Whip Deflation Now
Lower consumer prices can go too low.
Just a few short months ago, the primary bogeyman for the U.S. economy was inflation. Now, in the wake of one of the most breathtaking commodity-price collapses in history, the specter of deflation looms. It's a phenomenon we haven't faced since the Great Depression.
Deflation, or a fall in prices, is an insidious process that first attacks asset values and then commodities, migrates to goods, and ultimately hits wages. The U.S. housing market peaked in 2006, and the stock market began its tumble one year later. As asset prices sank, financial institutions -- particularly those that had made loans against those depreciating assets -- found themselves with insufficient collateral. They responded by cutting back on lending.
This credit contraction, combined with the depressing effects of sinking house and stock values, caused consumers to pull back. Speculators, sensing the weakening economy, sold economically sensitive commodities, such as oil and copper, driving their prices lower.
Chain reaction. Meanwhile, businesses have started to cut back employment, putting downward pressure on wages, salaries and bonuses. That lowers income and consumer spending further. If this vicious circle is not arrested, the downward spiral of wages and prices will cause the real value of debts, such as mortgages, loans and bonds, to go up, increasing the burden on consumers and businesses.
This scenario played out in its most vicious form from 1929 through 1932, when consumer prices and real gross domestic product dropped by some 25%. The early stages of the Depression are frighteningly similar to conditions today.
What can the U.S. government do to prevent this destructive decline? First, it must back up financial institutions to ensure the integrity of deposits and the mechanism by which businesses pay their employees. Because this was not done in the 1930s, thousands of institutions failed and millions lost their savings. In the current crisis, the Federal Reserve and the Treasury Department have not only enhanced deposit insurance, they have also extended guarantees to participating money-market mutual funds.
But backing up deposits is not enough. Deflation, like inflation, is a monetary phenomenon. Inflation materializes when central banks create more money than the public wishes to hold; deflation occurs when they provide too little. To stop inflation, the government must stop expanding the supply of money and credit and jack up interest rates to slow spending.
Halting deflation is more challenging. The Fed can lift interest rates as much as needed to slow growth, but it can't cut rates below zero, and even that low a level might not be enough to stimulate spending. That's especially true when investors are extremely averse to risk, as is the case today, and are willing to hold ultra-safe government debt even at yields close to zero. When this kind of "liquidity trap" develops, John Maynard Keynes believed, monetary policy -- the regulation of the economy through the control of the money supply and interest rates -- is no longer effective.
But many economists believe monetary policy can be effective even if the Fed cannot lower rates below zero. The central bank can still expand liquidity by lending financial institutions money against their assets. Such action sets the stage for fiscal stimulus -- tax cuts or government-spending increases designed to stimulate demand. Let the government cut taxes and have the Fed buy the federal debt necessary to pay for the tax cut. That will put money directly in the hands of the public.
The Obama administration also promises to increase government spending on infrastructure and energy conservation. This combination of fiscal and monetary moves will prevent us from falling into the trap that sank the economy in the 1930s.
Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of stocks for the long run and the future for investors.