Deflation and Depression: Is There an Empirical Link?

According to standard economic theory, deflation is the necessary consequence of optimal monetary policy. In 1969, Milton Friedman argued that, under the optimal policy, the nominal interest rate should be zero, and the price level should fall steadily at the real rate of interest. Since then, Friedman’s argument has been confirmed in a formal setting (see e.g., V. V. Chari et al., 1996; Harold Cole and Narayana Kocherlakota, 1998). Most policymakers, however, are extremely reluctant to implement any policy that would lead to deflation. This reluctance seems to stem from the experience of the Great Depression, in which deflation and depression appear to have been tightly linked (see e.g., Ben Bernanke and Kevin Carey, 1996). That experience has led to theories in which deflation leads to depression. The quantitative ability of those theories to account for the Great Depression is now being debated (see e.g., Cole and Lee Ohanian, 2001). Here we examine the empirical relationship between deflation and depression in a broad historical context, including but not limited to the Great Depression. We use a panel data set on inflation and real output growth for 17 countries and more than 100 years. To focus on medium-term fluctuations, we break the time series on inflation and real output growth for each country into five-year episodes, and for each episode, we compute the average annual inflation rate and the average annual real output growth rate. For any episode, we define a deflation as a negative average inflation rate and a depression as a negative average real output growth rate. Throughout, we restrict attention to moderate inflations, those with average annual inflation below 20 percent. Our main finding is that the only episode in which there is evidence of a link between deflation and depression is the Great Depression (1929–1934). We find virtually no evidence of such a link in any other period. Here we have made no attempt to distinguish anticipated from unanticipated deflations, while theory, of course, makes a sharp distinction. Optimal monetary policy in a broad class of models with nominal rigidities dictates engineering small anticipated deflations and avoiding unanticipated deflations altogether. To the extent that the deflation in the Great Depression is thought of as unanticipated, as in most existing theories, this episode is not relevant for evaluating the costs of anticipated deflation. Our finding thus suggests that policymakers’ fear of anticipated policy-induced deflation that would result from following, say, the Friedman rule is greatly overblown. We note here that, since World War II, one country has come close to having both a depression and a deflation: Japan in the late 1990’s. Is Japan’s recent slowdown from an historically high average growth rate primarily due to its very low inflation rates? We doubt it. Since 1960, Japan’s average growth rates have basically fallen monotonically, and since 1970, its average inflation rates have too. Attributing this 40-year slowdown to monetary forces is a stretch. More reasonable, we think, is that much of the slowdown is the natural pattern for a country that was far behind the world leaders and had begun to catch up.