Lower Oil Prices: Dark Cloud or Silver Lining?

Current deflation is a good thing for the US economy

The plummeting price of oil is great news — not just for drivers, but for all consumers. So why are some economists so intent on seeing cheaper goods as bad news?

The 50 percent decline in oil prices over the last six months of 2014 was the economic event of the year. The tumbling oil price brought gasoline prices right down with it, which has been great news for consumers. With more than 90 percent of US households owning at least one car, the lower gas price manifests itself mainly as a positive income effect for almost all consumers. They get to do the same amount of driving (or a tad more) and buy more of other goods, even if their wages do not increase.

But it’s not just car-using households that benefit from cheaper oil and gas. Oil and its derivative products are inputs into nearly all other products, from plastics to transportation services. Thus, falling oil prices lead to corresponding declines — or at least forestall further increases — in the prices of essentially all goods. Lower energy prices thus also generate a substitution effect whereby people shift their budgets toward buying more of the vast array of goods made cheaper by declining energy prices.

Despite this fantastic news, some economists and pundits are grasping for a dark cloud to the silver lining of cheap oil. One obvious effect that pessimists point to is the negative impact on oil producers: lower prices mean lower profits, and hence less investment, less job growth, and probable layoffs for many oil drillers and workers in affiliated industries. While the bust in marginal oil exploration and production is clearly no picnic for investors, entrepreneurs, and oilfield workers who quite possibly had staked their livelihoods on the oil boom, these players are a tiny segment of the overall economy. The gains to all consumers from lower oil prices more than offset the losses to the comparatively small group of people employed directly in oil extraction.

So what do you do when the microeconomic analysis screams “great news for the economy: everything’s cheaper!” but you’re bent on dredging up doom and gloom?

The worrywarts turn to macroeconomics and warn us about the bogeyman of deflation. Recent reports have warned of “deflationary risks” and “deflation fears,” using terminology like “disorder” and “syndrome” to describe the effects of deflation. This pessimistic tone is standard fare in recent economic reporting. Pundits and journalists alike are sounding the deflation alarms, arguing that current “dangerously lower” inflation rates — even verging on deflation — portend an overall economic slowdown, a warning sign for the economy along the lines of what we experienced in the Great Recession of 2008–09.

Good deflation versus bad

Before dismissing the deflation concerns, we need to define our terms and explore possible cause-and-effect scenarios. Deflation means prices are generally falling. But there are two ways this could occur, each very different in its implications.

1.Demand-side or “monetary” deflation

One cause of deflation — the one worrying financial pundits — is a money supply that is declining relative to the demand for money. In modern, industrialized countries, this occurrence is typically associated with a financial crisis where there is a sudden loss of confidence in debtors’ solvency. Lending tightens, interest rates rise, and asset prices fall. The decline in total spending that this process generates can indeed be bad — very bad. Goods prices fall faster than wages, leading to a potentially large burst of unemployment. This kind of deflation is associated with both the Great Depression of 1929–33, when the United States experienced a cumulative consumer price deflation of over 24 percent, and the Great Recession of 2008–09, where we saw a much milder, although characteristically similar, decline in consumer prices of just under 1 percent.

2. Supply-side or “productivity” deflation

The other potential driver of falling prices — a cause hardly acknowledged by the financial press — is a large, sustained growth in productivity and output, often itself the outcome of underlying productivity advancements in the economy. In this case, although the money supply and aggregate spending are likely growing at a moderate rate, real output of goods and services is growing at a faster rate, resulting in falling prices or deflation. This kind of deflation is much more rare, especially in the modern era where government monetary authorities have been biased toward constant inflation. However, the US economy witnessed a small, steady deflation in the last three decades of the 19th century, when the huge productivity gains of the Industrial Revolution hit full stride. Even with consumer inflation averaging minus 1.5 percent annually, the economy managed an average real growth rate above 4.5 percent.

So which is it for us today? Is the recent decline in the inflation rate of the bad sort or the good?

The ongoing oil boom, led by innovative American producers applying fracking and directional drilling techniques to coax oil out of our large, erstwhile latent shale reserves, is largely responsible for the declining prices. The sharp and sudden price declines of late 2014 represent the latest iteration of a classic sequence of events. High prices spur entrepreneurs to innovate with new products or more efficient production methods in order to earn bigger profits. These innovations are eventually widely adopted, resulting in large supply increases (cost reductions). The lower costs then spur price competition among producers, which often eliminates the high prices — and high profits — that started the whole cycle to begin with. This story has played out repeatedly in the oil industry, not to mention nearly all other sectors of our highly competitive, innovative economy. This is what economic growth is made of. This time around, the beneficial price declines have been so swift that they caught the central bank by surprise and actually generated supply-side deflation trends the likes of which the US economy has not experienced in more than a century.

A blind spot in monetary policy

Federal Reserve policymakers are aware of the distinction between good and bad deflation; after all, they are allowing inflation to go below the target rate of 2 percent in the short term. However, their official statements, reinforced by media scaremongering, betray that they, too, are holding onto a theoretically baseless paranoia against falling prices.

The unwillingness of Fed officials to embrace “good” supply-side deflation is understandable, given their dual mandate of price stability and maximum sustainable employment. The Fed is supposed to keep prices stable; thus, it wants to avoid both inflation and deflation, so it targets consistent price growth of 2 percent. Why 2 percent? The official line is that a non-zero inflation target gives the monetary authorities some wiggle room, allowing them to undershoot their target without unleashing the ravages of deflation on the economy.

But this policy assumes that deflation is always and everywhere an evil to be avoided. As we’ve pointed out, that’s not true. There are two kinds of deflation, but economists have been so preoccupied with the bad type that they’ve had a hard time recognizing the good type. For example, economists in England labeled the late 19th-century era of falling prices and strong economic growth the “Long Depression,” simply because the output of goods was booming, growing faster than the money supply. Falling prices thus spread the benefits of rapid technological progress to consumers, leading to large gains in the average standard of living. Why was it called the “Long Depression,” then? Because economists are so accustomed to equating falling prices with depressions that they simply assumed that the deflation during this era must have been bad.

The bad deflations observed during the Great Depression of the 1930s and Great Recession of 2009 incubated the long-held fear of deflation in the minds of most economists. And, of course, deflation caused by a contracting money supply causes a disruption in the economy, a disequilibrium that can only be restored after a painful process of falling prices and recession. This was the situation in the 1930s and to some extent in 2008–09, but the current disinflation is significantly different; it is caused by productivity gains and lower oil prices, not a shrinking money supply. The proof is in the prices: whereas in 2009 all prices were falling — especially asset prices — today, the fall in oil prices has only affected goods prices. Prices of assets such as homes and stocks continue on a stable or upward trend, indicating that credit markets are mostly functional and forecasts for near-term economic growth are mostly positive.

Deflation and monetary reform

Economists advise never to reason from a price change. Instead, when we see prices change, we need to reason from underlying shifts in supply and demand. Falling prices can result from an increase in the supply of goods or a decrease in demand. An increase in supply means more for everyone to consume — a sign of economic progress. A decrease in demand means less to sell — a sign of economic recession. Because price signals are the intelligence of the decentralized market economy, it is crucial that prices send the right signals about the true state of the economy. In a period of strong economic growth, a strong case can be made for letting prices fall. This could mean, in the words of economist and monetary historian George Selgin, an inflation rate less than zero.

The fear and loathing brought on by the current deflation presents an excellent opportunity to reassess monetary policy. The current situation highlights an underappreciated disadvantage of inflation targeting: it does not distinguish between supply-side and demand-side causes of price-level fluctuations. With the current 2 percent inflation target, the economy faces costs of inflation, such as menu costs, price confusion, and a suboptimal tax on money, but with little benefit.

In recent years, a growing group of economists has advocated the replacement of the 2 percent inflation target with a 5 percent nominal GDP target. Nominal GDP targeting would avoid imposing an unnecessary inflation burden on the economy and do a better job of alerting the Fed to demand-side problems that it could mitigate through monetary expansion. By focusing on spending rather than prices, the Fed and the financial press would not need to worry about deflation per se; as long as the nominal spending target is met, falling prices would automatically be understood as income gains for consumers.

The fear of deflation emphasizes the wrong thing. Productivity advancements that cause prices to fall are the essence of economic progress. They are how consumers gain from economic growth. Falling prices caused by financial crisis and monetary contraction are merely symptoms of a larger underlying problem. Instead of worrying about deflation, or even inflation for that matter, monetary authorities should simply work to prevent arbitrary distortions in the money supply from affecting the real economy.