, Rome and Great Britain, were able to exert some control over this scarcity. The Venetian gold ducats were successful at a time when there was a tendency towards a shortage of gold. However, the Spanish conquest of South America and the resulting flood of gold put an end to this. Although the gold content of the Venetian gold ducat did not change until 1797, it increasingly lost its purchasing power from 1500.
• Both in Rome and Great Britain, the out-of-control state budget deficits weakened the stable currencies and they were therefore abandoned. It is worth noting that, with the loss of their dominant military status, both countries transformed into high-inflation regions; the political decline went hand in hand with growing inflation.

So, historically, the absence of inflation has been seen more as an indicator of success than as a negative factor. But has this been the case in the world post 1900?

In 2004, the economists Andrew Atkeson and Patrick J. Kehoe empirically investigated whether there is a link between economic crises and deflation. They analysed the relationships between data on economic growth and on inflation in 17 countries over the past 100 years. The result was clear: With the exception of the 1929-34 economic crisis, there was no evident relationship between deflation and economic crises. They also showed that developments in Japan were due to factors other than deflation.

Therefore, anybody who cites the Great Depression of the 30s as proof of the dangers of deflation is making an improper generalisation on the basis of one specific case in history.

To be continued tomorrow.