Threat of Deflation is Exaggerated

By Mark Weisbrot

July 2, 2003 - Knight-Ridder/Tribune Information Services

A specter is haunting America (and Europe) -- the specter of deflation. Talk of deflation has moved financial markets, influenced the statements of the Federal Reserve, and gotten a lot of people worried that the United States could be headed toward a prolonged period of economic stagnation. The most feared example is that of Japan, which has been mired in a slow-growth swamp since its stock market and real estate bubbles burst in 1989.

What is deflation and how much should we be worried about it? Deflation refers to a sustained fall in the general price level -- the opposite of inflation. Most of us are not old enough to have lived through the Great Depression, so although we have seen falling prices for individual products (for example, computers) we have not experienced a prolonged drop in overall prices.

There is no doubt that deflation, were it to happen here, could create problems for our economy. But the threat has been exaggerated, and misunderstood, in several ways.

First it is important to realize that if the Consumer Price Index were to turn negative for a few months or even a year, this would not necessarily spell doom for the U.S. economy. The scary scenario that is often presented is a vicious cycle: the Fed can't lower interest rates below zero, so that weapon is gone when prices are falling. Consumers postpone purchases that they know will soon be cheaper, further reducing demand. Debtors (most consumers and home buyers) see the value of their debts rise relative to their incomes and other prices.

But most of this scenario is true when there is no deflation but inflation is falling -- for example, when the rate of inflation drops from 4 percent to 2 percent. And with short-term interest rates now at 1.0 percent, the Fed is already at the point where it doesn't have much left in the way of stimulating the economy through lower short-term rates.

The real danger comes if deflation persists -- then the problem of falling demand and increasing debt burdens become cumulatively worse. But there's no need to panic: it's not that difficult for policy makers to make prices rise if they really want to do so. The central bank (our Federal Reserve) can create all the money that it wants to create, and thereby drive prices back up.

The Japanese Central Bank was not aggressive enough in doing this, but that doesn't mean that our Fed would have to make the same mistakes. It's true that central banks tend to err on the side of slow growth -- most of our recessions in the post-World-War- II period (including the one before last, 1990-91) were actually brought on by the Fed raising interest rates at the wrong time, or too much.

But that is a different problem -- a political one. It means that if deflation were to start, our elected officials and the public might have to pressure the Fed to do the right thing. It does not mean that deflation is inherently a vicious cycle that, once begun, is difficult to break out of.

Prolonged deflation is not all that likely anyway, at least for now. The Fed recognized that in their May 6 meeting, seeing it as "only a remote possibility," partly because the dollar's decline against foreign currencies will raise the price of our imports. Interestingly, the Fed's public statement at the time was different, giving the financial markets the impression that the Fed saw deflation as a more serious danger.

Of course, our economy still faces serious weaknesses: business investment has yet to recover, and consumers can only add so much to their debt, which is already at record levels relative to income. The weak labor market adds to the problem of lack of demand, as do the massive spending cutbacks (and some tax increases) by financially strapped state governments.

And perhaps worst of all, there is a bubble in housing prices -- similar to the stock market bubble that burst in 2000 -- that could "disappear" some $3 trillion in homeowners' wealth.

So there are plenty of rocks in the road to economic recovery. No need to be overly alarmist about the dangers of deflation.