CORRECTED: Deflation is a dangerous distraction (part 2)

(Corrects spelling of Barack Obama's name in paragraph 29)

-- John Kemp is a Reuters columnist. The views expressed are his own --

By John Kemp

LONDON (Reuters) - The current downturn and fears about falling prices are prompting a plethora of historical comparisons with previous periods, many with the Great Depression of 1929-1933, some based on a very shaky understanding of the historical record.

HISTORICAL BUSINESS CYCLES

The attached chart provides a long-term overview of developments in both U.S. output and prices for the last century using official data published by the Federal Reserve and the Bureau of Labor Statistics. To remove some of the month-to-month volatility, the chart shows the twelve-month percent change in both series for a rolling three-month period, providing a better indication of the underlying trend (here).

Three points stand out immediately:

(1) The business cycle was much more pronounced in the first half of the period from 1913 to the early 1950s when there were massive booms interspersed with regular slumps. Year-on-year changes in industrial output of more than 10 percent and occasionally more than 20 percent were the norm.

Since 1950, the cycle has been much more muted. Only twice in the last 50 years has output grown briefly by more than 10 percent year-on-year, and only once has it shrunk more than that amount.

What made the Great Depression 1929-1933 unusual was not the suddenness of the contraction (which was not abnormal for the period) but its duration and depth. Previous downturns lasted a few months but this one dragged on for years with a massive loss of cumulative output. Industrial activity peaked in September 1929 and did not begin expanding again significantly until H2 1933.

What seared the Great Depression even more deeply into the collective memory was that by mid 1938, barely five years after the expansion had resumed, the economy slipped into another deep though mercifully much shorter slump, with output down by almost a third compared with the previous year. Only the advent of war ensured a sustained expansion for the next five years, before another slump in activity in 1946 when the economy was demobilized.

(2) Changes in real output were far more pronounced than changes in consumer prices throughout the 1913-153 period. Falling prices undoubtedly made conditions worse, especially for farming communities and other primary producers. But the loss of output and jobs created far more misery.

(3) Changes in output tended to occur ahead of changes in prices. In each slump, causality ran from falling output to falling prices, not the other way around. In the crucial 1929-1933 period, output began falling from Oct 1929, while inflation turned negative from Mar 1930 onwards. By May-Jul 1930, output was down 17 percent compared with the previous year, while prices were down only 2 percent. Deflation is best viewed as a symptom of severe business-cycle downturns, not the cause.

THE GHOST OF TOM JOAD

Much of the folk memory about the horrors of deflation stems from two factors:

(1) Prolonged deflations in the United Kingdom after the Napoleonic Wars and in the United States between 1879 and 1896 were characterized by an especially brutal compression of agricultural prices and wages that had devastating impacts on rural economies and rural states (especially southern and western parts of the United States during the final quarter of the nineteenth century).