...against fictions and other tall tales

Thursday, 15 August 2013

James Tobin on why deflation isn't a cure for unemployment

There's been a lot written lately on why the Pigou effect (i.e., increase in output and employment caused by an increase in consumption due to a rise in the real balances of wealth) isn't a foolproof way around the problem of the zero lower bound. It reminded me of these lines by James Tobin:
Suppose all dollar prices and wages are lower by x per cent. Will aggregate demand for products and for labour be greater? Maybe, because with the same quantity of currency and bank reserves, interest rates could be lower and encourage businesses and households to spend. But in depressions, interest rates may be already as low as they can be; after all, the interest rate on currency cannot be less than zero. Anyway, as Keynes observed, lowering the overall price level cannot reduce interest rates more than the central bank could on its own, with much less social trauma. 
Another possibility, stressed by Professor Pigou, is that owners of assets denominated in dollars feel richer after the purchasing power of the dollar has increased; therefore, they buy more goods. The trouble is that debtors with dollar obligations are correspondingly poorer. There is a small excess of privately owned credits over private debts, the monetary issues and near-money obligations of the central government. But this net credit may not be sufficient to offset the likelihood that increased private debt burdens deter spending more than the corresponding gains in the purchasing power of creditors encourage it. So argued Irving Fisher, my revered predecessor at Yale. Even if Pigou, rather than Fisher, is right, the direct effect of the price level on demand is not an equilibrating mechanism of any practical importance. Certainly, the big deflation during the Great Depression did no good. 
A serious drawback to deflation (or disinflation) as an adjustment mechanism is its perverse effect on aggregate demand. Even if lower prices stimulate demand once prices have fallen, the process of falling prices is destabilizing. If you expect falling prices, you will postpone purchases, preferring to hold money rather than buy goods. For this reason, Keynes and Fisher rejected concerted deflation as a remedy for depression and unemployment. 

Tobin, J., "Business cycles and economic growth: Current controversies about theory and policy", Bulletin, the American Academy of Arts and Science, Vol. XLVII, No.3, December 1993.


  1. Knowing that you are well-versed with the work of Jorda and Taylor, then allow me to highlight to your readers another excellent analytical piece by the latter, that will also help us forget the Rogoff debacle:


    I am almost certain that GC and MI have already viewed the paper as most of your more serious readers presumably have, and I know that jhcraw would have snickered as I did when looking at the UK metrics. 'Tis a sad case for Cameron and his League of Underperforming Gentlemen.

    Nod to you circuit!! It's great to know that someone out there is still listening to some great artists and sailors-reading your takes on Domar, Steindl and the great Jim Tobin is like reliving a golden age of economics. Deep thinkers and extraordinary muckers in the best sense of the word!!!!

    O Camelot, Camelot! wherefore art thou Camelot?

    ...without a well-designed keel, a boat can't deal with windage. well-done, circuit!

    1. @Swells: Thanks for the link. The Jorda and Taylor article is amazing. In my opinion, the research community they form (with Schularick and others) is the most promising out there. It is policy-oriented, empirically-focused, and forward thinking. Also, as this paper demonstrates, they think outside the box -- in a good way!

      On issue of austerity, it's worth pointing out that some Old Keynesians identified the fallacy of 'expansionary fiscal austerity' long ago.

      Here's a good example from Blinder/Yellen (2001):

      "As Robert Solow reminds us, those who promote the idea that, say, cutting government spending can be expansionary never suggest raising government spending to calm an overheating economy" (p. 97)

      A lot of folks out there have some catching up to do!!!

      As always, I appreciate the note.