In defense of Chinese deflation

“What’s so bad about deflation?” President Xi Jinping said, according to the Wall Street Journal. “Don’t people like it when things are cheaper?”

This (possibly apocryphal) nugget has been circulating in social and mainstream media as dreams of Japanification once again tickle the fantasies of even highly credentialed economists and pundits.

Old tropes and buzzwords are being flung with gleeful abandon – balance sheet recession, deflationary spiral, lost decade – as President Xi has so obviously demonstrated rank economic ignorance. 

Or has he? Han Feizi also asks the same question, “What’s so bad about deflation?” and will go so far as to hazard a startling opinion, “People definitely like it when things are cheaper!”

Every economist should be asking this question as China doubles down on its manufacturing sector, which, according to the UN, is on track to reach 45% of the global total in 2030 (up from 30% in 2022).

No, China is not turning Japanese. Deflation in China’s case is not analogous to what Japan saw in the mid-1990s, but is, in fact, its wholesale opposite.

Japan’s deflation was a result of a negative demand shock – the popping of its bubble economy. At the time, Japan was the world’s most expensive economy, topping the Economists’ Big Mac index, among other indicators. The bursting of the bubble shifted the demand curve in, resulting in lower aggregate demand and lower prices.

China’s current deflation is a result of a positive supply shock as credit has been redirected from the property sector into advanced manufacturing. Prices in China are currently among the cheapest in the world. Automation and advanced manufacturing have shifted the supply curve out, resulting in higher aggregate supply and lower prices.

China’s auto industry is the poster boy for this development as surging investment and unbridled competition among new EV entrants flood the market with whizzbang models of ever higher performance and more innovative features.  

In 2024, the average new car sales price in China was about RMB180,000 (~US$25,000), which bought a mid-level trimmed BYD Han large sedan. In 2020, the average new car sales price in China was RMB150,000 (~$22,000), which was good for a compact Toyota Corolla. The BYD Han was also introduced in 2020 with an entry-level price of RMB233,000 (~$34,000).

While both ASPs and unit sales have increased since 2020, the largest benefit to consumers was actually deflation – Chinese consumers were paying modestly higher prices in 2024 for slightly more cars. But they were able to buy larger more upscale models with better performance and superior features.

The price/performance/feature wars have gotten out of hand of late where multiple screens and ridiculous horsepower are not nearly enough; Chinese EVs are now expected to do party tricks like tank turn, compass turn around one wheel, crab walk (YouTube it) or jump over potholes – Knight Rider “Turbo Boost” style. 

China analyst Glenn Luk has tracked the prices and features of BYD’s entry-level Qin Plug-in Hybrid Electric Vehicle (PHEV). Over a period of 16 years, BYD has cut Qin prices by more than half (~$14,000) while quadrupling range and power.

True deflationary spirals are exceedingly rare, with the US great depression the only example that comes to mind. Unlike inflation, deflation tends to be self-limiting for the simple reason that prices can’t fall below zero and often quickly crash into underlying costs – as opposed to inflation, which has no upside limit.

Even Japan, which experienced a couple lost decades of economic growth, did not suffer a fall in living standards as deflation lowered prices, delivering higher-end goods and services as the Japanese became even more obsessive in their attention to detail and quality.    

Keynesian economists believe that a modest level of inflation is economically optimal. The idea is that falling prices incentivize consumers to hold off purchases in anticipation of better deals, resulting in lower production, employment and growth; Keynes coined it “the paradox of thrift.”

While this paradox may certainly be valid, modern consumers should intuitively understand that for many products, especially those with a technology component, replacement cycles are naturally deflationary and are often difficult for any reasonable amount of inflation to overcome.

In 40 years, we went from shoulder-carried JVC boom-boxes to Sony Walkmans to Discmans to Apple iPods to smartphones with wireless earbuds. Economists attempt to correct for these improvements with “hedonic” adjustments to inflation data – the accuracy of which is, at best, open for debate.

Consumer products in China are experiencing a revolution in “hedonic” improvements – and not just in the auto sector. Products and services from cars to electronics to smartphones to appliances to restaurant service to boutique hotels are all being upgraded at such a rate that it is preposterous to assign just a few percentage points for hedonic improvements. Han Feizi has written on this before (here, here and here).

Given the apparent ascension of the Industrial Party faction within the Communist Party of China, with the nation doubling down on industrial policy, advanced manufacturing and science-technology, we can safely assume that growth in the medium term will be driven by shifting the supply curve more than the demand curve – increasing aggregate supply while watching prices slide.

More goods of higher quality at lower prices is the definition of deflation but in its good form. Few goods of declining quality at lower prices is also deflation – in its bad form.

While outward shifts of the demand curve would be welcome, China’s leadership appears loathe to pursue that with policy tools. The Western economic Covid playbook was to hand out checks to consumers in order to push out the demand curve, risking inflation and the loss of buying power.

While China has implemented targeted consumption stimulus like trade-in subsidies for EVs and discount vouchers on appliances and mobile phones, stimulus measures have largely been directed towards the supply side – fixing local government balance sheets, installing digital/smart city infrastructure and directed lending to advanced manufacturing (e.g. EVs, solar, batteries, semiconductors, automation, etc). The risk of China’s approach is uneconomic investment resulting in low growth (with deflation as a backdrop).

Some analysts insist that China’s deflation is a result of weak demand. For the most part, this analysis stems from confusion.

Economists have never really seen supply-driven deflation in their lifetimes. Deflationary moments in recent memory have all been demand shock events – post-bubble Japan, the 1997-98 Asian financial crisis, the 2008 global financial crisis, etc. China’s moribund property market provides a superficial veneer of similarity.

The last time the world experienced prolonged supply-driven deflation was the glorious post-Civil War economy of the US from 1873 to 1899. After bloodily settling America’s family business in favor of the North, industrialization was pursued with a vengeance. Investments in railways, steel production and manufacturing resulted in extraordinary increases in output and, subsequently, falling prices.

With the largely successful Made in China 2025 project, the ascendency of the Industrial Party and a projected tripling of China’s STEM workforce in the next two decades, the likelihood of China experiencing two decades of supply-driven deflation should not be dismissed.

In fact, that kind of productivity increase – 20 years of deflation – may be the only way to industrialize the Global South, which needs capital and capital goods (i.e., solar, electrical systems, infrastructure, vehicles, etc) far more than it needs market access (see here).

So “What’s so bad about deflation?” we ask again. The worst part of deflation appears to be the rank economic ignorance it elicits.