By Rick Newman
Posted: July 20, 2010
When the price of cars or sweaters or iPods declines, it's a break for consumers and a welcome sign that economic productivity is improving. That helps drive up living standards. But when the price of everything drops, it's an alarming development that portends stagnation.
The consumer price index, which measures inflation, declines every now and then, usually when there's a big drop in the price of volatile goods like energy or food. But there hasn't been sustained deflation in America since the early 1930s. Now, we may be on the verge of yet another unnerving economic adventure. Inflation over the last 12 months has been a scant 1.1 percent, which is below the level most economists deem optimal. And so far this year, inflation on a monthly basis has been negative as often as it's been positive. The odds are growing that low inflation could become deflation—with some economists worried that it has already started to happen.
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If you feel like cheering, don't. The Federal Reserve, with a mandate to keep inflation in check, prefers a "Goldilocks" economy, neither too hot nor too cold, with modest growth and an annual increase in prices of 1 to 3 percent. But inflation projections for the next couple of years are now coming in lower than that, and Fed policymakers have begun to hash out what to do if overall prices actually start falling. Here's why deflation can be such a thorny problem:
Once it arrives, deflation is hard to cure. Sustained deflation can become a pernicious problem that's hard to shake even when the government attacks it, as Japan has learned over a prolonged deflationary period that began in 1991. Falling prices cut into revenue at firms that build things and provide services, so they need to cut costs to remain profitable. That usually leads to layoffs and pay cuts. When people bring home less money, they invariably feel worse off and buy less. So demand for products falls further, forcing even deeper price cuts to entice consumers. Breaking the cycle becomes a destructive game of chicken between companies and consumers, with neither willing to take the first step.
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The mere fear of deflation can cause it. The level of confidence in the economy can be self-fulfilling, especially with deflation. If consumers believe that prices in general are falling, they'll wait as long as possible to buy stuff they don't immediately need, to get the lowest price. Falling demand then forces merchants to cut prices even more, to lure buyers. A good illustration is the struggling U.S. housing market, where falling prices have kept buyers on the sidelines as they wait for the market to bottom out—while lack of demand sends prices even lower. This is one reason why moderate inflation is considered healthy. If consumers believe overall prices are going up over time, they might wait for discounts or seasonal sales on some stuff, but they won't wait indefinitely to make ordinary purchases. Deflation, by contrast, can badly distort buying decisions.
Falling prices can be ruinous. Deflation also wreaks havoc with lending and credit, which is essential to a healthy economy. When prices and wages are falling, debts become more expensive over time, which is the opposite of what happens with normal inflation. If your income were falling by 3 percent a year, for example, and you made a fixed mortgage payment every month, then the mortgage payment would eat up an increasing amount of your income over time. Such perverse economics encourages savvy investors and ordinary consumers alike to hoard cash, since a 0 percent return on money stashed under the mattress is better than "investing" money in a home, business, or other asset that's likely to fall in value. Since credit is the lifeblood of capitalism, a sharp cutback in lending and investing is a sure way to torpedo growth or make a recession worse. That's what happened in Japan during its "lost decade," and even now, Japan still struggles with deflation and its nasty side effects.
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Preventing deflation is tricky. The Fed has lots of experience at fighting inflation and fairly precise ideas for how to do it: Basically, raise short-term interest rates in order to raise the cost of borrowing, tamp down spending, and reduce the demand for goods, to help drive down prices. Doing the opposite to fight deflation works for a while, as lower rates make money cheap and boost the incentive to borrow and spend. The problem comes when the Fed's short-term rates get close to zero, which they are now. Since interest rates can't go below zero, this "zero-bound" problem forces the central bank to start pulling other, less-proven levers—like buying assets to inject money into the economy, which is essentially the same as printing money.
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The Fed has already executed some of those maneuvers, taking more aggressive action than bankers in Japan in the 1990s, who dawdled and made the problem worse. The Fed could do more if it seems necessary. The danger is that the Fed overshoots or guesses wrong, and ends up creating inflationary pressure that could force it to jack up rates down the road, which could choke off a recovery. At the moment, the Fed feels that deflation is possible but not likely, so it's sticking with policies geared toward low inflation. But the Fed has guessed wrong on the extent of unemployment and other issues, and its extended low-rate policy earlier this decade is widely viewed as a mistake that helped fuel the housing bubble. Let's hope the Fed has learned a thing or two.
Time for the Fed to blow the doors off. Inflation is deader than Jimmy Hoffa.
The Fed is exploring greater use of what is called "quantitative easing" and well it should.
The Fed, like many institutions, is often found re-fighting the last (as in previous) war.
Yes, yes, runaway inflation is a bad, and no one wants that. Yes, yes, we need resolve blah, blah, blah.
But now, the Fed could print money until the plates melt, and we won't get inflation for years. Unit labor costs are going down, commercial, industrial and retails rents are going down, and demand is feeble.
Deflation is corrosive to our banking system, and no one would or could ever buy property in a defationary environment. How do you lend on depreciating assets? If we have sustained deflation, every property owner in America, commercial or residential, will walk away from their property--the banks will collapse. Again.
Fiscal deficit spending might work, but we are already too indebted. This should be the Fed's hour, but instead we are getting the Fed's cower.
Additionally, as a practical matter, there is no way either of our two parties will balance the federal budget--so we need inflation to deleverage,
Waa--waa for the bond holders, but since when is any investment guaranteed? If you want absolute safety then you deserve minor negative returns. Rewards should go to equity holders, risk-takers--and this means a growth economy and some inflation.
I would rather live through a long inflationary boom than a long deflationary recession--and that is where we are headed unless we see some aggressive Fed action.
The key cause of pathological deflation (if we have any) is the collapse of "shadow money" caused by the inevitable collapse of the artificial boom across the long period structure of production -- i.e. the collapse of liquid assets premised on the wealth held in housing boom assets, inflated by Fed interest rate policy and the pathological housing policies of the Federal Government.
Your analysis misses the root cause of the type of "deflation" that you describe. The sudden, dramatic deflation described is damaging because of the sustained inflation we have experienced as a result of the fed's 1-3% inflation policy. The deflation that comes as a result of this type of intervention is necessary to remove the bad investments made while conditions were artificially distorted. The longer the inflation, the more dramatic the deflation.
The natural tendency of any free market system is subtle, consistent deflation. That type of deflation is not dangerous. Deflationary spirals are most commonly produced by inflationary monetary policy. There is a massive difference between the two both in their causes and effects.
It's not that this typical analysis needs to surrender to the Austrian's once and for all. It's that you need to stop ignoring Hayek and Von Mises completely and pretending that you have the issue covered from all possible sides.
Falling prices are the resolution for deflation. http://mises.org/daily/3296/
And Hyper-deflation is caused by the constant inflation created by the Fed's policy. 3% inflation in a year when productivity increases should have produced 5% deflation is actually 8% inflation. When the crash comes, a minimum 8% decline will be necessary to clear the market. It will no doubt be more because the 8% distortion further compounds the bad investments and drives capital away from more productive uses.
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final total catastrophe of the currency involved." LVM
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The global economy is mysterious, even scary. Chief Business Correspondent Rick Newman connects the dots. In addition to his writing for U.S. News, Rick is the co-author of two books: Firefight: Inside the Battle to Save the Pentagon on 9/11, and Bury Us Upside Down: The Misty Pilots and the Secret Battle for the Ho Chi Minh Trail.
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