QUIZZICALLY HE READ

Overblown: THE REAL RISK ISN'T DEFLATION (Noam Scheiber, 06.23.03, New Republic)

There are two key reasons the prices of certain goods are falling, neither of which has to do with the money supply. First, all the equipment and information technology that companies invested in during the last 20 years--particularly during the late '90s--has dramatically increased productivity, enabling companies to produce the same amount of goods more cheaply than ever before. Second, that investment has led to excess capacity, meaning companies are able to produce more goods than the market can absorb. According to The Wall Street Journal, for example, the global-production capacity for automobiles stands at about 80 million per year, while global demand is about 60 million. Companies that overproduce tend to cut prices to move all their extra goods. [...]

The mantra repeated again and again in the Fed's "Preventing Deflation" paper is that the costs of overcompensating to avoid deflation are exceedingly low. As a practical matter, what the Fed means by overcompensating is that a central bank facing the risk of deflation should determine where interest rates should be based on that risk and then push them even lower. What's more, it should keep them low for longer than it otherwise would. In general, this will lead to a period of higher-than-desired inflation once the risk of deflation passes. But that extra inflation is relatively harmless, the thinking goes, and in any case a cost worth bearing when you consider the horrible alternative.

All of which assumes, of course, that falling prices are, in fact, a horrible alternative. As we've established, they're not--unless the falling prices reflect a contraction of the supply of money and credit. But no sentient central banker would ever allow that to happen. The Fed gets weekly data on the money stock--meaning, according to Meltzer, that it would require a "massive error on its part" to allow the money supply to shrink. "You couldn't do it without knowing about it," he says. But, even if that error somehow got made and prices began to fall as a result, it wouldn't be so hard to correct: You just start printing money and injecting it into the economy.

In fact, not only is deflation not a serious risk today, but its mirror image, inflation--and the rising interest rates that accompany it--is. Thanks primarily to a recent orgy of tax-cutting, the projected ten-year federal deficit now stands somewhere in the neighborhood of $4 trillion. Even more alarming, according to a report ordered by former Treasury Secretary Paul O'Neill but subsequently suppressed by the Bush administration, is that the current value of the gap between all of the government's future liabilities and its future revenue is $44 trillion. Shortfalls like this are highly inflationary since they stimulate demand for goods and services in the short run, which raises prices, and because they often get paid for in the long run by printing money. Likewise, the dollar's recent decline--it has fallen by over 20 percent against the euro and almost 10 percent against the yen in roughly the past year--is also inflationary, since a weaker dollar raises the prices of imports.

In this context, the problem with "overcompensating"--that is, pushing short-term interest rates lower, and keeping them there longer, than you otherwise would--is that it compounds the inflationary pressure created by large federal deficits and the weakening dollar. That's especially problematic because inflation is very difficult to root out once it gets embedded in people's expectations: Consumers expect prices to rise quickly, so they bargain for higher wages; companies expect wages to rise, so they set higher prices.

Here are two things I don't get about this essay, most of which I agree with:

(1) Isn't it kind of disingenuous to talk about real interest rates later in the essay but ignore them early? Is an 8% interest rate in an inflationary environment worse than a 2% one in a deflationary environment if both represent a "real interest rate" of 4%? And isn't the problem that the Fed fought imaginary inflation pressures for several years in the late nineties & 2000, thereby creating usurious real rates?

(2) Isn't it kind of disingenuous to talk about the psychology of inflation but not of deflation? Posted by Orrin Judd at June 26, 2003 7:33 PM