Probably Not
Although inflation has been America’s main economic problem for the entire post-war era, a number of economists think deflation is the biggest threat now. This is a measure of how severe the economic crisis has become in recent months.
What, exactly, are inflation and deflation? Simple: changes — downward and upward, respectively — in the price of money.
Money is just a commodity, like pork bellies, legal services, or magazines. And like all commodities, money is subject to the law of supply and demand. If the supply increases relative to demand, the price goes down; if the supply decreases, the price rises.
But money is a very special commodity. In a modern economy, money is almost always found on one side of a transaction. Further, money is the unit of account, the commodity by which all other commodities are measured.
Because money is such a special commodity, we have a special word for a fall in its price: inflation. While the word is surprisingly modern (it was first used in this sense in 1864), the reality goes back to the earliest days of money itself. Roman emperors in the third century seriously debased the coinage, so the people, no fools, demanded more and more coins for their goods and services. Prices rose by 1,000 percent over 20 years.
When inflation occurs, government is the usual suspect, but it’s not always guilty. In the 16th century, gold and silver brought over from the New World greatly increased the European money supply, and prices quadrupled over the course of the century.
Inflation is harmful for a number of reasons. For one, it tends to feed on itself: As prices rise, workers demand higher wages. When companies pay higher wages, they pass the costs to their customers through higher prices, which prompt calls for still higher wages. Also, because loans are denominated in the currency that is inflating, their value decreases proportionately. So lenders demand ever higher interest on them.
Of course, it’s an ill wind that blows no one good. Inflation is great for those who have already contracted debts, because they can pay back those debts with cheaper money. This is just as true of the federal government as it is of someone with a mortgage: In the 1970s the national debt nearly tripled in dollar terms, but because of roaring inflation that reached into double digits toward the end of the decade, the debt actually declined as a percentage of nominal GDP.
If an inflationary spiral gets out of control, the results can be devastating. In 1923, the German government was issuing bills in denominations as high as a hundred trillion marks, and even these bills bought nearly nothing. This wiped out the financial assets of the German middle class as their savings became worthless.
But assuming there is the political will to do it, inflation can always be stopped. Paul Volcker, then chairman of the Federal Reserve, proved that in 1981–82. The Fed sharply raised interest rates and increased the amount of money banks were required to hold in reserve. This damped down lending, and thus demand. The economy cooled, and the inflation subsided. As is often the case, this was a painful process: Unemployment reached 10.8 percent in November 1982, the highest since the Great Depression.
Deflation can be as harmful as its opposite — though, just as inflation is good for debtors, deflation is good for creditors, up to a point. Deflation often results when a credit crunch causes a drop in the money supply. Here’s how that process unfolds.
Today, banks create most money, and do so by making loans. Say you go to the store and put the cost of a flat-screen TV on a credit card. The bank that issued the card is quite literally creating money, rather than just transferring money, because loans are assets to a bank: By loaning you the money, it is creating an asset for itself while its liabilities (its deposits) remain unchanged. This increases the money supply.
When banks face a spate of bad loans or have to write down the value of questionable assets, they often must curtail credit to stay within capital and reserve requirements. They call in demand loans (as the name implies, these are loans the borrower must repay on demand) and cut credit lines. If enough banks do this, a credit crunch develops, and since credit is what creates most money, the money supply drops. Companies and people then buy less, cutting demand for many commodities. As demand falls, so do prices. As companies selling those commodities take in less money, they cut the number of employees and, if things get bad enough, cut wages for those left. This further cuts demand, and a deflationary spiral begins.
Deflation is much harder to fight than inflation. Inflation can always be stopped by raising interest rates sufficiently and taking other actions to reduce the money supply, but the standard remedy for deflation — lowering interest rates — can go only so far. Interest rates, after all, cannot fall below zero. Banks will not pay you to borrow money.
Japan, for several years after its stock-market and real-estate bubbles burst toward the end of 1989, fought deflation with what were effectively 0 percent interest rates. It did not work. Deeply ingrained habits of Japanese consumers kept demand down (they tend to save more money than consumers elsewhere), while people remained wary of putting their money in the many Japanese banks with bad loans on their books.
The government also tried to prime the pump with massive infrastructure projects and aid for insolvent corporations. This did little more than give Japan the highest national debt as a percentage of GDP of all major countries. Japan’s debt today is about 170 percent of GDP, versus 72 percent for the U.S. No wonder the Japanese call recent years “the lost decade.”
As for America, it’s unclear how big a problem deflation will be. If we are in for an extended period of deflation, it won’t be the first: In the depression of 1837–43, the money supply fell by about a third. After the Civil War, rapid industrialization created huge efficiencies of scale, causing lower prices, while the gold standard kept the money supply relatively flat. The late economist Milton Friedman calculated that prices fell about 1.7 percent a year between 1875 and 1896.
One modern factor that could cause deflation is the housing-bubble collapse, which has certainly created a credit crunch. Default rates on mortgages rose and the prices of mortgage-backed securities declined markedly, leaving banks no choice but to reduce credit sharply. In September, as once-mighty financial institutions such as Lehman Brothers and Wachovia Bank became insolvent, many banks refused to lend at all, even to other banks overnight. The whole credit market began to seize up.
Many commodity prices have declined sharply, especially that of oil, which dropped by an astonishing two-thirds from its high in July. Altogether, prices declined by 1.8 percent in October, the sharpest one-month drop in more than 60 years.
There are reasons for optimism, however. Certainly the federal government will not make the same mistakes that turned the recession of 1929 into the Great Depression — the Fed kept money tight to fight inflation and defend the gold standard in 1930 and ’31, even after the money supply began to fall. In other words, the Fed treated the patient for fever even after he had begun to freeze to death. And Congress raised taxes substantially in the summer of 1932 to help balance the budget. The economy, already contracting sharply, went into free fall.
Further, while the federal government spent about 3 percent of annual GDP in 1930, today the figure is over 20 percent. This, together with such safety-net programs as unemployment insurance, acts in the economy the way a flywheel does in a machine, inputting energy to keep the machine cycling steadily even when other factors work to slow it down.
And Americans are not like the Japanese, with their high savings rate. Americans are optimistic by nature and very consumption-oriented. They may hunker down for a while, but not for long if they have a choice.
So, most economists predict no more than a sharp recession, such as the one the country experienced in 1981–82. Those predictions, of course, are predicated on the situation’s stabilizing. If there is another wave of major bank failures or a full-blown crash on Wall Street, all bets are off.