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In Defense of Deflation

Mises Daily: Tuesday, August 10, 2010 by


The Obama stimulus and bailouts haven't decreased unemployment rates or bankruptcy filings while home prices and home sales have fallen and can't get up. PIMCO's Bill Gross told Bloomberg this can all be fixed with nearly zero interest rates and additional debt to stimulate the animal spirits of investors and entrepreneurs. The federal-funds rate has been pegged at 0 to .25% since December 16, 2008, and Uncle Sam's debt is $13.3 trillion and counting. If this hasn't goosed the animal spirits, what will?

The failure of central bankers to make things all better again by creating some money and lowering some interest rates has the financial press fretting about deflation and thinking the US economy is turning Japanese. James Bullard, who heads the Federal Reserve Bank of St. Louis, came out with a paper entitled "Seven Faces of 'The Peril'."Download PDF He concludes that the Federal Open Market Committee's (FOMC's) "extended period language may be increasing the probability of a Japanese-style outcome for the U.S." To avoid that outcome, Bullard argues that the Fed's most important tool is quantitative easing — printing money to buy government debt.

The Wall Street Journal's James B. Stewart claims deflation is bad because "deflation erodes profits and asset values," in his "Smartmoney" column.

People wait to buy expecting lower prices, reducing demand. Lower profits cause companies to cut expenses, including employees. It is a downward spiral that, if Japan's experience is any indication, is difficult to arrest.

Mr. Stewart is wrong on all counts. Profits are the difference between the price we sell a good for and the price it costs to produce that good. As Jörg Guido Hülsmann makes clear in his book Deflation & Liberty, "In a deflation, both sets of prices drop, and as a consequence for-profit production can go on."

And while asset values may drop, the assets don't go away. The real wealth of the nation — assets used for production — are still available to produce. However, it may be that because the debt is liquidated on those assets as prices fall, new owners will own and operate the assets, but commerce and production will certainly carry on.

Lower prices increase demand; they do not reduce or delay it. That's why more and more people own flat-screen TVs, cellular telephones, and laptop computers: the prices of these goods have fallen, and people with lower incomes can afford them. And there are more low-income people than high-income people.

Lower prices don't mean lower profits; nor do they mean that employees will be laid off. More demand for a good or service means more employees needed to produce those goods and services. "There is no reason why inflation should ever reduce rather than increase unemployment," Hülsmann writes.

People become unemployed or remain unemployed when they do not wish to work, or if they are forcibly prevented from working for the wage rate an employer is willing to pay. Inflation does not change this fact.

Hülsmann goes on to point out that only if workers underestimate the amount of money created by the central bank and therefore reduce their real wage-rate demands will unemployment be reduced. "All plans to reduce unemployment through inflation therefore boil down to fooling the workers — a childish strategy, to say the least."

Of course, Mr. Bullard over at the St. Louis Fed doesn't mention anything in his paper about individuals attaining their goals through subjective knowledge and pricing decisions. Instead he draws lots of lines on graphs and talks about Taylor-type policy rule, zero bound, the Fisher relation, "targeted" steady states, and lots of stuff that has nothing to do with economics.

So while the bond-buying Mr. Gross says zero rates will arouse the animal spirits in all of us, Mr. Bullard worries that "promising to remain at zero for a long time is a double-edged sword." Bullard writes that zero rates are "consistent with the idea that inflation and inflation expectations should rise in response to [that] promise." But in the same paragraph he continues,

But the policy is also consistent with the idea that inflation and inflation expectations will instead fall, and that the economy will settle in the neighborhood of the unintended steady state, as Japan has in recent years.

Wow, no wonder Keynesian central banking is so hard. You're damned if you cut rates and damned if you don't. "I moved the line on the graph. Let's see some animal spirits for crying out loud!"

In the real world, banks aren't lending because, as Murray Rothbard points out in America's Great Depression, if rates are too low, bankers have no incentive to lend, especially in a risky economic environment. Also, as Professor Jeffrey Herbener wrote in the Asian Wall Street Journal, "with distressed banks, reflation fails to induce another bank credit expansion."

Keynesians have mistaken the impotency of the Bank of Japan to restart credit expansion in the 1990s as a liquidity trap. But the problem is not that interest rates are so low everyone expects them to rise and therefore hoards cash. Banks refuse to lend because of the overhang of bad debt. Any cash infusion is held as reserve against it. Businesses refuse to borrow because of their debt burden, built up to expand capacity during the boom, and their over-capacity resulting from their malinvestments.

Japan has tried every stimulus trick in the book — in addition to holding rates at zero — and still its economy has been in a funk for two decades. But firing a worker in Japan is virtually forbidden and don't get the idea that consumer prices have fallen through the floor. According to the International Monetary Fund (IMF), last year saw the biggest drop in consumer prices at 1.13%, after prices rose 1.4% the year before. The chart of Japan's inflation rate is essentially flat. Not exactly the deadly deflationary spiral it's made out to be.

Hülsmann explains that the Japanese government hasn't allowed deflation to heal their economy, with "the only result of this policy [being] to give a zombie life to the hopelessly bureaucratic and bankrupt conglomerates that control Japanese industry, banking and politics."

As for Bullard's quantitative-easing (QE) idea, the Bank of Japan has done plenty of it, buying not only government bonds but corporate debt and stocks as well. Bullard's colleagues over at the San Francisco Fed have studied whether it worked. In a 2006 report, Vice President Mark M. Spiegel wrote that QE lowered long-term interest rates and "there appears to be evidence that the program aided weaker Japanese banks and generally encouraged greater risk-tolerance in the Japanese financial system."

Spiegel concluded, "In strengthening the performance of the weakest Japanese banks, quantitative easing may have had the undesired impact of delaying structural reform."

"Deflation is one of the great scarecrows of present day economic policy and monetary policy in particular," Hülsmann told his Economics of Deflation class at this year's Mises University. It seems a nation will destroy its finances battling the nonthreat. The Organization for Economic Cooperation and Development (OECD) says the Bank of Japan "needs to keep interest rates close to zero and continue its asset-purchase program until there is a 'definitive' end to deflation," Bloomberg reports. But in the same report the OECD worried that the Bank of Japan's ability to stimulate would be curtailed by Japan's public-debt-to-GDP ratio approaching 200%.

Sounds like the folks at the OECD, like Mr. Bullard, can't make up their minds. What Austrians know for sure is that, as Professor Hülsmann makes clear, "the dangers of deflation are chimerical, but its charms are very real." Inflation, on the other hand, only helps those who are massively indebted and inefficient — governments.