Why is the ECB so worried about deflation when a country like Switzerland is experiencing negative inflation together with a healthy rate of economic growth and low unemployment? What makes Switzerland so different?
The community of central bankers, led by the Federal Reserve, have promoted a near obsessive fear of inflation that is too low/deflation. There are two potential sources of deflation: monetary deflation (bad like the 1930s) and technological deflation that would result from higher productivity growth (in my view clearly good since higher productivity growth promotes higher long-run wealth and real incomes). Empirical work from former economists at the Minnapolis Fed looked at deflation over the last 100 years and across 24 countries (or something like that) and concluded that outside of the Great Depression and Japan's lost decade (plus), there is no evidence that deflation harms economic growth. However, these two episodes were massive financial crises with bank failures and it is hard to distinguish whether the damage was done from deflation per se or from the bank failures. From a theoretical perspective, Milton Friedman argued that the optimal rate of inflation was negative the real interest rate since there would be no incentive to economize on money balances (since short term financial instruments would also carry a zero nominal yield). The problem with the fear of deflation is that monetary policy is kept excessively loose at low inflation rates to avoid a deflation risk and this distortion of nominal rates may cause more harm than good (e.g. the prelude to the 2007-09 financial crisis).
John,
Your comments are right to the point.
I might just add another factor that might be worth exploring:
The central bankers are confident that they can control inflation. The German hyperinflation of the 1930's is too far back in the past and occurred in such different world economic environment that it is not considered relevant. However, it is easier to central bankers today to relate to the success of Paul Volcker intervention in the 1970's. I am not sure that his policies were the only factor that started several decades of low inflation. I believe that the rise of China followed by other developing countries increased productivity (as usually measured by economists) and was a deflationary factor on a world wide basis through the introduction of a vast lower paid and increasingly skilled workforce. Nevertheless Central Bankers seem to feel that they have the recipe to control high inflation.
On the other hand, I believe that they fear deflation as they don't seem to have the tools to fight control it. The 1930's crisis is an example but also, the Japan lost decade (and still not well controlled ) that you appropriately mention is closer and vividly present in their mind.
Well of course you can have high growth and deflation. Just have aggregate supply grow faster than aggregate demand. Straight out of the equation of exchange.
It turns out that Switzerland is no different from other countries. Japan has no relationship with inflation, disinflation, or deflation and output growth and neither does the US. The correlations from years of data are zero. Zero is small.
For the 7972nd time: there is no inflation just because an economy grows fast. And there is no stagnation just because there is deflation. It's never shown up in the data anywhere at any time (unless you get to hyperinflations or hyperdeflations; problems exist then because markets can't correct fast or well enough to significantly changing prices).
Japan's problems with growth (if they have any; I think not) are not a monetary problem at all.
Phillips has just got to be retired.
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