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------------ 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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