------------ EH.NET BOOK REVIEW --------------
Published by EH.NET (November 2005)
Richard C.K. Burdekin and Pierre L. Siklos, editors, _Deflation:
Current and Historical Perspectives_. Cambridge: Cambridge University
Press, 2004. xxii + 359 pp. $75 (cloth), ISBN: 0-521-83799-5.
Reviewed for EH.NET by Kris James Mitchener, Department of Economics,
Santa Clara University,
With oil prices accelerating rapidly over the past year, housing
prices "frothing" in coastal areas, and the Federal Reserve raising
the federal funds rate twelve times since the end of the most recent
recession, the timing of a new book addressing the topic of deflation
seems somewhat inopportune. Nevertheless, it is worth remembering
that, as little as two years ago, American policy makers were
seriously pondering the possibility of deflation. Improvements in
labor productivity and the expanding use of global supply chains to
manage input costs were holding the lid on the overall price level,
and short-term interest rates were approaching the zero bound in the
wake of the 2001 recession and the collapse in spending on
information technologies. Such circumstances warranted the
consideration of the small-probability event of sustained deflation,
given Alan Greenspan's risk-management approach to central banking.
Deflation and related issues such as asset price booms and busts,
liquidity traps, and the operation of monetary policy in extremely
low interest-rate environments consequently received renewed
attention from domestic policymakers and economists. Moreover, policy
debates over the effects of deflation and the appropriate response to
it had been taking place for some time in other parts of the world.
In particular, Japan was bearing witness to the first recorded
deflation in an industrialized country since the Great Depression.
These issues and policy debates form the backdrop for the edited
volume by Richard Burdekin and Pierre Siklos, which offers a critical
evaluation of historical episodes of deflation and some long-run
perspective on more recent events.
The edited conference volume consists of twelve chapters that examine
deflation by drawing on theory, history, and empirical evidence. The
book features interesting contributions by many eminent financial and
economic historians. This alone would make it appealing to
specialists working in macroeconomic history, but it ought to attract
a broader readership, including macroeconomists, central bankers, and
policymakers, since the editors were careful to include papers that
employ more recent data and theory. Indeed, one of the strengths of
the volume is that the contributors employ a variety of
methodological perspectives to analyze monetary phenomena and compare
present issues with past episodes of deflation.
After an introductory chapter that provides a useful summary by the
editors, the book is divided into four sections. The first part of
the book, entitled "Fears of Deflation and the Role of Monetary
Policy," begins with an essay by Hugh Rockoff. He suggests that the
U.S. bank failures of the 1930s exhibit characteristics that are
similar to twin crises (banking and exchange rate crises) that have
occurred more recently in national economies. Rural regions in the
U.S. experienced "capital flight" because depositors feared that
declining export prices and demand would undermine the ability of
borrowers to repay; this eventually prompted runs on some banks and
led authorities to impose restrictions on withdrawals (bank
holidays). Rockoff contributes to the growing literature on regional
differences in bank performance during the Great Depression by
focusing on "silent runs" -- the withdrawal of deposits from rural
areas and their movement to Eastern financial centers -- a process
that was driven in part by declining prices and deflation. The
interregional evidence is consistent with his argument, although
individual bank data showing that losses of deposits had important
consequences for the survival of banks would further strengthen his
argument.
In the second chapter of this section, Forrest Capie and Geoffrey
Wood take a longer-run perspective and examine whether debt-deflation
had damaging effects on the British economy between 1870 and the
1930s. J.M. Keynes' views on debt deflation suggested that expected
real rates are important for generating real effects, whereas Fisher
emphasized that rising realized rates produced dilatory effects on
existing debtors. The authors use simple time-series analysis to
produce price-expectation series and then construct real interest
rates that take into account either expected inflation or actual
inflation, according to the respective ideas of Keynes and Fisher.
They use these series as well as bond spreads to assess the effects
of debt deflation, and find little statistical evidence that
debt-deflation in Britain created adverse effects for the real
economy (or for financial stability). The authors rightly point out,
however, that Britain's experience with deflation was much milder
than that which occurred in the U.S., so it is difficult to rule out
the debt-deflation hypothesis in general.
Klas Fregert and Lars Jonung close out the first section of the book
by examining two cases of interwar deflation in Sweden, 1921-23 and
1931-33. They use the relatively short interval of time between these
two episodes to assess how policymaking and macroeconomic outcomes in
the first episode were influenced by the inflationary period of World
War I, and how this deflationary episode (and the persistent and high
unemployment that emerged in the 1920s) in turn influenced beliefs
and behavior ten years later. Fregert and Jonung employ qualitative
evidence to argue that the large deflation in the early 1920s greatly
influenced the thinking of economists, policymakers, and wage setters
in the latter episode. Heterogeneous expectations across these groups
limited the deflation of 1931-33 as wage contracts were shortened
and, in some cases, abandoned.
The second section of the book, entitled "Deflation and Asset
Prices," provides new contributions to the growing literature
examining the relationship between monetary policy and asset prices.
The first, by Michael Bordo and Olivier Jeanne, develops a model to
assess whether monetary policymakers should respond to an asset price
"boom" -- a term which, according to the authors, differs from a
"bubble" in that it is not necessary for policymakers to determine if
asset prices reflect fundamentals in order to act. If monetary
policies decide not to lean against the wind, they run the risk of a
boom being followed by a bust, and a collateral-induced credit crunch
dampening the real economy. On the other hand, pursuing restrictive
monetary policy implies immediate costs in terms of lower output and
inflation. Although the model is very stylized, they find that a
proactive monetary policy is optimal when the risk of a bust is large
and the monetary authorities can let the air out at a low cost;
moreover, they argue that such a policy rule will not look like a
Taylor rule in that it will depend on the risks in the balance sheets
of the private sector. They then present some preliminary empirical
evidence that the boom-bust cycles of their model appear to be much
more frequent in real property prices than in stock prices and more
common in small countries than in large. (The obvious exceptions to
this are Japan's experience in the 1990s and the U.S. during the
Great Depression.) Moreover, they suggest that such busts can create
banking crises and lead to severe reductions in output.
The second chapter in this section also examines boom-bust cycles in
credit markets, but focuses on the linkages between bank lending and
asset prices. Using vector autoregressions, Charles Goodhart and
Boris Hofmann argue that movements in property prices during the
period 1985-2001 had significant effects on bank lending in a sample
of twelve developed countries. Their impulse response functions,
however, show that bank lending appears to be insensitive to changes
in interest rates. On the other hand, asset prices seem to respond
negatively to interest-rate movements. The authors provocatively
conclude that there is limited scope for effectively using monetary
policy as an instrument to provide financial stability in periods
when there are asset-price swings, in part because the effects of
interest rates on asset prices and bank lending are highly nonlinear.
One challenge to their interpretation of the evidence is that
monetary policy is treated in isolation from changes in bank
regulation that also took place during this period. Regulatory
changes likely also influenced bank lending decisions. One prominent
example of this was the adoption of BIS capital-asset requirements in
1988 by Japanese banks, which strengthened the relationship between
bank lending and equity prices. Banks could count 45 percent of
latent capital as part of tier-II capital requirements; this ensured
that increases in equity prices increased bank capital, which in
turn, encouraged banks to lend more on real estate and supported
rising asset prices.
The third part of the book provides additional case studies of
deflation. Michael Bordo and Angela Redish point out that "good"
deflations are often defined as periods when prices are falling as a
result of positive supply shocks (like technological progress);
hence, aggregate supply outpaces aggregate demand. "Bad deflations"
are periods when prices fall because aggregate demand increases
faster than aggregate supply; this can occur when there are money
demand shocks. They suggest, however, that this simple classification
can be difficult to square with empirical evidence. Examining the
United States and Canada during the classical gold standard period,
they find some evidence that both negative demand shocks and positive
supply shocks drove prices downward between 1870 and 1896. Output
growth was more rapid during the inflationary period of 1896-1913
than the preceding period of deflation, but their time series
evidence suggests that there was no causal relationship: price
changes were not driving the determination of output.
Michele Fratianni and Franco Spinelli look at Italian deflation and
exchange-rate policy during the interwar period, and Michael
Hutchinson analyzes Japan in the 1990s. These two chapters make use
of a comparative historical approach. Fratianni and Spinelli compare
and contrast the Italian deflation of 1927-33 with the disinflation
that took place during the adoption of the EMS (1987-92) to argue
that fixed exchange rates became unsustainable as economic
fundamentals deteriorated. In particular, the interwar gold-exchange
standard imparted a deflationary bias, which eventually led
authorities to abandon the fixed exchange rate regime in order to
pursue lender of last resort activities (thereby assisting failing
banks and preventing banking panics) and stabilize the money supply.
Hutchinson provides a nice overview of the most important recent
episode of deflation, Japan, and shows how injections of liquidity by
the central bank (which eventually reduced nominal rates to zero)
have not been very effective at improving the growth in broad money
aggregates (at least until the last few years). He examines both the
liquidity trap and "credit crunch" views of the Heisei Malaise, and
argues that, in spite of some policy mistakes that prolonged the
deflation and made it more costly, Japan's deflationary experience
has been nowhere near as disastrous as the experience of the U.S. in
the 1930s. However, Hutchinson suggests that Japanese policymakers
could have made their commitment to zero-interest-rate policy more
effective by also adopting an explicit inflation target.
The last section provides three studies that explore the behavior of
asset prices during deflations. Lance Davis, Larry Neal, and Eugene
White examine how the 1890s deflation affected the core financial
markets of the time. Largely narrative in its treatment, this chapter
examines how the corresponding financial crisis of that decade
prompted different degrees of institutional redesign and regulation
in the financial markets of Paris, Berlin, New York, and London. In
the next chapter, Martin Bohl and Pierre Siklos study the behavior of
German equity prices during the 1910s and 1920s. They argue that this
period of German history is particularly useful for analyzing the
long-run validity of the present value model of asset price
determination because the model can be studied for periods of
deflation and hyperinflation. Their empirical results suggest that,
while the theory holds for the long run, German share prices
exhibited large and persistent deviations in the short run, perhaps
the result of noise trading or bubbles. The final chapter by Richard
Burdekin and Marc Weidenmier suggests that gold stocks might be a
useful hedge against asset price deflation. They find evidence of
excess returns on gold stocks after the 1929 and 2000 equity-market
declines, but scant evidence of excess returns after the 1987 crash,
and interpret these results as indicating that gold stocks only serve
a useful hedge if asset price reversals are prolonged.
Even though deflation has lost some of its immediate relevance to
policymakers, there is much to be commended in the editors' efforts
to design a book that demonstrates the importance of developing a
greater empirical and theoretical understanding of deflation.
Although one can always quibble with the compromises that occur when
assembling such a volume (for example, in this book, despite the fact
that many of the chapters discuss the interwar period, there is no
single chapter that attempts to examine deflation using a true
panel-data approach), this book's chapters certainly have enough
thematic overlap that the sum of the articles still ends up being of
greater value than the individual parts -- something that is often
difficult to achieve in conference volumes. In this respect, it is a
welcome addition to the literature for those interested in monetary
economics or those wanting an enhanced historical perspective on
recent policy debates.
Kris James Mitchener is assistant professor of economics and Dean
Witter Foundation Fellow in the Leavey School of Business, Santa
Clara University, as well as a Faculty Research Fellow with the
National Bureau of Economic Research. He is currently researching
sovereign debt crises during the classical gold standard period and
the effects of supervision and regulation on financial stability and
growth. Recent publications include "Bank Supervision, Regulation,
and Financial Instability during the Great Depression," _Journal of
Economic History_ (March 2005) and "Empire, Public Goods, and the
Roosevelt Corollary" (with Marc Weidenmier), _Journal of Economic
History_ (September 2005).
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Published by EH.Net (November 2005). All EH.Net reviews are archived
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