March 13, 2003

The Economist Is Scared of Deflation Now

The Economist is scared of deflation now. They want the Federal Reserve to cut interest rates, the European Central Bank to do the same, and governments to run bigger budget deficits over the next couple of years: ...Some economists argue that, since the present weakness in American confidence and spending is largely due to uncertainty about the consequences of a war with Iraq, it might be better to hold fire for now and see what the economy looks like once the conflict is over.... This argument is wrong, for two reasons. First, at a time of heightened uncertainty, it is wiser to take out an insurance policy against a future deep downturn. If a rate cut proves unnecessary, the cost of reversing it would be small. On the other hand, if the American economy remains weak, valuable time will have been gained in giving it an extra boost. When the world economy is groaning with spare capacity, there is little risk that any excessive easing of policy might send prices soaring. A greater risk is of deflation, not inflation. The lesson of Japan's failure to arrest deflation after its bubble burst in the early 1990s is that, as interest rates approach zero and the risk of deflation rises, a central bank should cut rather sooner than it might otherwise. Once deflation sets in, monetary policy can do little to pull an economy out of a slump...

Posted by DeLong at March 13, 2003 08:30 PM | TrackBack


OK, so how worried are "real" economists about this? Even ex-energy, the current CPI rates are not below zero. I know they could get there, and the market has already pushed the expected real yield on the 1-year note below zero, while consumer spending was not exactly hot last month, but wasn't the danger greater last year than now?

To put it another way, are there any academic economists who are more worried about deflation in 2003 than they were in 2002?

Posted by: Jonathan King on March 13, 2003 10:01 PM

I've been receiving the Economist for about seven years now and I feel they have become more and more conservative over the years. They have grown so supportive of Bush they can't argue against his economic policies. Therefore they throw it over to the Fed to resolve our economic issues.

I find it hard to believe that after all the rate cutting the Fed has done, another small cut (relatively speaking) will do much good. I am convinced this economy needs demand-side stimulus to resolve the situation the Economist describes as, "the world economy is groaning with spare capacity". If the problem is spare capacity, why not denounce Bush's supply-side economic policies and argue for demand-side stimulus? Payroll tax cuts, lower bracket income tax cuts, minimum wage hikes, minimum wages for importers, government spending programs (as a last resort). Sorry if I'm starting to sound shrill.

Posted by: Dan on March 13, 2003 11:44 PM

"are there any academic economists who are more worried about deflation in 2003 than they were in 2002?"

Well I don't know whether you consider Brad and Paul Krugman academic economists, but they certainly seem more worried now than they were a year ago. Again, Mervyn King, future governor of the Bank of England and excellent academic economist, is on record as being extremely worried. Of course, Ben Bernanke isn't allowed to tell us what he really thinks.

I'm afraid the underlying problem looks worse not better. The only irony is that short term the oil price rise pushes everything up a bit. This effect could later work in exactly the opposite direction, with a sharp drop in oil prices leading the way down. The bitter-sweet fruits of war?

On the other hand dropping the dollar 10% has undoubtedly helped the US, and put Germany into the front line. But again, you can't drop the currency 10% every year. I'm sorry to be such a lone rider here, but with historically low interests rates and budget deficits all round (there is, remember, already a lot of fiscal stimulus knocking around - as there was in Japan for a good part of the 90's - it's just that what there is, for some 'mysterious' reason isn't working) and now a doubling in oil prices, then why the hell aren't inflation's fires being nicely stoked-up?

Posted by: Edward Hugh on March 14, 2003 01:51 AM

Dan’s point is a good one. The Fed has dropped rates a very long way. Though we cannot know what state things would be in if they had not, it is a reasonable guess things would have been worse. The Fed has been the most aggressive G7 central bank, which means arguing that the Fed has not eased enough requires arguing that every single G7 central bank is wrong. They may be, but those making that statement have a high hill to climb. The mere fact that economies everywhere aren’t performing up to snuff is only a starting point. A good second step would seem to be trying to figure out why the Fed has not already gone farther, then countering that argument. The Fed’s argument may prove to be a good one.

My guess is that timing has something to do with it. The war occupies our thinking for now, but what if getting “geopolitical uncertainty” out of the way doesn’t do the trick? More likely, what if geopolitical uncertainty is not very much reduced by getting war out of the way? Then the Fed faces a world in which more stimulus is needed, and it faces that world with however many basis points are left on the shelf. If, at this very late point in the process of easing, and with lags being what they are, the most important impact in the near term of any new stimulus is psychological, perhaps waiting is wise. If we are vastly disappointed by the economic results of resolving the war, then the Fed will want to get busy showing off its ability to do something for the economy. Having a few more basis points with which to show off won’t hurt.

Other than making a show of doing something, tell me how 25 bp is going to do much good. Hasn’t seemed to help Europe much.

Posted by: K Harris on March 14, 2003 04:17 AM

To way oversimplify, doesn't this situation call for massive stimulation of demand now, but strict fiscal responsibility in the near future?
And couldn't this administration's plan basically be called the opposite? (Showing no evidence of recognizing fiscal discipline problems [or actively dismissing those concerns when their own projections fall off a cliff] while spending massive amounts that do not offer very little immediate demand stimulus).

As an aside, isn't Kaus an awful lot like those that when told about global warming point to a big blizzard and mention (or chuckle) how that proves how ridiculous that concern is?

Posted by: theCoach on March 14, 2003 06:29 AM


The answer that your proposal would draw from classically minded, lifetime spending economists is, I suspect, that swinging from liberality to restraint won't trick the savvy consumer, who will save today's largess in anticipation of tomorrow's restaint, for no net effect on spending. I don't believe it, but that's the argument. It seems to me that consumers are even savvier than the classical types want to believe, and would understand that today's largess will help assure a faster pace of growth in output and incomes, allowing us to smooth spending over the years without saving every penny of today's government stimulus. That's just me.

Posted by: K Harris on March 14, 2003 07:45 AM

K Harris,
Thanks for the response. Implicit in that is that doing anything does not really matter because the market will immediately or very quickly come into equiliberium. Correct?

My econ is feeble, but what type of effect would a massive govt program to provide the 'last mile' in fiber optics to every household?
It seems to me that it would create a lot of jobs now, alleviate some of the problems with under-used capacity, and provide a platform for many businesses to build on. Can someone explain to me what would be wrong with that plan (or one like it) given the current circumstances? TIA.

Posted by: theCoach on March 14, 2003 07:56 AM

The 'present weakness in American confidence and spending' is _not_ due to uncertainty about the war--maybe except among the rich--it's due to no jobs, no opportunity, contempt for workers and rising costs (oh, yeah, except for the rich).

Maybe uncertainty about the war is a business issue, but we shouldn't talk about it as if it's a people issue (and, oh yeah, can we stop calling people 'consumers' as if that's not only the only reason they exist but the only thing motivating any decisionmaking they undertake?)

Posted by: DebC on March 14, 2003 08:21 AM

"and would understand that today's largess will help assure a faster pace of growth in output and incomes"

Unless of course they were a free rider, and decided that this was a good principle for everyone else to adopt, but 'personally' would put something by 'just in case'. Are you spending as much as you possibly can right now K Harris?

But seriously isn't our coach's response on target, I mean whereabouts is the 'equilibrium' trajectory right now. Aren't the majority of the fiscal and monetary arguments we've been getting in the comments lately based on the assumption that the underlying 'fundamentals' are just about as OK as they can be? Or am I being unfair?.

Posted by: Edward Hugh on March 14, 2003 09:45 AM


Way more. Plug it into lifetime spending and income thinking, and I'm really screwed.


Can't oblige you. For the sake of clarity and brevity, people are consumers when we talk about demand, workers when we talk about labor market activity, investors/savers on one side of financial activity, borrowers on the other. When they get sick, they are patients, when wounded, causualties. We are legion...

Posted by: K Harris on March 14, 2003 10:31 AM

No matter the stock market jump for a day, every economic report I read tells me the economy is slowing rapidly. Consumers spending has slowed and may finally be slow for months. There is no reason for business to do more than simply modernize capital equipment, and since prices for technology products are trending down there is no reason to expect significant revenue increases. Employment seems to be more and more of a problem, and snow does not seem to be the reason.

I am quite worried.

Posted by: anne on March 14, 2003 11:28 AM

Energy price increases in an economy that is growing far below the growth of productivity will not lead to inflation. Rather, the energy price increases will be balanced by price weakness in areas where demand is weakening as the cost of energy saps spending in other areas.

Growth now seems about 0, while productivity gains continue. Thus there is no demand for labor and there may be more little job creation for months. We are growing too slowly. As the months of slow growth continue and productivity grows strongly, there is less and less need for new workers.

Look folks, a tax cut on stock dividends ain't gonna do it. Fiscal policy has been awful.

Posted by: anne on March 14, 2003 12:15 PM

>>My econ is feeble, but what type of effect would a massive govt program to provide the 'last mile' in fiber optics to every household?<<

Better yet, a national program to retrofit our homes and buildings to be energy efficient! (Jerry Brown, 1992) This would greatly reduce our energy requirements, and paying for itself over time. How many people would that put to work? How many industries would it stimulate? (And they'd have to hire HERE not India because the buildings are here!)

On the other topic - how does an increase in the price of oil help against deflation? Sure, it makes the CPI go up, but it reduces consumer demand, which is part of the cause of deflation!

Posted by: IssuesGuy on March 14, 2003 02:01 PM

"This would greatly reduce our energy requirements, and paying for itself over time. How many people would that put to work? How many industries would it stimulate?"

Probably not the energy industry :)

"Growth now seems about 0"

Anne, while I completely agree with your sentiments I have to wonder what access to information you have that allows such precise predictions.

Posted by: Dan on March 14, 2003 02:08 PM

The economist is wrong on at least one thing-monetary policy is not useless in the contect of deflation-Monetray autrhorities can choose to expand the money supply rather than target an interest rate-thereby creating inflation. This is the link Mickey K missed in his comment on Krugman. You can have deflation, an inflationary monetary response, and then a really inflationary monetray response to the Federal Debt. In fact Krugman policy response for Japanese deflation was an inflationary monetray response-

Posted by: Lawrence on March 14, 2003 02:19 PM


This is my "guess" based on last quarter's numbers, 1.4%, a mild continuing of consumption and production trends in January and then a dramatic slowing in February carrying through early March. Much of the 1.4% last quarter was inventory building, that does not bode well in a slowing consumption environment.

Suppose I "guess" about 1%? That may be more realistic.

Posted by: anne on March 14, 2003 02:25 PM

You say: "But again, you can't drop the currency 10% every year." Last time around, the dollar had to fall 50% to rebalance the trade accounts. This time the imbalances are more severe - meaning the dollar might even fall slightly more. That would be good for quite a few years of continuous dollar declines. Of course, it never plays out that neatly.
I really do not see how the United States can avoid the attendant stagnation in the living standards of its citizens. Of course, it is absolutely unfathomable why the administration should want to aggravate the situation by betting heavily in the current bull market for American military power.

Posted by: Joerg Wenck on March 14, 2003 02:46 PM

It would seem that more people are getting closer to seeing the pattern I see emerging.

There is a global capacity glut, increasing the money supply has been inefective, still the spectre of deflation persists.

Hmm...a long term increase in the price of oil would work wonders to create inflation. It also has strong upwards redistributive effects.

If you chart the price of oil over the last 60 years and inflation (lagged one year) you will see some pretty strong similarities. In fact, if someone who was better at econometrics than me did a regression of inflation against oil, I suspect that the correlation would be rather high.

A professor of mine has been predicting this stagflation since 2000. It seems he was right.

Posted by: Lorenzo Dei Medici on March 14, 2003 08:36 PM

k so i have construction experience up north where you get real heating bills...

so some idiot spent 40k (at least) to save himself 1500 dollars a year in heating and cooling costs...

his house is ridiculously tightly insulated, tripple pane low e windows, etc etc etc...

but he's a complete idiot, as even with a 4.5% cost of money,current rate on a 15 year mortgage, the interest cost/opportunity cost is more than payoff...

and this was done on an essentially uninsulated shack that was 75 years old

so benefits are likely to be even less as you go further south... while you CAN save money with higher energy efficiencies, you have to be in really bad shape if you can make anything close to a rational argument for doing the investment...

Posted by: libertarian uber alles on March 15, 2003 11:28 PM
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