By Donald Losman Friday, November 26, 2010
Filed under: Economic Policy, Boardroom, Government & Politics
Federal Reserve Chairman Ben Bernanke clearly worries about a deflationary spiral. That explains, in part, his push for and vigorous defense of so-called quantitative easing. St. Louis Federal Reserve President James Bullard has also expressed deflation concerns, as has Eric Rosengren, president of Bostonâ??s Federal Reserve Bank. Smart Money magazine, in its October issue, published poll results showing that 40 percent of respondents are worried about deflation, with one of its columnists writing that the â??latest scare for already nervous investors â?¦ is deflation.â?
It is true that price-level measures have indeed been subdued. The Consumer Price Index (CPI) showed a one-tenth of a percent increase for September and a two-tenth percent increase for October. In the past, this has generally been good news, lauded as successful anti-inflationary policy creating a relatively stable price level. Today it is interpreted as something nefarious.
The deflation chorus frequently invokes the image of a deflationary Japan, a former economic success story gone awry. While Japanâ??s problems for two decades have been real, fears of a Japanese-style deflation in the United States are excessive and, if continued or magnified, likely to generate negative sentiments that bias both private behavior and public policy. Simply put, we are not Japanâ??we have enormous demographic, cultural, and policy differences. For several significant reasons, deflation is very unlikely.
First, the Federal Reserveâ??s efforts to keep the economy afloat have resulted in the banking system holding roughly $1 trillion in excess reserves. As banks start lending again, these could yield major future increases in the money supply, placing upward, not downward, pressures on price levels.
Second, the business community has enormous cash stockpiles that will eventually turn into spending and investing. U.S. nonfinancial corporations, for example, have almost $2 trillion in cash, the highest amount in more than 50 years. Formerly spendthrift American households have, at least temporarily, changed their ways, and sit on $8 trillion in cash or near-cash. Hedge funds, too, have raised their already relatively large cash holdings, by roughly 20 percent over the past four months alone.
Inflationâ??s traditional cause is too many dollars chasing too few goods. As balance sheets and cash holdings improve, we couldâ??and eventually willâ??see the revival of considerable spending, although it is hard to estimate exactly when this will happen. Let us not delude ourselves into believing that John Q. Publicâ??s recent conversion to penny-pinching is a complete change in personality. More likely, it is a reasoned response to adverse conditions, with reversion to the mean to be expected in improved times.
Third, there are some serious measurement issues involving price-level calculations. Many mainstream economists generally view a CPI increase of 1 percentage point to be masking 1- to 2-percent deflation, since quality improvements are alleged to be inadequately reflected in the official numbers. This popular view, however, ignores widespread quality deterioration, particularly in the service sectors. Very few Americans have not suffered inordinate waiting times and the â??press one, press two, please holdâ? routine when calling their banks, insurance companies, and doctorâ??s offices. While airline â??pat-downsâ? are a hot current complaint, problems like longer waiting times, closer seats, less leg room, and delayed take-offs and arrivals all escape the CPI. In the medical field alone, a 2006 survey found that the average wait to get a dermatologist appointment was 38 days, while in Boston it was 73 days. Persistent overbooking also means longer time in the office waiting for a doctor. If such degradation outweighs quality advancesâ??a strong possibility, in my viewâ??real inflation may be higher, not lower, than the price indices suggest.
There are also technical measurement issues, as Nobel Prize winner Vernon Smith pointed out. In 1983, the Bureau of Labor Statistics substituted â??rent-equivalentâ? for the direct costs of owner-occupied homes, an adjustment which yielded a minor CPI understatement of inflation through 1996. Between 1999 and 2006, however, the price-to-rent ratio increased more than 50 percent, leaving â??an important component of inflation remaining outside the index. In 2004 alone, the price-rent ratio increased 12.3 percent.â? Smith calculated that if â??home-ownership costs were included in the CPI, inflation would have been 6.2 percent instead of 3.3 percent.â? Here again, we may be a lot further from deflation than official numbers suggest.
Finally, the dollar has lost almost 30 percent of its value against gold over the past year. Gold is a traditional inflation hedge, suggesting that while Bernanke apparently fears deflation, the marketâ??s concerns are the opposite. In a related vein, another factor likely to spur more inflation rather than deflation is the price of oil, which has been steadily rising and will likely continue to do so, for two reasons. The economic reason is that a recovering global economy will raise the demand for oil, putting upward pressure on its price. The second reason is that oil, traditionally priced in dollars, has generally risen in cost as the dollar depreciates.
This worm can turn very quickly. Indeed, in late June the Swiss National Bank suggested that deflation risks have just about disappeared in their country and inflation has been inching upwards, expected to rise 2.2 percent in 2012 and 3.1 percent in 2013. While their unemployment rate is much lower than ours, Americaâ??s real economy will one day recover and inflation threats could, as in Switzerland, easily reappear.
The likelihood of deflation is further dampened by the position of the dollar. In the future, the dollar no doubt will fall relative to a number of Asian currencies, particularly Chinaâ??s. And on August 20, the dollar began a decline against the euro. While that trend has been interrupted, a successful resolution of the Greek crisis will likely continue that decline. A reduced currency value will raise the cost of imports, again inflating rather than deflating average American prices. Allan Meltzer, the dean of American monetary economists, noted in July that there have been just seven periods of deflation in the last 97 years. â??Only one, 1929-33 brought the country close to disaster.â? The others were mildâ??the last being 1960-1961, a slowdown whose recovery looked like most other recoveries. The end is not near!
Finally, a small bit of deflation is no more problematic than an equivalent modest inflation, say 1 to 1.5 percent each year. Such inflation rates barely gain notice and hardly distort economic calculations. A deflation of similar magnitude would be similarly uneventful. Further, a little deflation should evoke smiles from those no longer in the labor force. While wage recipients enjoy productivity gains via higher pay, retirees and stay-at-homes are left out of generalized productivity advances because they no longer earn wages. With modest deflation, however, they can share in societyâ??s productivity gains via lower prices and experience a modest rise in the purchasing power of their savings.
American policy makers must understand that false fears about extreme deflation can lead to negative business and investor expectations as well as ill-advised public policy.
Donald Losman is professor of economics at the Industrial College of the Armed Forces, National Defense University. The views expressed are solely his own.
Image by Darren Wamboldt/Bergman Group.
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