Price of Deflation: An Upside-Down World
For half a century, Americans have assumed that when it comes to prices, there is only one direction -- up.
We railed against this apparent fact when the inflation of the 1970s eroded the value of our money. We reveled in it when the boom of the ‘90s sent our stock values through the roof. But one way or another, we’ve always taken it for granted that prices only rise.
Now comes word from the folks at the Federal Reserve that up may not be the only direction after all, and that we may be on the verge of a deflation -- a broad price decline.
If they’re right, hold on to your hats. We could be headed for a looking-glass world in which all the familiar rules of work, money, investment, even daily life get turned on their heads.
“Alice in Wonderland has nothing up on deflation. It would upset almost every settled notion we have about our economic lives,” said Roger M. Kubarych, a former senior Fed official who now is an executive with HVB Americas Inc., the U.S. subsidiary of a major German bank.
To fully appreciate how different an era of down could be from the now possibly passing age of up, it’s important to make a distinction.
People generally associate deflation with cataclysms such as the Great Depression, when prices plunged along with almost everything else in the economy.
But it doesn’t have to be this way. Prices can fall gently while the economy rises, and they have for substantial chunks of American history; for instance, for much of the period from the end of the Civil War through the start of the 20th century.
Of course, that wouldn’t make the experience of deflation any the less strange -- or unsettling -- for modern Americans.
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New Strategy: Avoiding Pay Cuts
Take raises. Most people assume that sooner or later they will get one. It may not be as big as they want. It may not cover their growing appetite for wide-screen TVs and DVD players. But it’s still a raise.
However, if deflation were to set in, raises would almost certainly vanish, and pay cuts would become the order of the day.
That’s because as prices across the economy fall at, say, 3% a year, each dollar you receive in wages would be able to buy that much more and so would be that much more valuable to you -- and to your employer.
A good strategy under such circumstances: “You should march into your boss and announce that you will not accept a penny more than you make right now as long as he agrees not to pay you a cent less,” said Marc Weidenmier, an economist at Claremont McKenna College in California.
Or consider debt: Americans were happy to load up on it during the inflation-wracked 1970s and early 1980s, when rising prices ensured that the dollars with which they repaid their loans were less valuable than those they had borrowed. And they have been happy to load up again in the early 2000s, when extremely low interest rates seem to be erasing the cost of borrowing.
But matters would look considerably different if prices went into a general decline, causing repayment dollars to become more, not less, valuable. Consumers and companies probably would react by throwing their finances into reverse and paying off loans as fast as they possibly could.
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Evidence of Impending Deflation Is Mixed
Given such a disruptive possibility, there is some mystery about why the Fed chose to highlight the deflation danger this week.
After meeting Tuesday in Washington, the central bank’s policymaking Federal Open Market Committee issued a statement that represented an abrupt shift from its half-century obsession with eliminating inflation.
It warned that over the next few quarters “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup.”
The mystery is only deepened by the fact that evidence that a generalized decline in prices is underway is, well, mixed.
To be sure, some prices have been falling so fast that it is hard to imagine how companies stay in business.
Personal computer prices, for instance, have been plunging at better than a 20% annual rate for the nearly five years that the Bureau of Labor Statistics has been keeping track. New-vehicle prices have been sliding at a rate of as much as 2% during the same period, according to the bureau. Television prices have been going down for at least a decade.
But for each of these declines, there are prices of other, perhaps even more important goods and services that have been going up. Health insurance, for example, has been rising at an 8% annual rate. Private college tuition and fees have been climbing at an almost 6% clip. The price of postage stamps is up nearly 4%.
“I myself don’t see much evidence” of deflation, said Barry Bosworth, a Brookings Institution economist whose skills at spotting price trends were first honed in the late 1970s as director of President Carter’s ill-fated Council on Wage and Price Stability.
Theories about what is behind the Fed’s new deflation warning run along two lines.
Tactically, Fed officials are in a nasty bind. With conditions so weak, they don’t want to speak ill of the economy. Having already cut their benchmark federal funds rate to a four-decade-low 1.25%, they are running out of conventional steps to take. And in President Bush and the Republican majority on Capitol Hill, they face a White House and Congress liable to jam through another big, deficit-ballooning tax cut if growth doesn’t improve.
The deflation argument offers the Fed’s Open Market Committee a way out of this bind. In effect, the central bank declared Tuesday that the prospects for growth are good enough that Bush and congressional Republicans need not act.
But, they added, there is another problem -- deflation -- that’s potentially so serious the Fed can be forgiven if it takes unconventional steps such as pumping so much credit into the economy that it causes a little inflation.
“Masterful,” exclaimed Goldman Sachs economists William Dudley and Edward McKelvey. “It is hard to imagine a better solution than the one the committee came up with,” the pair said of the Fed’s statement.
By contrast, others think the economy really does face a deflation danger and they believe that Fed Chairman Alan Greenspan and his colleagues do too.
“Greenspan wants to anticipate what the next problem could be, and it could be deflation,” said David M. Jones, a longtime Fed-watcher and Denver-based economic consultant. “It’s a very dicey economic situation.”
Dicey, if falling prices feed into a downward spiral of wage cuts, layoffs and plunging demand. But not so dangerous if the price declines are caused by improving productivity and remain mild.
And not necessarily bad for ordinary Americans.
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The Upside of Falling Prices
Mild deflation would assure working people (at least those who fend off pay cuts) of steadily rising real wages.
A 3%-a-year decline in overall prices translates directly into a 3% boost in people’s buying power.
It would offer Americans an appealing alternative to the maddening task of trying to pick investments, and a tax-exempt one at that. Just sew your money in a mattress and watch its value rise.
Finally, it might help slow the frantic pace of American life.
Alice in Wonderland-like, “deflation elongates time,” said Kubarych, the former Fed official. “It means that you don’t have to hurry out and buy something for fear the price will rise.
“It feeds a certain relaxation of attitude because the longer you wait, the lower the price.”
That doesn’t sound half bad.
