China’s Economy and Silliness on Deflation

It’s hard to be an economic nerd when we have a wannabe dictator working overtime to destroy democracy in America, but it is necessary just to beat back nonsense about the problems China’s economy faces. For the second time in less than a month the New York Times had a major piece on China’s economy warning about its problem with deflation. While China does appear to be facing modest deflation, it is absurd to imagine that the deflation is somehow a problem separate from its cause, a weak economy.

This confusion of cause and effect in economic reporting on deflation is a longstanding problem. Instead of starting from scratch, I’ll just repost a segment from a piece from a couple of years ago.

“Before explaining why the discussion of deflation is silly, it’s worth first briefly discussing what deflation means. When we have deflation, it means that average prices in the economy are falling.

"The point about “average” is crucial. All prices don’t move at exactly the same rate. When we have a low rate of inflation, say 0.5 percent, it means that a substantial share of items (say 45 percent) have falling prices, but a somewhat larger share (say 55 percent) have rising prices.

“If we switch to having 0.5 percent deflation, then these ratios might reverse. In that case, we might have 55 percent of items with falling prices and 45 percent with rising prices.

“This simple point should make the point about the needless hysteria over deflation clear. If 55 percent of items have falling prices, rather than 45 percent, what’s the big deal?

“There is a point about falling prices making investment less desirable. If a car company is looking to expand, but it expects the price of cars to fall by 1.0 percent a year, it will be less likely to invest at a given interest rate, than if it expects the price of cars to rise by 1.0 percent a year.

“But zero has no special importance in this story. At a given interest rate, it will be more likely to invest if it expects car prices to rise 2.0 percent a year rather than 1.0 percent a year. The problem is that lower expected inflation discourages investment. If inflation turns negative its investment prospects worsen, but that is also true if the rate of inflation falls from 2.0 percent to 1.0 percent.

“In short, crossing zero has no special importance for an individual product or the economy as a whole. It is just a story where lower inflation is worse than higher (but still low) rates of inflation.

“The other part of the story that gets high marks for silliness is the idea that deflation will cause consumers to delay purchases, thereby dampening consumption, that this Bloomberg piece raises. The reason this is silly is that the rates of deflation being discussed (less than 1.0 percent in absolute terms) are too trivial to have a noticeable impact on consumption.

“To take a simple example, suppose prices are falling at a 0.5 percent annual rate. If someone is thinking of buying a $1,000 refrigerator, this means that if they put off the purchase by six months, they would save $2.50. Know anyone who would do this?

“Deflation can be fast enough that this sort of delay could make sense, but we haven’t seen this story in any major economy for many decades. Certainly, the deflation rates of 0.0 to -1.0 percent that Japan and China have occasionally experienced don’t fit the bill.

“The point here is that an inflation rate that is too low can be a problem. A negative rate of inflation (deflation) is a bigger problem than low positive rates, but there is nothing magical about crossing zero. It is absurd to panic about a small amount of deflation, with the idea that everything is fine with a low positive rate.

“Making things more complicated, these are quality-adjusted prices. The statistical agencies try to adjust prices for quality improvements or deterioration. Many buyers may be unaware of the ways in which quality is assumed to have improved and just see a price increase, when the quality-adjusted price stays the same or falls. This is true with many consumer goods like computers and televisions, where quality-adjusted prices have fallen sharply, even as there has been little change in the average price of the product.

The point here is simple: deflation is a symptom of a weak economy. It is not a problem in its own right. The people who whine about are simply showing their ignorance, not providing information.

This matters for the China discussion because China has one problem, insufficient demand. Trump’s tariffs will make the problem worse, although not hugely so. China’s exports to the U.S. were equal to roughly 2.0 percent of its GDP, although the value-added in these exports is considerably less. For example, we would count the full value of an iPhone as an export, but the value added from China is far less than half of the price of the iPhone.

In any case, there is a simple remedy to China’s problem: the government needs to spend more money. It creates demand by spending money on pretty much anything it wants. It could spend it to improve the living standards of the Chinese people by improving its health care system and public pension system. It could also create demand by bolstering foreign aid, for example by picking up the cost of AIDS program for Africa that Trump nixed.

Anyhow, there are pretty much an infinite number of ways that China can boost demand by spending money. The limit it faces is that at some point, excessive spending would cause inflation. The fact that it is now seeing modest deflation means that this is not a major worry for the foreseeable future.