Not to Deflate You . . .
Are we there yet?


‘Deflation is everywhere right now. Housing prices, gas prices . . . ” says California businessman Rob Arkley. But, he quickly adds, “Fear not. These are not necessarily certain signs of permanent deflation. In fact, I don’t think that deflation is much of a long-term problem. Politicians will not let it continue for long.”

Are we in a Christmas season of deflation? If not, is it coming? Is there anything we can do to stop it? Perhaps it is not inevitable, but could happen if we don’t play our cards right? What is your thinking and what are your cautions?

I think deflation is our economy’s fundamental problem. Unlike in the early 1930s, however, it is not caused by a shrinkage of the money supply, but by a sharp decline in velocity — the speed at which people and businesses spend money. Since velocity is the ratio of the money supply to GDP, it means that the same quantity of money will support a smaller nominal GDP. This will require either a decline in prices or a fall in output. Right now we are seeing both.

The Fed, to its credit, is attempting to expand the money supply to compensate for the fall in velocity. But it is hampered by the extremely low level of interest rates on Treasury securities. On Friday the yield on three-month T-bills was 0.01 percent. This indicates the existence of a liquidity trap. It means that the Fed cannot expand the money supply by buying Treasury bills since there is at this point essentially no difference between a Treasury bill and a dollar bill.

The Fed must become more creative and buy longer-term securities and others that have higher yields. Fed Chairman Ben Bernanke has indicated a willingness to do so, but it will still take time for new money to circulate and stimulate consumer spending, business investment, and bank lending.

Bruce Bartlett was a White House economist in the Reagan administration and a Treasury Department economist in the George H. W. Bush administration.

A central point of Milton Friedman’s work was that the Fed caused the Depression by allowing the money supply to collapse, causing sharp deflation. The Fed should maintain a stable effective supply of money, including raising the supply to offset any declining velocity. But the real solution is a stiff dose of Reaganomics, which would get the real sectors of the economy booming again, in turn unfreezing the credit markets as lenders are induced to participate in the boom, aided by a new worldwide influx of investment capital. The resulting boom is also the only good way to stop the decline in housing prices, and, of course, would short-circuit deflation. 

– Peter Ferrara is director of entitlement and budget policy for the Institute for Policy Innovation.

Historically, deflation has sometimes helped economic development in the U.S. After the Civil War, we had several decades of deflation while the U.S. greatly expanded industrial production. The increasing supply of goods and services (and competition among suppliers) led to both slow deflation and strong economic growth. Kerosene, for example, went from 58 to 8 cents a gallon and John D. Rockefeller’s Standard Oil Company not only made America energy independent, it also supplied over half the oil used by all nations on Earth. The U. S. became a world power. Many Americans today are enjoying the falling prices of oil, copper, and other commodities.

Deflation can be a problem if it results from low purchasing power (liquidity) or a decline in money supply, which in the 1930s helped cause the Great Depression. Fed policy led to this problem then, which suggests the possibility that federal tinkering is the cause — not the solution — for both inflation and deflation. In the 1930s, for example, Roosevelt artificially raised the price of gold and silver to attack deflation, and then, under the AAA, paid farmers not to produce. In doing so, he traded deflation for a prolonged Great Depression. Ouch!

– Burton Folsom Jr. is professor of history at Hillsdale College and author of New Deal or Raw Deal? (Simon & Schuster, 2008).

The credit markets are like a stopped-up pipe. There’s something not very pretty stuck down there, preventing much new credit from getting to borrowers. The pipe poses two grave dangers, one if it stays clogged, and the other if it doesn’t.

Without credit, there is little buying. When credit dried up for overvalued housing two years ago, house prices started to plummet. Now, the credit crisis is affecting the price of goods and services.

As demand for everything from steel to luxury purses has plummeted by double digits, the consumer price index declined by 1 percent in October compared to the previous year, the sharpest drop on record.

This deflation, if sustained, has chilling implications. Foreclosures and other debt defaults will rise as old debt becomes more expensive relative to new, lower prices.

That’s why the Fed is furiously pumping money and its own credit into the stuck pipe, trying to get some of it past the clog to borrowers. It’s not working, yet.

What’s the best-case scenario? That over time, what the Fed is doing will work — but not too well. By creating credit modestly for consumers and businesses, the government can make what’s already going to be a painful but necessary adjustment — a mass switchover from consumer borrowing to saving, and a continued decline in house and other asset prices — a little less painful. If this happens, and if the Fed sees that it’s happening, it can mop up some of the extra money and credit it has tried to push into the economy before . . . well, before it turns into a worst-case scenario.

What’s the worst-case scenario? That suddenly, and mysteriously, the pipe may unclog, sending all of the money and credit the Fed has created into the economy, vastly amplifying it, too. Suddenly, the economy would have more money and credit that it knows what to do with. At the same time, the stuff to buy with that money and credit would have become more scarce, because of all of the missed farm-growing seasons, factory closures, and layoffs we’re hearing about today.

Deflation and hyperinflation are opposites, but it’s a very thin line.

Nicole Gelinas is a chartered financial analyst and a contributing editor of City Journal.

“Is deflation coming?” It’s already here!