Defeating Deflation - Option 2, Stimulus and Deficit Spending

Let's get a couple of myths out of the way up front.  This isn't a political blog post.  The world today can barely debate a topic on the merits of the facts because ideology clouds all judgment and discourse.  I'm not attempting to prove X ideology was wrong and Y ideology was right.  I'm trying to separate the ideology from the policy.  In my mind there is a clear distinction.

 

From an economic perspective, the following are important truths to remember:

 

1. Deficits DO matter, at least as a percentage of GDP.
2. Advocating stimulus and deficit spending is NOT the same as saying deficits do not matter.

 

 

So let's say that the party in power would prefer not to respond to a period of deflation by letting millions of people lose their jobs, let the market reestablish a new lower equilibrium for wages, and also have billions in debt go into default when folks can't meet their non-deflation adjusted debt obligations thanks to their new low wage.  If that particular scenario doesn't sound so great, that's because it isn't(we ought to know, it was happening in front of our very eyes as banks failed).  Economist Irving Fisher wrote his debt-deflation theory after the 1929 crash:

 

1. Debt liquidation and distress selling.
2. Contraction of the money supply as bank loans are paid off.
3. A fall in the level of asset prices.
4. A still greater fall in the net worth of businesses, precipitating bankruptcies.
5. A fall in profits.
6. A reduction in output, in trade and in employment.
7. Pessimism and loss of confidence.
8. Hoarding of money.
9. A fall in nominal interest rates and a rise in deflation adjusted interest rates.

This is the precise cycle of what we've seen in 2008 and 2009.  It is just as relevant today as it was in 1929.

 

In the current economic crisis, Republicans proposed tax cuts to the wealthiest Americans, a staple of supply-side policies as a means to encourage spending and capital investment.  But as mentioned before, it's not enough to just encourage spending to defeat deflation.  Even the wealthy will just hold their funds if they fear that their investments will go down, or that a dollar spent today will be worth less tomorrow.  (see step 8 above) That doesn't mean that cutting taxes for those individuals is a bad move, but it does mean that expecting tax cuts alone to stop deflation is beyond silly.  There has to be spending initiated by the government that brings the money in off the sidelines and into the economy.

 

In the 1930's it was considered the height of irresponsibility to propose deficit spending to fight deflation. After all, that was considered a pro-inflation stance.  Keynes and Fisher spent the first 5-6 years of the great depression attempting to make arguments that distinguished inflation from re-inflation and advocating that Hoover stop raising taxes to offset losses in tax revenue from people not working, then urging Roosevelt to stop raising taxes to cover the cost of his spending programs.    Hoover never listened, Roosevelt finally did. 

 

Does running deficits really save wages, though?  There is no doubt that while policy is being formulated and passed through Congress, jobs are being lost and wages lowered.  A stimulus package will head off unemployment and I'm sure it could be debated in a partisan fashion whether government spending is required to spur spending, after all, that is what cable news debated ad nauseum for weeks during the auto-bailout and stimulus package discussion.  But for economists, the question isn't one of whether it's required or not, it's a simple matter of efficiency.  Government dollars used to get an economy moving again and prices back on a measured, steady upswing is absolutely more efficient than letting the market self-correct.