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The American economy is growing at a 5.2 percent rate. Unemployment is near record lows, while job satisfaction is at an all-time high. And wages have been rising faster than prices for nearly a year. Now, even after accounting for inflation, real wages in the United States are higher than they were before the pandemic, when approval of the economy sat near a two-decade high.
The debate over how to reconcile these disparate facts has been raging for months. Some insist that the Biden economy’s unpopularity represents the triumph of “vibes” over reality, as social media’s bias toward negativity and conspiratorial discontent has led the public to mistake a boom for a “recession.” Others point to rising interest rates and declining bank balances and argue that the electorate’s souring mood is rooted in their eroding financial circumstances.
I’m inclined to think that everybody’s a little right. But I think the primary cause of the public’s discontent is fairly simple: Prices are roughly 19 percent higher today than they were in 2020, and voters haven’t gotten over that.
In a sense, goods and services have become more affordable this year, since Americans have seen their earnings rise faster than consumer prices. Thus, the typical worker’s paycheck goes further today than it did back in January. Yet this year’s advance in real wages pales in comparison to the declines that workers suffered in 2021 and 2022. The median American is worse off financially now than they were when Biden took office.
What’s more, people tend to attribute wage gains to their own efforts while blaming price increases on economic dysfunction. For this reason, inflation may dim the public’s view of “the economy” more than wage growth brightens it, even if the latter outpaces the former.
Before 2021, America had not experienced a sustained period of high inflation in four decades. Sudden price increases therefore came as a shock. And the public’s expectations of what things should cost has remained anchored to pre-pandemic levels, despite the fact that nominal wages are now dramatically higher than they were in 2019.
What voters want, in other words, is not for the rate of price growth to slow, but rather for the price level to fall. Asked about their top-priority issue in a recent YouGov survey, 64 percent of voters said lower “prices on goods, services, and gas.”
The word for a sustained drop in consumer prices is deflation. And it is all but a synonym for economic crisis.
That’s because deflation tends to correlate with severe recessions or depressions. And economic theorists have long argued that this isn’t a coincidence, since deflation can trigger a self-reinforcing cycle of inadequate demand.
Their story goes like this: When prices fall for a sustained period of time, consumers start putting off spending, since they’ve learned that goods and services will be cheaper tomorrow than they are today. This reduces consumer demand, forcing businesses to cut prices further and lay off workers, which then reduces consumer demand even more, as unemployed workers have less money to spend.
Meanwhile, the real cost of debt soars in deflationary conditions, since debtors are forced to pay back loans in more valuable currency. This discourages borrowing and investment, which further reduces demand for labor and goods, thereby reinforcing deflation.
It might therefore seem like American voters are demanding the economically impossible: a dramatic and sustained decline in prices that leaves wages, employment, and output untouched.
And this is partly true.
Recent research on deflation suggests that the standard story about its catastrophic consequences is actually overstated. Under certain conditions, prices can fall for a sustained period of time even as the economy prospers. That said, a deflationary episode profound enough to restore the price level of 2020 would be impossible to achieve in the absence of an economic depression. Voters who demand the return of pre-pandemic prices are making a wish on a monkey’s paw; if their dream ever came true, it would be a nightmare.
Dreams of a slight decline in the price level are less quixotic. Although deflation has long been a byword for disaster among economists, not all deflationary episodes are bad.
From 2012 through 2016, Switzerland experienced five consecutive years of declining prices. This was largely a consequence of the declining economic fortunes of the nation’s neighbors: As other European countries entered debt crises following the 2008 crash, investors fled their currencies for the relative safety of the Swiss franc. As demand for the franc surged, its value relative to goods and services swelled. The Swiss therefore experienced falling consumer prices.
Economists expected this sustained period of deflation to push Switzerland into recession. In reality, the Swiss enjoyed higher real growth per person, and lower unemployment, than most other developed countries during its deflationary period.
The Swiss example validates a conclusion that’s garnered growing support among economists in recent years: The belief that deflation is inherently economically detrimental is rooted more in the traumas of the Great Depression than the weight of empirical evidence.
When deflation is caused by a self-reinforcing decline in demand, its results are indeed devastating. But a demand collapse isn’t the only thing that can bring about a falling price level; a large expansion in the economy’s productive capacity can do the same.
To see why this is the case, consider what would happen if we ever developed commercially viable fusion power. That technology would radically reduce the cost of energy throughout the economy. And since energy is an input into the production of every good, a fusion breakthrough could bring about a drop in the price level. Yet there is little reason to think that this sequence of events would lead to an economic depression rather than a bonanza.
The prospect of technological breakthroughs contributing to deflation isn’t merely hypothetical. In a 2004 paper, the economists Michael Bordo, John Landon Lane, and Angela Redish examined the late-19th-century deflationary periods in the United States, Britain, and Germany. They found that a primary cause of these deflationary episodes was an expansion in each economy’s productive capacity, partly as a result of technological innovation. As a result, these economies experienced deflation and economic growth simultaneously.
More recent research indicates that the correlation between falling consumer prices and shrinking economies is not always causal. In a 2015 article for the Bank for International Settlements, a team of economists led by Claudio Borio found that modest deflation in consumer prices doesn’t typically cause downturns. Rather, it is the deflation of asset values — not consumer prices — that drives economic downturns.
Borio and his co-authors gathered data from 38 countries, and then examined the various deflationary periods that occurred between 1870 and 2010. When they controlled for the impact of falling stock and home prices on economic growth, they found that declining consumer prices had no statistically significant impact on output.
By contrast, falling asset values reliably led to economic downturns. Which makes sense. Falling stock prices discourage firms from investing, which leads to lower capital expenditures economywide, which in turn leads to lower employment and thus lower consumer demand.
Meanwhile, falling home prices can severely constrain household spending. People’s homes are generally their most valuable financial asset. And they typically acquire that asset by taking on debt and often draw on home equity to finance their consumption. When the value of their principal asset falls sharply, their mortgages become more burdensome while their capacity to debt-finance spending grows constrained. A pullback in spending naturally follows.
Therefore, falling asset prices lead to reduced demand, which leads to falling consumer prices and often a recession. Consumer-price deflation thus correlates with downturns, but doesn’t necessarily cause them.
All this suggests that wishing for modest declines in the price level isn’t tantamount to wishing for a depression. But modest is the key word. There’s reason to think the conventional narrative about the ruinous implications of deflation still applies to large and rapid declines in consumer prices.
During Switzerland’s five-year period of benign deflation, prices declined at an average annual rate of 0.5 percent. In order for prices to swiftly return to pre-pandemic levels in the United States, we would need to see rates of deflation comparable to those of the first years of the Great Depression, when prices fell at an average annual clip of 8.6 percent. Since 1929, America has never witnessed an annual deflation rate above 2.5 percent outside the context of a severe economic downturn. There is no precedent for an economy erasing a 19 percent increase in prices without suffering a cataclysm.
If wages continue to grow faster than prices, Americans will eventually stop suffering sticker shock each time they go to the grocery store. For now, though, it’s entirely reasonable for consumers to resent the large increase in prices since 2020 and to wish for a modest decline in the price level.
But pre-pandemic prices aren’t coming back. And no one should want them to, since it would take a depression to make that dream come true.