‘The rising threat of deflation’
This article was originally on a blog post platform and may be missing photos, graphics or links. See About archive blog posts.
The incessant deflation warnings from the likes of liberal economist Paul Krugman are an argument for another huge round of federal stimulus spending.
That has sparked attacks by conservative critics who believe that the deflation talk is baloney, and is merely aimed at justifying more government intervention in the economy.
But Krugman is getting support from an unlikely source: the conservative American Enterprise Institute. Or at least, the AEI allowed visiting scholar and economist John Makin to effectively come to Krugman’s aid under the institute’s letterhead.
In a paper headlined ‘The Rising Threat of Deflation,’ Makin last week noted that inflation has been a no-show despite the massive monetary and fiscal stimulus programs undertaken since 2008 in the U.S., Europe and Japan:
Many market participants and policymakers have warned that such aggressive easing will lead to inflation. Contrary to those expectations . . . core inflation has steadily moved lower in the United States and Europe and is approaching outright deflation, which Japan is already experiencing. By later this year, persistent excess capacity will probably create actual deflation in the United States and Europe.
I realize that many people will say they aren’t seeing prices go down for most of what they buy, but Krugman, Makin and other deflationistas warn that the trend is rapidly heading in that direction. A slowing U.S. economy will just egg it on.
The year-over-year increase in U.S. core inflation (consumer prices excluding food and energy) was just 0.9% in May, a 44-year low. The June report is due from the government on Friday, and it is expected to show continued price weakness.
Of course, if you have loads of cash and no debt, falling prices sound wonderful. But the danger, as Makin notes, is that a broad deflation could cause many people to stop spending and hoard cash, figuring that they could get whatever they wanted for less if they just waited.
That’s the economic death spiral that the Federal Reserve fears more than anything else. Falling prices could then lead to a new recession, or worse, as companies’ sales plunge, slashing profit margins and fueling a new round of layoffs and/or wage cuts.
‘There is a bigger risk that deflation will intensify sharply because once the price level actually starts to fall, the demand for [cash] will be further enhanced,’ Makin wrote. ‘A deflationary spiral -- a self-reinforcing, accelerating drop in the price level -- can result. This is because a falling price level means that cash ‘earns interest’ since it enhances the purchasing power of otherwise sterile cash assets that pay zero interest.’
As I noted in this recent column, plenty of people and companies already are hoarding cash (more than $5 trillion) in bank accounts that pay virtually nothing.
Sounding exactly like Krugman, Makin asserts that this is the wrong time for governments and central banks to pull back on financial aid to their economies:
At this point in the post-bubble transition to deflation, fiscal rectitude and monetary stringency are a dangerous policy combination, as appealing as they may be to the virtuous instincts of policymakers faced with a surfeit of sovereign debt. The result of Europe’s embrace of fiscal rectitude will be -- paradoxically in the eyes of some -- to export deflation to the United States, Asia and the emerging markets.
If this sounds like the only way to avoid a deflationary spiral now is to set the stage for an inflationary cycle later (by further loosening monetary and fiscal policy), that’s exactly the risk -- or the opportunity, depending on your perspective.
-- Tom Petruno