Monday, November 2, 2009

Dealing with deflation (also What I'm reading, November Edition)

Some good press on NPR and the Wall Street Journal led me to the new book from Bruce Bartlett, The New American Economy:The Failure of Reaganomics and a New Way Forward.  I'm sure that sounds horrendously boring to 99.99% of people, but I haven't moved that fast to buy a book since the last Harry Potter novel. I'm odd, what can I say.

It's fascinating to me that a man credited with creating and implementing supply-side economic policy in the Reagan years can write such a profound endorsement of Keynesian economic ideas.  It takes true intellectual honesty to call into question everything you have ever written previously, and say "You know, I might have been wrong."  That kind of integrity is worthy of my reading.

The New American Economy starts with a reminder on the causes of the Great Depression, and how similar those causes are to what caused the crisis of 2008.  Bartlett points out that Roosevelt initially rejected Keyne's ideas for running deficits to stimulate the economy out of a period of entrenched deflation.  For all the immediate expansion of the federal government that Roosevelt pushed through, they were funded with tax increases.  Only when the economy faltered again in 1937, Roosevelt was forced to rethink his ideas.  Manufacturing support of Europe in WWII was born out of economic necessity as much as it was out of national defense worries.

It's important to point out that dealing with deflation is a much tougher task than dealing with inflation.  The 2008-2009 crisis was made even more difficult because we already had exceptionally low interest rates.  There was not a lot of room for maneuvering by the Federal Reserve because you can't go below 0% interest rates, after all, banks won't loan money at a negative interest rate.  Under a scenario of inflation, there is no upward ceiling on how high you can raise rates to check rising prices.  The Fed though, can only encourage money circulation, it can't actually spur spending when the public fears that prices will continue to fall.  Deflation is the nastiest of economic beasts because of the impact it has on consumers attitudes.  People fear spending money and producers fear capital investment.  Additional measures are required beyond just making capital available through loans.  As Bartlett says, only lowering interest rates in a period of deflation is like trying to get fat by buying a bigger belt.  You've enabled capacity, but you haven't set anything in motion.

Deflation requires one of two options for recovery, it really is that cut and dried.  It requires a lowering of real wages to offset falling prices for goods (otherwise firms fail), or it requires massive spending by the government as a means to get products and goods flowing again.  This is the dichotomy that defines supply-siders and Keynesians.  Any attempt to do something in between or halfway only results in furthering deflation and encouraging consumers to hoard cash.  The Fed cannot act alone to get prices moving upward, and they are especially hog-tied if deflation hits during a period of already low interest rates.  The correlation of the Great Depression to the current crisis should be getting clearer now...

In my mind there are a couple of lessons to be learned and hip pocket solutions that policy makers should have at the ready to address deflation in the future.  In the next week, I'll try to put those thoughts in writing here.

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