Rethinking Deflation

November 3, 2002 • Commentary
This article was published in the Washinton Times, November 3, 2002.

Several economic analysts claim there is a serious risk the United States may slip into deflation — a situation where most prices keep falling. Stephen Roach, chief economist at Morgan Stanley, writes: “America is already on the brink of deflation.”

Deflation anxiety is nothing new. On Nov. 10, 1997, the Business Week cover was “The threat of deflation.” Much of that analysis was based on the stubborn Keynesian mythology that strong economic growth is inflationary, therefore, weak growth (at that time in Asia) must be deflationary. The Economist, with its British Keynesian bent, has likewise been arguing lately that Europe and the U.S. should foster higher inflation, reasoning that inflation and economic growth go hand in hand. But glancing at the economic figures at the back of the Economist raises serious doubts.

Over the past year, consumer prices in China fell by 0.7 percent, a slightly deeper deflation than Japan. Yet China’s real GDP is up 8.1 percent for the year, and industrial production is up 13.8 percent. Clearly, falling prices are not always such a bad thing. By contrast, prices in Argentina are up 38½ percent, but the economy is down 13.6 percent. In contrast to Keynesian theory, inflation is obviously quite compatible with economic contraction and deflation with economic expansion. Abundance generally means lower prices, and scarcity has the opposite effect.

In one recent column, I showed that U.S. stock market weakness mainly reflects poor profits and that a big reason for poor profits was that costs were rising faster than prices. Those who worry about deflation are presumably referring to prices that U.S. businesses receive, not prices they pay. Most of us would welcome some “deflation” in the price of imported oil, and consumers rarely object to markdowns, discounts and rebates.

In another column, I noted that comparisons between the U.S. and Japanese economy are superficial, partly because the U.S. has smarter tax policy and sturdier banks. Yet I did remark that although Japan’s prolonged economic weakness has many causes, it is probably aggravated by an avoidable deflation. What appears to be a surplus of goods during such a deflation is really a shortage of money, so people have to liquidate goods and assets to obtain the cash they want (for security) or need (to pay their bills).

Robert Barro of Harvard, writing in Business Week, says, “At some point [U.S.] monetary policy may have to shift from a concern with inflation to the avoidance of the kind of deflation that prevails in Japan.” He rightly notes that this would involve printing more money to create a little inflation, and that interest rates would rise rather than fall if that happened. Japan’s super‐​low interest rates are a symptom of trouble, not of stimulus. If Japan’s economy were growing by 4 percent and inflation was 1 percent, then long‐​term interest rates would closer to 5 percent than to 1 percent.

Way back in July 1984, I wrote a Wall Street Journal piece called “The Fed flirts with deflation.” The phrase “flirts with” was carefully chosen. I certainly did not mean we were anywhere near an actual deflation, but that we could be heading in that direction unless the Fed reversed course (as it did). The evidence I cited consisted of high real interest rates, a soaring dollar and falling commodity prices. The fed funds rate at that time was twice as high as any measure of inflation. The high real rate of interest on cash made it attractive to liquidate longer‐​term assets, commodities and foreign currencies and invest the proceeds in a money market fund.

It would be difficult to retell that story about the U.S. today. The fed funds rate is 13/4 percent and producer prices were essentially flat over the past year, if you leave out food and energy. Subtract almost any other measure of inflation from the fed funds rate, and it is hard to argue that real, inflation‐​adjusted interest rates are much too high. The Economist’s index of commodity prices is up 21.2 percent over the past year, gold is up 13.4 percent, and oil is up 28.9 percent. That makes it quite challenging to argue that falling commodity prices are signaling a broader price decline ahead. The same journal’s measure of the dollar exchange rate has dropped from 119.6 percent to 115.1 over the past year, making it equally tricky to argue that the dollar is rising too fast. The producer price index fell in September. But if you leave out food, the index rose from 136.3 in January to 139.3 in September.

All these figures make it difficult to figure out what the deflationists are talking about, unless it is merely that they are forecasting weak economic growth and trying to explain their forecast in a simple way. Yet if weak growth is the real complaint, there is that inconvenient fact that the world’s fastest‐​growing economy, China, also has the world’s deepest deflation.

We may just be expecting too much from monetary policy. The Fed can only print money. It can’t print jobs.

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