The Corner

Feeling Deflated?

In a recent issue of NR, John Steele Gordon, author of An Empire of Wealth: The Epic History of American Economic Power, writes:

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.

Others, however, say deflation is here. Others think it is not quite here but is a real, imminent threat. Here on NRO, we gathered a collection of economists and other experts to address the issue — including Kevin Hassett, David M. Smick, author of The World Is Curved: Hidden Dangers to the Global Economy, and Frank Hanna, author of What Your Money Means (and How to Use It Well), among many others. Read them all here.


The Latest