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Friday, November 29, 2002

Now the Washington Post Joins the Club: Deflation Fretting

Two articles in this weeks Washington Post illustrate how Bernanke's deflation 'wake up call' is going the rounds. In support of a generally upbeat analysis which tends to 'reassure' more than forewarn there seem to be four key arguments.

Firstly there is the clean bill of health of the US economy. In this Bernanke agrees with Greenspan that, at present, the U.S. economy is too resilient and too stable for some type of shock to generate a deflation. This is an assertion whose truth or otherwise we are about to witness. Of course the same argument was being used only a coulple of years ago to suggest that growth this decade would be higher than normal due to the large productivity improvements which were flowing from the new technologies. So while it may be true that the the US economy is financially and economically resilient, we could be entitled to entertain doubts. Stephen Roach's structural imbalances arguments would suggest otherwise. The cases of Enron, and WorldCom which are cited to reassure, could also be interpreted otherwise. Only if and when the housing boom ends will we know just how financially resilient the US banking system is.

A second line of argument from Bernanke runs as follows: "Under a paper-money system, a determined government can always generate higher spending and hence positive inflation". Unfortunately this is far from a universal truth, as Japan is finding out to her cost. One of the more preoccupying myths about Japan is that they have not been trying, believe me , they have.

Another of the disturbing myths is put forward by Alan Meltzer.In a new book, "A History of the Federal Reserve, 1914-1951," Meltzer of Carnegie Mellon University
suggests that the 1930's deflation and the resulting Depression were primarily the result of a mistaken Fed policy that allowed the money supply to decline sharply. Following this line Meltzer last week told an audience at the American Enterprise Institute that he was confident the Fed, using different tools, could deal with any deflationary threat. This US centric account of the Depression is far from complete. Sure the monetary policy purued by the Fed in the 1930's was open to question, in fact any human action, with hindsight, is open to question. The problem is to be right, on the right question, and at the right time. Is, for example, the monetary policy of the ECB now the right one for the right problem. Whatsmore, what if there is (as I suspect, and others argue coherently, more to the Depression than US monetary policy) then the defence is flawed. No one would dream of playing chess like this.

Finally there is the Japan argument. For Bernanke the inability of the Japanese government to deal with its deflation using monetary policy tools is not that the tools are inadequate but that the country faces multiple problems, including a huge overhang of bad loans on the books of its banks. "The failure to end deflation in Japan does not necessarily reflect any technical infeasibility of achieving that goal," he said. "Rather, it is a byproduct of a long-standing political debate about how best to address Japan's overall economic problems." Actions to deal with those problems, however, "will likely impose large costs on many, for example, in the form of unemployment or bankruptcy," So really, Japans failure is rooted in the incapacities of its political system. Sure, a worse system for putting out this fire would be hard to imagine. But still I beg to differ. The problems run deeper and are more intractable. The 'infamous' Fed paper also has its part to play here. Useful as this paper is for alerting to the danger and the need to act, and much as its contents need to be thoroughly assimilated here in Europe, ther is a danger that the paper can have precisely the opposite effect to that which it's authors intended. It could be used as saying, if only the Japanese had acted early and vigorously, as we of course have, then they wouldn't be in the mess they are now. I beg to differ. We need to dig deeper.

Federal Reserve Chairman Alan Greenspan recently assured Congress that "we are not close to a deflationary cliff," and that should the United States ever get near such a dangerous place, the central bank has the tools necessary to flood the country with money and get prices up and the economy moving again. In a speech last week to the National Economists Club, Fed Governor Ben S. Bernanke, an expert on monetary policy, acknowledged that some people have expressed concern that the nation could face a deflation -- a general decline in prices -- a perilous, debilitating circumstance in which borrowers have to repay their debts in dollars worth more than those they borrowed.

Bernanke said in his speech that the current concern about deflation "is not purely hypothetical" because it "is brought home to us whenever we read newspaper reports about Japan, where what seems to be a relatively moderate deflation -- a decline in consumer prices of about 1 percent a year -- has been associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems in the banking and corporate sectors."

Overnight interest rates in Japan have been pegged at zero by the Bank of Japan, that nation's central bank. But with deflation, when the nominal rate is zero, the inflation-adjusted rate, which is more important in terms of influencing economic decisions, is actually about 1 percent. In contrast, the U.S. financial system is in good shape, with financial institutions holding enough capital that they can absorb even very large losses, such as those associated with the bankruptcies of Enron, WorldCom and some other large companies, without severe damage to their balance sheets.
Source: Washington Post

After half a century of trying to prevent prices from rising too fast, economic policymakers have a new concern: Prices aren't rising fast enough. Government statistics show that average prices for products have declined in the past year, including those of cars, clothing, computers, furniture, gasoline and heating oil. So, too, have the prices for services such as telephones, hotel rooms and airplane tickets, even as costs for other services such as health care, housing, education and cable television continued to rise. The broadest measure of prices in the economy shows they rose less than 1 percent during the 12 months that ended in September, the smallest increase in 50 years.
Until now, the slowdown in overall inflation has been a boon to the American economy, giving consumers more for their money and allowing living standards to continue to rise even during a period of slow economic growth. But economists warn that if disinflation turns into deflation -- a broad and sustained decline in prices -- it would create a dangerous dynamic that could drag the economy into a nasty recession from which it could be difficult to escape. "If you had asked me a year ago, I would have said it was ridiculous to worry about deflation," said Alan S. Blinder, a Princeton University economist and former vice chairman of the Federal Reserve. "But the prospect of deflation is now sufficiently probable -- I'd say 15 to 20 percent -- that it's now worth talking about."

Deflation, like cholesterol, comes in good and bad varieties. The good kind, such as many of the price declines over the past few years, happens when companies find ways to produce goods and services more cheaply, usually by making use of new technology or new ways of doing business. In varying degrees, these productivity gains are passed on to consumers as lower prices, to workers as higher wages and to shareholders as higher profits. That makes almost everyone better off. By contrast, the bad kind of deflation occurs because there are too few customers chasing too many goods and services, resulting in repeated rounds of competitive price cutting that leads to layoffs, falling wages, and a decline in business investment and consumer spending.
Source: Washington Post

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