Deflation risk

There are plenty of things to worry about in the current economic situation. But deflation isn’t one of them.

Greg Mankiw had a great article last weekend in which he challenged the view that macroeconomists have learned enough to prevent a repeat of the Great Depression. Greg notes some disturbing similarities between our current difficulties and the problems of the 1930s:

From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today. The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks. As they withdrew their funds, the banking system’s normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households’ debts….Deflation across the economy is not a problem (yet), but deflation in the housing market is the source of many of our present difficulties. With so many homeowners owing more on their mortgages than their houses are worth, default is an unfortunate but often rational choice. Widespread foreclosures, however, only perpetuate the downward spiral of housing prices, further defaults and additional losses at financial institutions.

Greg is certainly correct that house price declines have a potential to cause similar problems today as we saw in the 1930s. But I believe it is more than an academic distinction whether we are talking about a relative price change (house prices go down but the dollar price of most other items goes up) or a true deflation (the dollar price of almost everything you buy goes down). The reason is that the latter problem is absolutely one that the Federal Reserve could fix, whereas the former problem may not be.

In a general deflation, the purchasing power of a dollar bill goes higher and higher, and as Greg notes, this can produce big economic problems, as it did for the U.S. in the 1930s or Japan in the 1990s. But it is absolutely a problem that the Federal Reserve can fix. If you increase the quantity of dollar bills fast enough, you’re sure to create inflation, not deflation. And the Federal Reserve has unlimited power to increase the quantity of dollar bills.

Some of my colleagues still talk of the possibility of a liquidity trap, in which the central bank supposedly has no power even to cause inflation. Their theory is that interest rates fall so low that when the Fed buys more T-bills, it has no effect on interest rates, and the cash the Fed creates with those T-bill purchases just sits idle in banks.

To which I say, pshaw! If the U.S. were ever to arrive at such a situation, here’s what I’d recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we’re at it! Print an arbitrarily large quantity of money with which you’re allowed to buy whatever you like at fixed nominal prices, and the sky’s the limit on what you might set out to do.

Of course, the reason I don’t advocate such policies is that they would cause a wee bit of inflation. It’s ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we’re flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.

Notwithstanding, I think Greg is raising a very valid point. Allowing the overall deflation in the U.S. in the 1930s and Japan in the 1990s was one quite fixable policy error. But perhaps modern macroeconomists have deluded ourselves into thinking that if this policy error had not been made, the whole episodes could have been avoided. How bad would the Great Depression have been if the price level had not fallen? Not as bad as it was, I’m convinced, but maybe still pretty bad.

I still like Brad DeLong’s perspective on all this:

Is 2008 Our 1929? No. It is not. The most important reason it is not is that Bernanke and Paulson are both focused like laser beams on not making the same mistakes as were made in 1929….

They want to make their own, original, mistakes..

Originally published at Econbrowser and reproduced here with the author’s permission.

2 Responses to "Deflation risk"

  1. Anonymous   November 7, 2008 at 9:26 am

    Don’t we already have “true inflation”?Most things are way down against the US dollar: equities, commodities, energy, houses, consumer goods, most other currencies … what’s going up? Certainy not wages.

  2. Guest   November 7, 2008 at 9:26 am

    Absolutely completely different problems to anyone who has studied the GD.