Swedroe: Deflation Not Bad For Economy Or Stocks

Research doesn’t support the common idea that deflation is bad for growth or returns.

Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

The standard definition of “deflation” is “a fall in prices.” A common assumption among investors is that deflation is bad for real economic growth and, therefore by extension, also for real dividend growth.

However, that may not necessarily be the case. For example, deflation can be separated into good deflation, which typically follows a positive supply shock, and bad deflation, which typically follows a negative demand shock. Investor fear of deflation stems from the possible consequences of bad deflation.

The common association of deflation with economic weakness is rooted in the incorrect belief that deflation signals an aggregate shortfall in demand, which lowers prices, incomes and output. But as noted above, deflation can also be a result of increased supply. Examples include improvements in productivity, greater competition, and cheaper and more abundant inputs (both labor and goods). Supply-driven deflation depresses prices while raising incomes and output.

Some investors today might be worried about the risk of deflation because of the current low U.S. inflation rate, deflation in other countries and what deflation might do to the economy, the stock market and their portfolios. To address that issue, we’ll look at the findings of a recent study on the subject.

Economic Growth & Deflation

The study “The Costs of Deflations: A Historical Perspective,” which was published in the March 2015 issue of the BIS (Bank for International Settlements) Quarterly Review, covered the period 1870 through 2013, and 38 economies. Its authors found that, in the postwar period, growth in GDP per capita has actually been higher during periods of mild deflation compared to periods of inflation.

Only during the period from 1929 through 1938, which includes the Great Depression, was there a significant difference between GDP per capita growth in periods of inflation and in periods of deflation. When looking at the whole data sample but excluding the period 1914 through 1947, which—still leaves 117 years (or 82% of the full sample)—the average growth in periods of deflation (+2.5%) and inflation (+2.4%) is virtually identical.

Growth during persistent deflationary periods (a five-year accumulative drop in consumer prices), is only somewhat lower (+1.9%). However, the authors did find that output growth is consistently lower during both property and equity price deflations.


‘Deflation & Depression’

A study by Andrew Atkeson and Patrick Kehoe, “Deflation and Depression: Is There an Empirical Link?” published in the May 2004 issue of the American Economic Review, surveyed international data over the longer term (from 17 countries over more than 100 years) and found that, outside the Great Depression (1929-1934), nearly 90% of the periods with deflation did not see recessions (65 out of 73 episodes). Splitting the data into pre-1939 and post-1949, they find that real output growth in the post-1949 period was actually higher in years with deflation compared to years with inflation.

And since 1994, median annual real GDP growth in Japan has been slightly higher (+1.5%, year-over-year) in years with deflation compared to years with inflation (+1.1%). In summary, empirical evidence does not generally support the theoretical claim that deflation leads to lower real economic growth. Causation usually goes the other way around.

Stock Returns & Deflation

Unfortunately, the academic literature doesn’t have much to say on the relationship between deflation and stock prices. Thanks to Michael Clemens, author of the September 2016 study “Deflation and Stock Prices,” we now have data to examine. Clemens defined a deflationary period as one in which the annual change in the CPI was negative over the prior 12 months.

For the United States, the data covered the period 1872 right into 2016. Following is a summary of his findings:

  • Price-to-earnings (P/E) ratios are highest in periods of low inflation (normal). The P/E ratio averaged 16.9 when inflation was 0.5%.
  • P/E ratios suffer much more in periods of high inflation compared to periods of deflation. When inflation was more than 5%, P/E ratios averaged just 10.4. When mild deflation (0% to 3%) occurred, P/E ratios averaged 15.5. When deflation was greater than 3%, P/E ratios averaged 14.5.
  • Periods that lead up to mild deflation have the highest nominal and real returns.
  • Returns are most stable before and during periods of low inflation.
  • Real returns are actually higher in periods of mild deflation (21.9%) and severe deflation (11.0%) than in periods of mild inflation (9.4%) and severe inflation (-1.5%).

Even in periods of deep deflation, real returns have been positive and higher than in periods of high inflation, and around the level seen in periods of mild deflation and low inflation."


Same Seen In Japan & Switzerland

As a robustness check, Clemens examined Japan and Switzerland, both of which have experienced periods of mild deflation in recent years. Japan has been on/off deflation since the mid-1990s, while Switzerland’s experience is more recent. With Switzerland, P/E ratios were higher during periods of deflation compared to periods of inflation, while in Japan, during the period 2010 to 2016, P/E ratios were highest during inflationary times. Interestingly, for both countries, P/E ratios during periods of deflation were higher than in the United States, which did not experience deflation during the periods he investigated.

Clemens concluded: “From a stock market perspective, deflation doesn’t appear to deserve a bad name. Several observations support this:

  • The 1930s was a statistical outlier and not representative for a deflationary period
  • Deflation does not seem to create recessions, causality goes the other way
  • Real stock returns are lowest in high inflation environments, while real stock returns are positive and around average in the periods leading up to and following the onset of deflation
  • The empirical evidence and the theoretical exercises are mixed as regards the impact on P/E ratios from deflation. When moving from low inflation to mild deflation, P/E ratios are virtually unchanged

Deflation illusion might explain the surprisingly small decline in P/E ratios in the face of deflation.”


Deflation has a bad name among economists and investors. Say the word “deflation” and most people picture in their minds the Great Depression of the 1930s. Yet the data doesn’t seem to support the view that deflation is either bad for the economy or bad for the stock market. And when the long-term evidence doesn’t support the theory, it’s time to throw out the theory.

That said, we should be careful, because we have only a few episodes of persistent deflation in the postwar period. Present debt levels are at, or close to, historical highs in relation to GDP. And deflation does raise the real cost of debt. This should provide a caution to investors against drawing sweeping conclusions or firm inferences about the future.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.