Almost everybody prefers inflation to deflation. Certainly, economists and politicians do. And the general public prefers inflation too. Why do you think Viagra sells so well? But you have probably noticed that those TV ads for drugs to cure erectile deflation warn that if you experience medically induced concupiscence for several hours, you should see your doctor.
And that’s exactly our economic dilemma these days: we are printing so much money to conquer deflation that we might be hit with fearful inflation as soon as we recover. According to the Wall Street Journal, the United States has pledged to spend, invest, or loan as much as $10 trillion to fight deflation. President-elect Obama wants to toss in another trillion bucks soon, probably to be followed by much more. The government and the central bank will get some of this money back, but much of it could turn into inflation. The Federal Reserve has not only lowered short-term interest rates to almost zero but it has also run the monetary printing press to buy bonds so that long-term interest rates, particularly on mortgages, will come down.
To make sure that deflation doesn’t quickly morph into inflation, the Fed will have to be nimble to raise interest rates as soon as the economy appears to recover. It has never displayed such agility, partly for political reasons. Politicians love easy money; it’s like distributing booze to voters on Election Day.
On December 16, the Fed lowered the federal funds rate, the interest banks charge each other, to a range of zero to one-quarter of a percentage point — a big markdown from 1 percent and the lowest rate on record. But in some senses, it was meaningless: banks haven’t been loaning to one another, so the rate was effectively around zero already. Also, the Fed has already been buying bonds to bring long rates down. Bottom line: neither strategy has been working. The economy seems to get worse every day, and both consumer and producer prices are falling.
Monetary policy has clearly not whipped deflation. In their private moments, policymakers are afraid of a rerun of the 1930s. Why is deflation scary? Buyers delay their purchases, figuring that prices will be lower in the future. This leads to a down-spiral. Deflation encourages saving because money will be worth more in the future — the reverse of inflation’s incentive. As people save, they purchase less. The government and central bank want them to resume the old habits of borrowing too much to consume too much. “It’s not clear to me that we could or should make people consume more,” says James Hamilton, economist at the University of California, San Diego. “Running up the debt is part of the problem that got us here in the first place.” Amen.
Critics say that Japan tried zero interest rates to no avail during its 1990s depression. The money the Japanese government poured into infrastructure spending didn’t jump-start the economy either. But Todd Buchholz, San Diego author-economist with degrees from Cambridge and Harvard, says Japan is not such a good analogy. “I wrote an article calling their strategy ‘Hoover Economics,’ ” says Buchholz. “They raised taxes. The yen went up, and they couldn’t do much about it. It took years for them to recognize that their financial institutions were zombies that they wanted to keep propping up. It was a zombie economy.” Buchholz believes that the United States’ policy of driving down both short rates and long rates will succeed.
But others argue that this is not a credit crisis. It is a debt crisis. As in the 1930s, people do not want to borrow money to spend. Period. The Fed can pour money into banks, as it is now doing through several strategies, such as buying equity in the institutions, but it won’t work if the horse that is led to water simply won’t take a drink. In trying to get consumers to spend, the central bank will in effect be pushing on a string.
Some years back, the government and its central bank decided — secretly — that the best strategy would be to induce inflation of asset prices instead of inflation of goods and services. Everybody would be happy. So first we had a stock market bubble, then a housing-price bubble, then a commodities bubble. All the bubbles popped ignominiously, wiping out investors who would probably have preferred having their grocery and gas prices go up. “I don’t remember another time when we had a [tech-stock], housing, and commodities bubble in such a short period of time [as we did leading up] to 2008,” says Buchholz. “I hope we learned our lesson.” He doesn’t think the Treasury and Fed are plotting another bubble, even though interest rates are lower now than they were during the other crazes. He doubts that the people will stand for it. (Some argue that point.) But Buchholz doesn’t foresee consumer inflation: “It’s going to be a trick, but I don’t believe high inflation is baked in the cake.”
Ross Starr, economist at the University of California, San Diego points out that “in the 1930s, interest rates were near zero, the banks were very liquid, had immense cash reserves, but there was a shortage of lending opportunities.” People just didn’t want to borrow; they were too insecure — hardly surprising, with unemployment so high. Starr concedes, “It’s perfectly possible that today the strategy of quantitative easing [running the monetary printing press] and zero interest rates will fail.” But he doesn’t think so. He thinks people now delaying real estate purchases will take advantage of lower interest rates. “Prices are now more reasonable; now we need the credit to permit them to buy.”
The federal government will pump money through the system by making direct gifts to ailing states, propping up unemployment benefits, financing public works that are already in the pipeline, and creating new energy programs. The trick with these infrastructural programs is to get the money into the system quickly. He agrees that “households are looking at their balance sheets; they were robust a few years ago because of real estate values and 401(k) values, and they may save money to replenish their balance sheets. But I hope there are enough consumers out there to buy homes that have been postponed.”