VoxEU Column Macroeconomic policy

Preventing deflation

Deflation risks are more related to very low inter-temporal discount rates than to falling prices. This column argues that long-term pre-emptive action should be channelled through taxation rather than central banks.

In principle, there is nothing wrong with falling prices. As the argument goes, excess supply brings about lower prices, higher real money balances, lower interest rates and higher aggregate spending. The demand curve shifts to the right (responding to the previous shift of the supply curve) and a new equilibrium is reached at a higher level of output and (if the money supply does not grow enough) a lower price level. In order to get persistent deflation from a fall in prices, something has to go wrong in the causal chain. This may be due to a vertical demand curve – the infamous liquidity trap. To get deflation, aggregate demand must cease to be responsive to falling prices. Then, both lower prices and larger money supplies fail to boost demand – the economy does not self-correct and central banks become impotent. Nominal GDP typically falls and profits get particularly hurt as they are the least sticky term in the nominal equation GDP = Wages + Interest Payments + Property Rent + Profits. This illustrates why deflation is so bad for stocks (and good for bonds) and why it should be avoided at all costs.

“Deflation Proneness”

Nobody really knows what triggers deflation. Most economists would agree that it has to do with a sudden change of expectations in an already vulnerable environment. Expectations of lower future prices delay expenditures, causing current prices to fall. Following Paul Krugman’s notation let Pe be the expected future price level. If i is the interest rate then (1+i) (P/Pe) is the price of current consumption in terms of future consumption. If Pe is too low, the story goes, P has to fall enough to "engineer" positive expected inflation in order to kick off current expenditure. If, in turn, Pe falls further, then deflation spirals down without limit. So far so good, but what makes an economy vulnerable to deflation? And are all economies equally vulnerable?

Deflation proneness probably has much to do with intertemporal preferences. The intertemporal discount rate (IDR) is "the" deep interest rate of an economy. It is like the black hole around which the whole galaxy of other interest rates gravitates. Different societies may have very different IDRs, most likely due to differing demographic profiles. An aging society is likely to have a preference for lower present consumption relative to future consumption than a younger society. How can that be if older people are more likely to die before younger people? The answer is bequests and power. Apparently there is a point in life beyond which people care more about what they will be leaving to their offspring than about what how much they can consume before they die. And as long as they live, they keep control of their wealth. In fact, their intertemporal discount rate probably becomes negative. The Gamma discounting model (Weizman, 2001) shows that negative IDRs of older generations have more than proportional effects on reducing the average IDR of a society. This is illustrated in Table 1 with a simple simulation.

Table 1: Average intertemporal discount rate (IDR), various assumptions
  10% Old 90% Young 30% Old 70% Young
  -4% IDR 4% IDR -4% IDR 4% IDR
Horizon Average IDR
Average IDR
10yr 2.8% 0.9%
20yr 2.3% 0.1%
50yr 0.3% -1.7%
Source: Own calculations based on Weizman (2001)

Concentration of wealth among the elderly is likely to make things worse. Capital preservation as opposed to risk-taking is likely to dominate asset allocation.

Finally, the absence or the wrong kind of inheritance tax should reinforce deflation proneness in aging societies by failing to incentivise early transfers of wealth to younger generations with higher intertemporal discount rates. All these features seem to fit Japan. The possibility that Japan's average IDR is negative is supported by a number of economic studies dealing with the consequences of aging populations (Kato, 1998), which had to use negative IDRs ranging from -1% to -7.5% to account for the high savings ratio in Japan.

Other socioeconomic features to consider when assessing deflation proneness are institutional/economic flexibility and the health of the financial system.

Putting everything together, a country with a low intertemporal discount rate, the wrong inheritance/gift tax, rigid socioeconomic structures, and a weak financial system should be more vulnerable to perverse effects of falling prices than a country with the opposite characteristics. This is because preferences for future over current consumption may facilitate the entrenchment of falling Pe, thus making demand insensitive to rising real money balances. A weak financial system may further clog the pipe if an increase in the money supply by central banks is not fully transmitted to economic agents. Rigid macro- and microeconomic structures may prolong situations of excess supply or capacity and make falling prices more intense and/or persistent, thus increasing the risk of entrenched deflation expectations. A rather subjective assessment of how this applies to various countries is presented in Table 2.

Table 2: Deflation proneness scoreboard
  US UK Germany Japan
Aging +++ + -- ---
Immigration ++ + - ---
Inheritance/Gift Taxes + ++ - ---
Socioeconomic Flexibility +++ + -- ---
Financial System -- -- -- ---
Deflation Process Very low Low High Very high
Source: Own guesses. Positive + steers away from deflation, while negative – drives to it.
Pre-emptive action

Is there a case for pre-emptive action? Yes, both in the short and long run. In the short run, central banks' conventional instrument to fight deflation is control of the money supply. By pumping extra money into the system when prices fall, they accelerate the real balances effect that, by lowering real interest rates, should ultimately boost aggregate demand. Thus monetary policy should reinforce the self-correcting mechanism of the economy. Non-conventional instruments, such as quantitative easing, strengthen the effect even further as the manipulation of the yield curve accelerates the process. However, there is no guarantee of success, as the Japanese experience shows. A longer-term perspective for fighting deflation is necessary.

Taxation may be the best instrument for fighting deflation in the long run. At the core of deflation lies the problem of elder generations keeping their wealth away from entrepreneurial undertaking. A severe inheritance tax combined with a generous gift tax may reshape the battlefield of the war against deflation in a very favourable way, moving the focus inside households. Aging societies should try hard to mobilise their wealth. The best way of doing so may be establishing strong tax incentives for elders to transfer wealth to the younger generations while they are still alive.


Kato R. (1998) "Transition to an Aging Japan: Public Pensions, Savings and Capital Taxation", Journal of the Japanese and International Economies

Krugman, Paul (2009) "Can Deflation be Prevented?"

Weizman, Martin L. (2001) "Gamma Discounting", The American Economic Review, March

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