6 July 2023
Ziņas un Viedokļi
The Myth of “Good” Inflation and “Bad” Deflation

The myth that inflation is a “good” thing has become quite deeply entrenched over the past decades. Its proponents insist that it indicates a high level of consumer confidence and demand. At the same time, they also argue that deflation is extremely dangerous, because it significantly reduces the ability of borrowers to service their debt.

This myth is directly linked to another myth that consumption is the engine of economic growth. The roots of both myths can be traced back to the 1980s. This was the time when the world economy saw the launch of widespread financialization that supported debt-based consumer demand.

Economic fundamentals and history, however, allow us to conclude that inflation can be easily “bad”, while deflation can be certainly “good” (see Picture 1 and Picture 2 below reflecting long-term historical trends of inflation and GDP per capita growth rates in the United Kingdom as well as Picture 3 and Picture 4 below reflecting trends of inflation and GDP per capita growth rates in select economies in the past 60 years).

How does any economic system function? To produce goods and services we need three factors of production: 1. natural resources, that is land, water, weather conditions, etc.; 2. labor, that is economically active population; 3. capital, that is property, plant, equipment, tools, transport vehicles, infrastructure, etc.

However, the production process also requires a certain degree of organization. The effectiveness of organization depends on three aspects: 1. a biological aspect which implies that workers must be biologically — physically and mentally — healthy and competitive; 2. a social aspect, that is a level of social development and cooperation within a society; 3. a technological aspect, that is a level of technological advancement achieved by a society.

We can exchange goods and services using a direct barter system, that is exchanging one good or service directly for another good or service. But a better way of doing things would be the exchange of goods and services based on a money system where money serves as an indirect equivalent of goods and services.

In the long term the economic well-being of a society depends on the availablity of three factors of production (natural resources, labor, capital) and how effectively the production process is organized (biological, social, and technological aspects) (see my article Is There Life After Capitalism: Happy Post-Capitalism, Communism, Scarcism, or MadMaxism?).

In the short term and, probably, in the medium term the availability of money can have an impact on fluctuations in the level of economic activity around a long-term trend. But the availability of money cannot serve as a “perpetual financial engine” that boosts long-term economic growth. In the long term it affects the price level only.

For illustrative purposes we can provide a schematic presentation of various combinations of economic growth and inflation with historical examples as follows (see Picture 5 below):

A1. Stagflation. It is a period when low economic growth (stagnation) and high inflation happen at the same time. It usually results from supply chain — technological and logistical — disruptions due to various shocks: geopolitical and domestic political crises, or natural and technogenic disasters. This is what the world economy has been experiencing over the last couple of years. This is what the world was going through for 10 years in the 1970s and early 1980s due to declining rates of technological progress, geopolitical confrontation, abandonment of the gold standard, and oil crises.

A2. Financial Bubble. High rates of economic growth accompanied by high rates of inflation. This combination is usually the result of an easy money policy implemented by central banks in a calm geopolitical environment. The vivid examples of financial bubbles are particularly typical for small open economies where an unhindered inflow of capital may lead to a spectacular rise in financial and real estate markets. This is what many economies were experiencing in the mid-2000s, that is in the years immediately before the Global Financial Crisis.

A3. Monetary Boom. High rates of economic growth accompanied by moderate rates of inflation. This is what central banks have been striving to achieve for the past 50 years after abandoning the gold standard. Loose monetary policy and declining interest rates contribute to an increase in investment, thus achieving rates of technological progress and labor productivity far surpassing rates of inflation. In the mid-1990s the world economy was experiencing positive effects stemming from of the end of the Cold War where solid economic growth was accompanied by declining rates of interest and moderate rates of inflation.

A4. Stagnation. This is a period when low economic growth is accompanied by low or moderate inflation. This is what many economies were experiencing in the 2010s in the aftermath of the Global Financial Crisis: post-crisis rates of economic growth and inflation were low due to weak consumer demand, high household indebtedness, and declining rates of technological progress and labor productivity.

B1. Long-Term Labor Oversupply. The oversupply of labor puts a downward pressure on wages and labor costs, thus eventually leading to lower and more competitive prices for goods and services. This situation is certainly favorable for company owners. The long-term oversupply of labor might be linked to high birth rates, the relocation of many industries to other regions and countries, or an influx of job seekers from abroad. It is one of the most fundamental issues in many developing countries with a high proportion of young people. It is also one of the most sensitive political issues in developed countries with a high share of industrial relocations abroad or a high share of labor immigration. In fact, this is one of the underlying economic reasons that explains well the outcome of the Brexit vote in the U.K., and the popularity of Donald Trump in the U.S. or right-wing movements in Europe.

B2. Steady Technological Progress. Steady technological progress leads to lower production costs, thus lowering the prices for goods and services. It also facilitates a rise in labor productivity. Higher rates of labor productivity will lead to a sustainable rise in growth rates of wages and consumption (!). This situation is in stark contrast to inflationary consumption due to a rise in the money supply. This is how the “golden age” of classical capitalism in the 19th century looked like when prices, on average, followed a long-term downward trend while the growth rate of GDP per capita was significantly higher than the historical average (see Picture 1 and Picture 2 below).

B3. Short-Term Positive Supply Chain Shock (Oversupply). The accumulation of large inventories of a particular commodity can lead to a temporary huge surplus, thus contributing to a strong drop in its price, a moderate rise in demand and faster GDP growth rates. The large accumulation of crude oil inventories during the pandemic in the spring of 2020 caused the price of oil futures to fall briefly into negative territory. Since oil is the main source of energy, the overall effect on the economy was positive.

B4. Technological Breakthrough. Fundamental and widespread technological improvements lead to significantly lower costs throughout the whole economy. This stimulates a substantial rise in labor productivity and wages, thus creating the best environment for higher and more sustainable rates of demand for goods and services. In today’s world fundamental technological improvements linked to new sources of energy (hydrogen, nuclear fusion, storage of solar or wind energy, etc.) could probably serve as one of the best examples of a potential decisive technological breakthrough. A gradual decline in the price of oil in the second half of the 19th century facilitated more widespread use of kerosene in manufacturing and everyday life, thus contributing to a rise in labor productivity and living standards. Another example is the Green Revolution in agriculture experienced by developing countries in the post-war period in the 20th century. This contributed to significantly higher yields for many crops, thus lowering their prices and raising living standards.

C1. Monetary Recession. A much tighter monetary and interest-rate policy implemented by a central bank to fight high inflation leads to a gradual decline in the rate of inflation. However, this also leads to lower rates of economic growth. One of the best historical examples is a policy of sharply higher benchmark interest rates implemented by the U.S. central bank during the 1979–1982 period. The U.S. central bank’s federal funds rate was eventually raised to 20% in 1980 to fight a 15% inflation rate. By early 1983, the inflation rate had dropped below 3%. However, during the period from 1979 to 1982 the United States was demonstrating its worst economic performance between World War II and the Global Financial Crisis.

C2. Disinflationary Slowdown. Within the business cycle, excess supply (accumulated high inventories) exerts a downward pressure on the price level, thus gradually leading to lower levels of production and economic activity. This was the standard situation in the 19th century under the gold standard when central banks were restricted in their ability to deliver smoother rates of economic growth by manipulating the money supply.

C3. Post-Bubble Financial Depression. One of the most recent examples is the Great Depression of the 1930s when tight monetary policy in the aftermath of the financial bubble of the roaring 1920s led to a severe decline in the level of economic activity and prices. Financial depressions were frequent episodes in the 19th century under the gold standard.

C4. Structural Deflation. You may encounter this situation when there is a structural decline of one of the leading industries in the economy. A rapid decline of the coal industry in large coal-producing countries such as the United Kingdom in the 1920s, 1930s, and 1940s under the gold standard led to a decline in economic activity and a significant decline in prices. This negative development was partially offset by a rise of new industries.

D1. Supply Chain Collapse. A supply chain collapse might be a by-product of natural and technogenic disasters. The pandemic was the most recent example of such a collapse when the supply of many commodities and goods was abruptly halted, thus leading to a sharp rise in prices. But, most often, supply chain collapses result from geopolitical or domestic political crises. One of the most recent examples is the oil crises of the 1970s which led to a multi-fold rise in oil prices and economic recessions in oil-importing economies.

D2. Short-Term Negative Supply Chain Shock (Undersupply). A decrease in supply of certain widely used goods, semi-finished products, or commodities can cause a short-term rise in the price level and a moderate economic recession. The shortage of semiconductors during the pandemic caused a sharp rise in their prices as well as a temporary shutdown of car factories in Germany, Japan, the United States, and other countries. This certainly had a general negative impact on their economies. A sharp rise in European natural gas prices in 2021 and 2022 due to a geopolitical crisis had a general negative impact on the economies of this region too.

D3. Persistent Technological Decline. The loss of technological skills leads to more extensive use of resources, thus lowering labor productivity and making final goods and services more expensive. In this situation a country’s economy experiences a long-term downward trend. This is how civilizational or societal collapse looks in economic terms. The collapse of the Western Roman Empire, for example, led to the loss of many technologies, the decline of many industries, a significant decline in population, and the “Dark Ages” in Western Europe in the socio-economic and cultural sense.

D4. Long-Term Labor Supply Shortage. When an economy experiences declining birth rates and/or high rates of emigration, it faces a long-term shortage of labor. This, in turn, leads to a situation where a rise in wages exceeds a rise in labor productivity, thus causing production costs and prices for goods and services to rise. However, demand faces a long-term downward trend due to the lack of domestic consumers and the loss of competitiveness in international markets. You can find such situations in many East European countries that experience a long-term decline in birth rates and high rates of emigration.

Certainly, in most cases many various factors affect the economy simultaneously. That is why in real-life situations you can find the economy mostly being in a dynamic, transitional state. However, this schematic approach makes it easier to understand what measures need to be taken to address the most pressing economic challenges.

Obviously, few people are happy with the current stagflationary or near-stagflationary situations you can find in most world economies (see Quadrant A1 in Picture 5 below). What should we do to correct these situations? As you can conclude based on the relationships depicted in Picture 5, monetary policy is unlikely to be helpful. Higher interest rates, sooner or later, will force the rate of inflation to decelerate. But this will happen at the expense of economic growth. Thus, the economy is likely to move from Quadrant A1 to Quadrant C2 or Quadrant C1.

If we want to move the economy to Quadrant B1, Quadrant B2, Quadrant B3 or Quadrant B4, we should implement relevant fiscal and structural policy measures. Easier migration policies and practices will improve the availability of labor resources, thus reducing labor costs and lowering the prices of goods and services (Quadrant B1). By calming geopolitical tensions or by establishing new logistical and technological chains we can significantly reduce the prices of imported raw materials, semi-finished products, or final goods (Quadrant B3). The ideal solution would be faster growth rates of technological progress and labor productivity. A significant decline in those growth rates over the past 50 years has been the major source of the current economic challenges. Faster growth rates of technological progress would help reduce the rate of inflation and accelerate the rate of economic growth (Quadrant B2 and Quadrant B4).

Deflation can be both bad and good. Bad deflation almost always follows bad inflation and the bursting of a financial bubble. Sometimes it can follow the structural decline of a major industry in the economy. Good deflation is caused by rapid growth rates of technological progress or a positive supply chain shock (oversupply).

However, high inflation always means that there is “too much money chasing too few goods”. Alternatively, high inflation may reflect severe supply chain disruptions. The myth of “good” inflation is closely related to the myth that consumption is the engine of economic growth. Faster rates of technological progress and labor productivity are the real and most sustainable engines of economic growth. They make our life cheaper, and therefore, they make it economically better. High inflation always means that the growth rates of technological progress and labor productivity have been slowing down, stagnating, or even falling. The economic history of the last 50 years underscores this fact very well (see Picture 6 below).

We Are Living in an Age of Exploding Inflation
We Are Living in an Age of Slowing Growth Rates of Technological Progress
The GDP per Capita Growth Rates in Developed Economies Have Been Dramatically Falling
The Consumer Price Growth Rates Have Been Also Falling But Are Still Substantially Above Historical Averages Despite Poor Growth Rates
Deflation May Be the Result of a Technological Breakthrough. Inflation Almost Always Implies That There Is “Too Much Money Chasing Too Few Goods.”
Consumption Is Not the Engine of Economic Growth. Faster Rates of Technological Progress and Labor Productivity Are the Real, Sustainable Engines of Growth. 

Autors: Oļegs Jemeļjanovs, LinkedIn profile

SWEDBANK FINANŠU TIRGUS DAĻAS INVESTĪCIJU JOMAS VADĪTĀJS Oļegs Jemeļjanovs Latvijas Universitātē ir ieguvis maģistra grādu uzņēmējdarbības vadībā, kā arī doktora grādu ekonomikā Roterdamas Erasma Universitātē Nīderlandē. Arī ir ieguvis sertificētā finanšu analītiķa (CFA) kvalifikāciju. Ir strādājis finanšu jomā gan privātajā, gan valsts sektorā (Latvijas Banka, FKTK, Finanšu ministrija). Finanšu tirgus jomā ir strādājis kopš 1999. gadā, tirgus risku vadības, finanšu aktīvu pārvaldīšanas un pārdošanas sfērā. 2019. gadā kļuvis par Swedbank Finanšu tirgus daļas investīciju jomas vadītāju.