 or
years, a number of economists have been warning that deflation was
the economy's most serious problem. Deflation is negative inflation,
or falling rather than rising prices. Of course, some prices are always
falling, even during periods of inflation. The term deflation, therefore,
refers to a simultaneous fall in a broad range of prices for many
goods and services.
The economists
warning about deflation argued that certain prices tend to lead
the general price level up or down. These include gold, the exchange
value of the dollar, and prices of long-term Treasury securities,
among others. The reason is that speculators, who sense that inflationary
or deflationary conditions may be arising, will attempt to profit
from this knowledge by buying commodities or assets that tend to
rise especially fast during inflations and selling them short during
deflations. Someone who sells "short" benefits from falling prices
because he sells first and then buys later, presumably at a lower
price.
When one sees
a sustained fall in sensitive commodity prices — those that
lead changes in the general price level — one can predict that
eventually this trend will work its way through the economy as a
whole. The lag, however, can be long because prices for most things
that people buy change only very slowly. Thus our measures of general
price changes, such as the Consumer Price Index, are really backward-looking.
Now we are
starting to see deflation showing up in price indexes. The CPI fell
0.3% in October, and the Producer Price Index dropped a huge 1.6%.
Economists and journalists who had previously pooh-poohed the idea
of deflation suddenly took notice. For example, on Nov. 2, Floyd
Norris of The New York Times wrote an article titled, "For
the First Time Since Ike, a Whiff of U.S. Deflation." A Nov. 12
Wall Street Journal report was headlined, "Falling Wholesale
Prices Give Whiff of Deflation."
This has led
to a counterattack by some economists, who maintain that inflation
is the true economic problem. Milton Friedman has warned that increases
in the money supply that have already occurred may lead to inflation
next year. Craig Thomas of Dismal.com
says he would strike the word "deflation" from the dictionary if
he could. Lew Rockwell of the Mises Institute said that even if
there is deflation, which he doubts, it is a good thing. Lower prices
just mean that he can buy the things he wants for less.
To be sure,
small, isolated episodes of deflation are nothing to be concerned
with. Indeed, they are an unavoidable consequence of achieving price
stability. It is impossible to have zero inflation month after month
even under the most stable price regime. But prices will tend to
fluctuate around zero over time, with brief periods of inflation
offset by equal and opposite deflations. That may be all we are
experiencing.
However, those
who have been warning about deflation for some time, such as Jude
Wanniski of Polyconomics.com,
say that because sensitive prices have yet to turn up, the recent
declines in the CPI and PPI will continue for some time, as past
deflationary forces work their way through the economy. These forces
are fundamentally monetary in nature and thus the result of a tight
Federal Reserve policy.
Therefore,
it is still possible that the worst of the deflation is yet to come.
If this is the case, the economy may fall further before it rebounds.
That is because deflation raises real interest rates. Since the
real rate equals the market rate minus the change in prices, deflation
adds to the market rate. Thus, if prices are falling 5% per year
and the nominal interest rate is a modest 3%, then the real interest
rate is actually a high 8%.
Sustained
deflations also raise real wages for the same reason. Higher real
wages force layoffs as employers try to economize on labor costs.
And deflation rewards creditors and those with cash at the expense
of debtors and those with illiquid assets. For these reasons, most
economists believe that a sustained deflation is far more damaging
to the economy than an equivalent inflation. Indeed, a recent study
from the Milken Institute argues that economic growth is maximized
at an inflation rate of between 1.6% and 3% per year.
The outcome
of this debate is important not just for economic forecasting, but
because the Federal Reserve is very much influenced by the conventional
wisdom among economists. When the Fed meets again on Dec. 11, the
topic of deflation will undoubtedly be on the agenda for discussion.
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