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Deflating Deflation

This isn't Germany or Japan; the Fed will step in if prices fall dangerously.

June 08, 2003|Robert M. Solow | Robert M. Solow is institute professor emeritus at MIT.

CAMBRIDGE, Mass. — The 17th century French mathematician and philosopher Blaise Pascal suggested that it was worth betting that God existed; the chances of winning were very small, but the reward was great if you won. Today's talk about deflation -- a continuing general fall in prices -- is like that: The event is very unlikely, but the consequences could be important. In this case, however, the probability of deflation actually happening in the United States is so very small that the current chatter is a diversion and a waste of time.

Deflation is bad for several reasons. First, it transfers wealth from borrowers to lenders. If you have to pay back a loan in dollars of higher purchasing power than the dollars you borrowed, that is a real burden. Second, because the Federal Reserve, which sets monetary policy, cannot push interest rates below zero, falling prices can severely limit its capacity to act just when it is needed. Finally, deflation can easily become cumulative. If buyers decide to wait until prices get lower, they will make it happen, and that will encourage more waiting, so prices will fall further.

That some prices are already falling is not evidence that deflation is here. Not so long ago, when inflation was the danger of the month, we often heard it said that a stable price level was the proper target for economic policy. But if prices are steady on average, roughly half of them have to be falling at any moment, and the other half rising. That is what price stability means in a dynamic economy.

What is the current state of affairs? If you look at all the hundreds of prices that are tracked by the Bureau of Labor Statistics as elements of the consumer price index, you can list them in order: from fastest rising to steady to fastest falling. In the middle of the list are goods and services whose prices are rising at about 2.6% a year. Half of all prices are rising faster than that, and the other half less fast. The prices at the bottom, the ones that are falling, can only be a small fraction of the total. Even in manufacturing, 70% of all prices are rising. That does not look like deflation at all.

If consumers are asked how much they expect prices to increase during the next year, the average answer is about 3%. They may be right or wrong about that. But there is no reason for consumers to hold off buying in general to wait for lower prices because they do not expect prices in general to be lower.

Well then, what about Japan, where deflation is real, and Germany, where deflation threatens if it has not already arrived? Japan and Germany differ from each other, and both differ from the U.S.

Japan has been seriously depressed for a dozen years. Its stock-market bubble was bigger than ours and was matched by a giant real estate bubble. When both bubbles collapsed, the Japanese economy suffered an enormous loss of apparent wealth. Neither the Ministry of Finance nor the Bank of Japan rose to the occasion. They were living examples of too little, too late.

Why? Probably because the ministry and the bank suffered from obsolete economic analysis and ideology and also because they were unwilling at the time to reveal how deep in the tank Japanese banks had fallen under the burden of bad loans and evaporating collateral. By now, the problem has become even more difficult because years of falling prices have created the expectation of continuing deflation.

Germany is a different story. German industry has become noncompetitive within Europe. High labor costs are the most obvious reason but not the only one. Not so long ago there would have been an obvious remedy: a devaluation of the deutsche mark to get German costs in line with European prices. But there is no longer a deutsche mark, and the value of the euro affects all European countries equally. Since the rest of Europe has very low inflation, the only way to bring German prices into line is by actually lowering them. The German recession is forcing that unattractive deflationary outcome on the economy. That risk was always inherent in the formation of the European Monetary Union.

Neither the Japanese nor the German story applies to the U.S. What we have in this country is low inflation and a weak economy. So, some prices are falling. What really needs attention is the near-stagnation that leaves companies able to meet slowly growing demand for goods just from the benefits of rising productivity. The result is that some jobs are destroyed and fewer are created.

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