Deflating Deflation
The 17th century French mathematician and philosopher Blaise Pascal suggested that it was worth betting that God existed; the chances of winning were very small, but the reward was great if you won. Today’s talk about deflation -- a continuing general fall in prices -- is like that: The event is very unlikely, but the consequences could be important. In this case, however, the probability of deflation actually happening in the United States is so very small that the current chatter is a diversion and a waste of time.
Deflation is bad for several reasons. First, it transfers wealth from borrowers to lenders. If you have to pay back a loan in dollars of higher purchasing power than the dollars you borrowed, that is a real burden. Second, because the Federal Reserve, which sets monetary policy, cannot push interest rates below zero, falling prices can severely limit its capacity to act just when it is needed. Finally, deflation can easily become cumulative. If buyers decide to wait until prices get lower, they will make it happen, and that will encourage more waiting, so prices will fall further.
That some prices are already falling is not evidence that deflation is here. Not so long ago, when inflation was the danger of the month, we often heard it said that a stable price level was the proper target for economic policy. But if prices are steady on average, roughly half of them have to be falling at any moment, and the other half rising. That is what price stability means in a dynamic economy.
What is the current state of affairs? If you look at all the hundreds of prices that are tracked by the Bureau of Labor Statistics as elements of the consumer price index, you can list them in order: from fastest rising to steady to fastest falling. In the middle of the list are goods and services whose prices are rising at about 2.6% a year. Half of all prices are rising faster than that, and the other half less fast. The prices at the bottom, the ones that are falling, can only be a small fraction of the total. Even in manufacturing, 70% of all prices are rising. That does not look like deflation at all.
If consumers are asked how much they expect prices to increase during the next year, the average answer is about 3%. They may be right or wrong about that. But there is no reason for consumers to hold off buying in general to wait for lower prices because they do not expect prices in general to be lower.
Well then, what about Japan, where deflation is real, and Germany, where deflation threatens if it has not already arrived? Japan and Germany differ from each other, and both differ from the U.S.
Japan has been seriously depressed for a dozen years. Its stock-market bubble was bigger than ours and was matched by a giant real estate bubble. When both bubbles collapsed, the Japanese economy suffered an enormous loss of apparent wealth. Neither the Ministry of Finance nor the Bank of Japan rose to the occasion. They were living examples of too little, too late.
Why? Probably because the ministry and the bank suffered from obsolete economic analysis and ideology and also because they were unwilling at the time to reveal how deep in the tank Japanese banks had fallen under the burden of bad loans and evaporating collateral. By now, the problem has become even more difficult because years of falling prices have created the expectation of continuing deflation.
Germany is a different story. German industry has become noncompetitive within Europe. High labor costs are the most obvious reason but not the only one. Not so long ago there would have been an obvious remedy: a devaluation of the deutsche mark to get German costs in line with European prices. But there is no longer a deutsche mark, and the value of the euro affects all European countries equally. Since the rest of Europe has very low inflation, the only way to bring German prices into line is by actually lowering them. The German recession is forcing that unattractive deflationary outcome on the economy. That risk was always inherent in the formation of the European Monetary Union.
Neither the Japanese nor the German story applies to the U.S. What we have in this country is low inflation and a weak economy. So, some prices are falling. What really needs attention is the near-stagnation that leaves companies able to meet slowly growing demand for goods just from the benefits of rising productivity. The result is that some jobs are destroyed and fewer are created.
So what was the Federal Reserve saying at the last Open Market Committee meeting, with its delicate reference to the undesirability of further reduction of inflation? Do I know something it doesn’t know? I don’t think so. The comments were intended as a signal to U.S. businesses, consumers and investors. The message: This is not Japan or Germany. We are not asleep at the switch. We are doing what we can to revive a weak economy; if necessary, we will do more. And if, by any chance, the danger of deflation should begin to look real, we will take countermeasures. Do not bother to form deflationary expectations, because we will jump in to keep them from coming true.
Central banks tend to be hidebound institutions. One of the good things that distinguishes Alan Greenspan’s Fed from the Bank of Japan and the European Central Bank has been its flexibility, its willingness to think outside conventions. Some of the deflation talk is spiced with fears that there is not much left that the Fed can do. The federal funds rate -- the short-term interest rate that the Fed controls -- is already at 1.25%. There is little room to lower it.
But there are also unconventional actions available to an imaginative central bank. It could buy long-term Treasury bonds directly. After all, it is long-term rates that really matter, and there is room to push the 10-year rate down from its current level near 3.35%. The Fed could also buy agency bonds or other assets.
The real problem for grown-ups, deflation or no deflation, is the weak economy. I don’t pretend to know how long we will continue to edge along with productivity outrunning demand, and unemployment and excess capacity weighing down families and firms. If stimulus is called for, it is a pity that the Bush administration has been allowed to give away the store in tax reductions to the already satiated. There were far better options available. If the economy recovers in 2004 of its own accord, it is a fair bet that inflation will be the panic of the month shortly after.
