Deflation Defies Expectations—and Solutions

The old bogeyman of deflation has re-emerged as a worry for the U.S. economy. Here’s something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works.

Deflation is usually associated with a Great Depression-like drop in demand. Consumer prices, incomes and asset prices fall. Interest rates go to zero, as low as they can go. As prices and incomes fall, the cost to borrowers of servicing debt does not, sucking life out of the economy and pushing prices down further. A bad situation, in short, gets worse.

In 1932, U.S. consumer prices fell 10% and between 1929 and 1933 they fell 27% in all.

But Japan’s experience has looked nothing like this. Rather than being deep, destructive and concentrated in a few years, deflation has been a surprisingly mild, drawn-out affair. Consumer prices have been falling in Japan for 15 years, but never by more than 2% in any single year. Japan’s deflation has been a morass, but not the destructive downward spiral many economists predicted. Why? And what does it portend for the rest of the world today?

Economists don’t have good answers. “We don’t know how deflation works,” says Adam Posen, a member of the Bank of England’s monetary policy committee who has been studying Japan since 1997. “We don’t have a way of rationalizing steady, several-year flat deflation,” he says.

This is a pressing issue for the U.S. Federal Reserve and other central banks. Ireland is already experiencing deflation. Spain has flirted with it. The Fed’s preferred inflation gauge was up 1.3% in June from a year earlier, below its informal target of 1.5% to 2%. Some officials worry prices could go negative if the recovery falters.

On paper, Japan looked like a candidate for a deflationary spiral. The economy consistently grew slower than estimates of its capacity to grow. Unemployment rose from 2.1% in the early 1990s to more than 5% a decade later. That growing economic slack should have driven prices down and down. Large burdens of delinquent loans at banks should have exacerbated the debt burden on society.

But that didn’t happen. Old textbook tradeoffs between unemployment and inflation might not be working the way they used to. The standard Phillips Curve theory, named after Alban William Phillips who helped explain it, is that when unemployment rises, inflation falls.

Fed officials saw evidence in the U.S. before the crisis that this dynamic might have gotten less powerful over time, meaning a big rise in unemployment might not create the kind of deflationary shock it would have in the past.

Japan’s experience reinforces that view. Mr. Posen cautions that this might help explain short-run shifts in unemployment and inflation behavior, but Japan remains a puzzle because its problems persisted so long. Perhaps economists misread how much slack there was in the economy in the first place.

Another explanation turns on the psychology of households and businesses, which modern economists believe plays a big role in driving inflation. If people believe inflation is going to rise a lot, they will demand higher wages and push up prices. If people believe prices won’t move or they expect them to fall, they will act accordingly and create the environment they expect. Japan might be stuck in a slow deflation because over time it is what Japanese households and business became conditioned to expect. Even when the economy recovered between 2002 and 2007, prices kept falling.

Government plays a role, too. Japanese officials responded to their crisis, but many U.S. economists complained officials failed to cut interest rates quickly enough early in the crisis, pulled back fiscal stimulus too soon and were too slow to clean up banks and restructure inefficient industries.

Government intervention might have helped to keep Japan’s economy from going through the floor, but it might not have been aggressive enough to truly revitalize the economy and set it in a different direction, says Mark Gertler, a New York University economist who studied Japan’s malaise with Ben Bernanke in the 1990s.

There are other explanations. Japan’s aging consumers, for instance, might have been more inclined to save for retirement and more reluctant to spend, undermining consumer demand and weighing on prices.

For the U.S., there are good and bad implications in this. “This is the most significant economic issue there is out there,” Mr. Gertler says.

The good news is that the Fed might not need to fear a Depression-style deflationary spiral. The bad news is that if the U.S. does fall into deflation, it could be stuck there for many years like Japan, and suffer the subpar growth that has gone with it. And because deflation is so poorly understood, policy makers could discover they have no good solutions.