On Wall Street, alas, no bad deed goes unrewarded. After failing to anticipate even one of the past three recessions, and after sitting idly by during the housing bubble as the “safety and soundness” of the U.S. banking system evaporated, the Federal Reserve’s mandate expanded. No longer does it merely set the short-term “policy rate” – the Fed Funds rate. Now it manipulates bond yields with “quantitative easing” and tries to precisely set the U.S. inflation rate. Alarm bells sound in the Marriner S. Eccles Building on Constitution Avenue when the inflation rate drifts below the Fed’s 2% target; supposedly this means we’re headed toward the same deflationary sinkhole that swallowed the U.S. in the 1930s and Japan in the 1990s.
In a recent speech Chair Yellen explained, “The FOMC strives to avoid inflation slipping too far below its 2 percent objective because, at very low inflation rates, adverse economic developments could more easily push the economy into deflation.” Yellen thinks low inflation poses two risks. It raises the “real” Fed funds rate and, secondly, “persistent inflation well below this expected [2%] value increases the real burden of debt for households and firms, which may put a drag on economic activity.” Another central banker gone wild, IMF head Christine Lagarde, agrees, warning, “If inflation is the genie, then deflation is the ogre that must be fought decisively.”
Meet the Whacky Marx Brothers
The logical flaw in central bankers’ low inflation fixation is exposed by the famous Marx brothers, Manny, Moe, and Jack. They each agreed with Yellen and Lagarde while uttering these whacky non sequitors:
Manny, a graduate student in Boston: “High inflation is great. Paying off my student loans should be really easy, because for the past six years my tuition bills soared 10% per year. Unfortunately, salaries in my intended profession have been pretty stagnant.”
Moe, a middle class father: “This low inflation is killing me. It’s getting harder and harder to pay my mortgage because cheap natural gas is cutting my heating and cooling bills. Plus, I get all this free stuff on the Internet that I used to have to pay for.”
Jack, a small business man: “I love these inflationary pressures. Obamacare, a rising minimum wage, and Obama’s war on coal are sending my costs through the roof. I have to try to raise prices, but I’ll lose some customers and my profit margins will be squeezed. I’m holding off any new hires until my costs stabilize.”
The point is that often inflation (soaring tuitions that render higher education unaffordable, rising costs due to over-regulation) impedes economic growth and, conversely, deflation (cheaper energy, cheaper information via the Internet) unambiguously promotes economic growth.
Deflation / Inflation: the Cause Matters
Like many economists, Yellen and Lagarde’s Olympian 35,000 foot perspective ignores nitty gritty micro-economic reality—i.e., what causes high or low inflation.In the real world, there are two types of deflation, one “bad” and the other “good:”
- Debt deflation, a vicious spiral where prices decline because consumers and businesses are unable to service their debts, so they sell assets, causing prices to decline further, which makes debt even more unmanageable.
- Benign deflation, where technological advances cut costs, so consumers get more for less. Fracking and the Internet are both great examples.
Rather than lumping these two, diametrically opposite, deflations together and creating a simple-minded inflation target, central bankers and other policy makers should address the specific institutional problems that are creating debt deflation. That means “structural reform” to promote economic growth, thereby shrinking the debt/GDP ratio:
- In the 1990s Japan failed to carry out structural reforms such as letting “zombie banks” die, eliminating incestuous cross holdings among corporations, deregulating farming and other protected industries, and opening up the country to imports.
- In Europe today, many of these same reforms are needed. Europe is about five years behind the U.S. in recapitalizing its banks to promote lending to small businesses. Hollande’s tax hikes have hurt hiring. Little has been done to free up the Italian economy.
- As for the U.S., Obama’s regulatory onslaught is raising energy costs and damaging what once was a flexible labor market. And there are the sins of omission—no corporate tax reform, no trade agreements, no Keystone XL Pipeline, etc. The result is slow growth and high unemployment. Debt, per se, is not the problem. Five years into an economic expansion the U.S. has already delevered; the debt burdens of businesses, governments, and households are manageable, provided economic growth is robust. Alas, I see no evidence that Chair Yellen realizes that over-regulation is impeding growth, particularly job growth.
Conventional Keynesians like Paul Krugman think higher inflation would benefit the middle class and hurt the rich. Wrong. Given a slack labor market and weak unions, rising inflation would not boost nominal wages much and real wages would fall, because rising U.S. inflation would weaken the dollar and increase commodity (i.e., food and energy) prices. This is the reverse of the 1998 pattern (see below). To the extent higher inflation reduced real interest rates, it would depress the incomes of middle class savers who own CD’s and bonds. Meanwhile Wall Street speculators would adjust to higher inflation. Commodity speculation would come back into vogue, and highly leveraged, filthy rich, private equity tycoons would benefit enormously from a reduction in their real debt burden.
A Blast from the Past (1998): “Benign Deflation?”
We have been here before. In 1997 and 1998 deflation stalked the world economy as one “LDC” after another—Thailand, Indonesia, Korea, Brazil, Russia–succumbed to tightening credit conditions and declining investor confidence in their ability to service debt. Eventually, in October 1998, financial panic visited the U.S. as Long-term Capital Management, a giant hedge fund run by former Salomon Brothers “rocket scientists,” which had borrowed from all the big houses on the Street, imploded. As inventories piled up and commodity prices plummeted, economists feared deflation would drag down the global economy. Interestingly, Asia carried out the “structural reforms” that have eluded Europe and got back on its feet in a year or two. Weak commodity prices were one reason why real wage growth in the U.S. was strong in the late 1990s. Despite “deflation,” median real household incomes increased 8.4% between 1996 and 1999; by contrast, it declined 4.2% over the three years ending 2012.
As this unpleasantness unfolded, I co-authored a research report for PaineWebber titled “Benign Deflation?” which became a reading assignment for a course at NYU’s Stern School of Business. You can find it on the Web by googling “doerflinger benign deflation NYU.” Here are the “good parts.”
Excerpts from “Benign Deflation?”
- If the U.S. were to experience deflation in coming years, it would be benign deflation similar to that of the late 19th century, driven by technological progress and accompanied by healthy economic growth.
- Benign deflation is distinct from debt deflation, when prices plunge because debtors are unable to pay their debts, the financial system is damaged, and economic activity declines. The current turmoil in Asia is a prime example of debt deflation.
- The risk of debt deflation in the U.S. is far lower now than in the 1980s, because 1) the U.S. economy has successfully made the transition to low inflation and 2) debt ratios are declining or stabilizing.
- By preventing companies from boosting earnings through price increases, benign deflation encourages cost-cutting via innovation. This occurred in the late 19th century and is occurring today.
Deflation is compatible with Growth
Even though the price level was declining, the decades after the Civil War were a period of explosive economic growth and creativity. The completion of a continental railroad network, and the concomitant telegraph system, created a national market that encouraged a spate of technological innovations. The number of patents issued doubled between the 1860s and 1880s. Among the specific innovations introduced were:
- Use of electricity in factories
- The electric streetcar
- Refrigerated cars for meat-packing
- The telephone
- The typewriter
- The roller mill to process oatmeal and flour
- Major advances in making steel, which replaced iron for many uses.
In the last four decades of the 19th century, value added by U.S. manufactures grew at a pace of 5-7% annually. From the 1870s to the 1890s—a period of rapid population growth driven by heavy immigration from Europe—national income per capita expanded by a remarkable 88%. It is quite possible that the deflation of the late 19th century to some degree caused this spate of technological innovation. Unable to raise prices in order to boost profits, businesses had no choice but to cut costs via innovation.
Increasingly, technological innovation will involve creative use of the Internet, which is doing for information what the railroads did for physical products—dramatically increasing the ease and speed with which information can be moved and manipulated. This is not only saving labor but also reducing inventory costs and raising the productivity of physical plant. By reducing inventory levels and minimizing inventory swings, better information technology is tending to mute the business cycle.
Copyright Thomas Doerflinger 2014. All Rights Reserved
