DEFLATION REARS ITS FOOT

Fears grow that US economy faces deflation (Financial Times, 5/17/2003)

Fears of deflation in the US rose on Friday as stock prices fell and government bond yields dipped to 45-year lows after a key measure of inflation dropped to its lowest level in 37 years.

The concerns were heightened by reports that Japan's deflation gathered pace in the first quarter with prices down 3.5 per cent from a year ago, their fastest 12-month drop on record.

Orrin's deflation fears are looking prescient. We may be in the midst of an economic pattern that seems to occur once a lifetime: a great boom, fueled in part by a grand expansion of credit, followed by an extended spell of debt liquidation, deflation, and economic weakness.

The last such spell was, of course, the 1920's-1930's. A recent Barron's article, "The Debt Bomb," noted that total household, business, and government debt was less than 100% of GDP in 1921, but rose to over 260% of GDP by 1932, before falling back to just over 100% in 1951. From there it gradually rose to 130% of GDP in 1980, before beginning a steep climb to 295% of GDP ($31 trillion) in the most recent Fed statistics. If anything, this debt burden is underestimated; it does not take into account unfunded liabilities for future Social Security and Medicare obligations. If pension promises globally were counted as debt, then the expansion of the welfare state since the 1960s has been the greatest debt boom in history.

The Federal Reserve seems to be following the orthodox economic prescription here, buying federal bonds aggressively with printed money. Currency in circulation is currently $687 billion, up from $570 billion three years ago, a growth rate of 6.5% per year. This is fairly loose; but there is room to print money more rapidly should they choose.

Personally, I think slow growth is much more likely than a new depression, although the next ten years may feel like a depression in misgoverned countries like France and Germany. I do believe that economists haven't learned much since the 1930's about how to deal with such problems, nor has their influence on policy-makers increased. My most reliable prediction: The next decade will offer plentiful opportunities for policy criticism and I-told-you-so's from economists such as Brad DeLong.

Posted by Paul Jaminet at May 17, 2003 7:54 AM