Analyzing the Deflation Scare

WASHINGTON-The scare word being whispered around Washington these days is "deflation." It means a falling price level and it sometimes implies a stagnant if not collapsing economy.

Deflation is the opposite of inflation, a rising price level which in the 1970s haunted America and other industrial countries.

So far, despite the sluggish U.S. recovery from the recession of 2008-2009, the price level has continued to creep up, but slowly. Consumer prices in June were about one percent higher than a year earlier.

"Deflation" has not crept into the language of Main Street yet, but in Wall Street and in Washington, people who worry about the economy are mindful of this possible threat to economic recovery from an unfamiliar direction. The spring slowdown in the economy - from an annual rate of GDP growth of 5% in the fall of 2009 to an "advance" estimate of 2.4% in the second quarter - ignited fear that a falling price level might be in the offing.

Japan set the Fed to worrying about deflation in 2001-2004. Yet it was the underlying economic structure of Japan and policymakers' errors, rather than deflation, that caused its economic problems. Its export-led growth, with government support for particular firms, made it difficult for new businesses to prosper.

Further, the Hashimoto administration raised consumption taxes in 1997, thinking that the economy had properly recovered, thus sending the economy spinning back into recession despite a global economic boom. This has parallels to the expiry of the Bush tax cuts and proposals for a value-added tax.

The Fed policy-making committee will meet again next Tuesday. The risks of deflation vs. a revival of inflation are sure to be discussed, but the Fed is not expected to depart significantly from its strategy of keeping short-term interest rates close to zero while starting to withdraw the billions of dollars of mortgage financing it injected into credit markets.

One Fed policy maker, President James Bullard of the Federal Reserve Bank of St. Louis, says that deflation is a real risk. Interviewed on CNBC on July 30, he said that if "actual inflation continues to drift down, we could get into a sticky situation here." He meant falling price levels, which economists fear might start a downward economic spiral.

The American Enterprise Institute's John Makin declared yesterday, "There's a real reason to be concerned. It kind of sneaks up on you."

Other prominent monetary experts disagree. Professor Charles Calomiris of Columbia University's Graduate School of Business told me, "I don't think we are experiencing deflation at the moment, but if we do, I'm sure that the Fed can and will stop it easily. It is nonsense to see it as a worrying threat."

Concern about deflation marks a sea-change from 1970s' thinking, when fears of inflation drove up interest rates. In the 1980s, even as the Fed was subduing double-digit inflation, home buyers accepted mortgage interest rates above 10%. Now, some buyers can get a fixed-rate mortgage for less than 5%.

For a guide to the influence of monetary policy and falling inflation on the economy, there's no better read than Robert J. Samuelson's 2008 The Great Inflation and Its Aftermath, just reissued in paperback by Random House, with new sections that discuss recent developments. Samuelson, an economics columnist for Newsweek and the Washington Post, offers insights particularly pertinent to politicians, economic policymakers, investors, businessmen and the public.

Crucially, Samuelson teaches, the Fed's independence from politics gave it hard-won credibility in the early 1980s and should not be taken for granted now. Samuelson is aware that President Obama has just appointed three people to open seats on the Federal Reserve Board, people who are expected to lean against an early shift towards credit restraint.

San Francisco Federal Reserve president Janet Yellen, MIT professor Peter Diamond, and Maryland regulator Sarah Raskin were approved by the Senate Banking Committee on Wednesday and await a vote by the full Senate in September.

In the 1970s governments attempted to maintain popularity by pursuing full-employment policies at the expense of a stable price level, Samuelson recounts, and he sees a risk that mistake will be made again. While America had a loose monetary policy in the early years of this decade, Germany accepted short-term pain between 2001--07 to restore its economic competitiveness. Now, Germany's unemployment rate is two percentage points lower than America's.

Failed attempts by Presidents Johnson, Nixon and Carter to micro-manage the economy should also provide a cautionary note to the Obama administration as it attempts to pick winners and losers. The new Consumer Protection Bureau, located within the Fed, has the power to judge which industries and companies to save now and which to allow to go bankrupt.

Samuelson told me this week that he believes deflation is unlikely. The case for deflation seems powerful, he said, given excess supply, empty office space, surplus labor, and wage cuts. But what shows up in aggregate statistics often masks individual sectors, which have curtailed capacity and so have been able to keep prices high.

Take the airline industry. As traveling diminished, airlines cut back on flights and staff, and prices for air travel are actually higher than last summer. Other industries will do the same, and any signs of renewed growth will lead to firming of prices.

What is of greater concern than deflation, Samuelson said, is that "our underlying structure is on an unstable path and we won't generate demand and employment."

Samuelson makes sense. If policymakers consider and heed his policy prescriptions in the final chapter of The Great Inflation and Its Aftermath - control inflation, cut back on entitlements, encourage honest free trade, and calculate costs as well as benefits of environmental legislation - then economic growth is likely to return and deflation will prove to be a moot point.