Macroeconomists Andrew Atkeson and Patrick J. Kehoe have ignited a firestorm of controversy over the proper relationship between deflation and economic depression. In their 2004 article titled “Deflation and Depression: Is There an Empirical Link?” they examined data from 17 countries over a century to investigate whether deflation inherently leads to economic downturns. Their results go against all commonly accepted thinking. Critics such as free-market economist Tom Woods insist that deflation isn’t bad for a country’s long-term economic health.
Atkeson and Kehoe’s study was deep—over a century. Their analysis was not limited to advanced economies, providing a wide-ranging picture of economic conditions in the midst of deflationary episodes. Based on that experience, they argued that past episodes of deflation are not an automatic precursor to economic depression. This is a surprising conclusion, given the common assumption that deflation means disaster is on the way.
Woods, a longtime critic of the deflation-depression line, contends that the idea is deeply misguided. He claims, “For the entrepreneur, one of the core responsibilities is predicting future prices. Entrepreneurs are constantly buying and selling the factors of production at auction. They do all of this while having to guess at the market value of their completed product. If they expect prices to be lower in the future, they lower their bids on forward-looking production factors. This amendment levels the playing field. Woods cautions that innovators who underestimate volatility will go out of business. That is not bad for overall economic output.
It all comes down to a common economic premise. Deflation, or a widespread drop in prices for goods and services, can cause consumers to stop spending money for fear that prices will fall even more tomorrow, sinking the economy into a recession. Yet, in fact, Woods argues, this view misses some of the most important things about how economies work. He emphasizes that as long as there remains a spread between input prices and output prices, the level of investment will remain stable.
Historically, the United States rose to industrial dominance when prices were declining. Woods points out that much of this success was achieved by using “inelastic” money. That’s because the money supply didn’t need to increase with the growing economic activity. He elaborates that when the level of economic activity increases, a money supply increase becomes unnecessary. Rather than creating inflation, prices instead need to go down so that the money that’s already out there is able to cover more transactions. If there’s more economic activity, you don’t need “more money” to accommodate it. Prices just drop so that the same amount of money can handle the newly increased level of transactions. No big deal.
Though these counterarguments exist, there are still many policymakers who continue to push for a return to a target inflation rate of around two percent. To counteract hoarding of cash and promote operational growth, they claim, a target inflation rate is necessary to motivate short-term spending and strategic investment. This view is consistent with old economic orthodoxy, where inflation was thought to spur growth by reducing the real cost of borrowing.
Critics like Cato’s Gerald P. This is because, as they contend, with the right pricing strategy businesses can flourish even in a deflationary environment. Entrepreneurs would likely quickly adapt in response to falling prices to avoid any proposed harms from deflation. The price system would help prevent those harms.