There's No Reason Why Deflation Couldn't Happen Again

Central bankers prefer not to talk about deflation. At the moment, the issue has their attention whether they like it or not. Last week, the Federal Reserve and its counterpart across the Atlantic, the European Central Bank, even issued statements on the subject.

Of course, when it comes to deflation, central banks speak elliptically (even by their standards). Fed Chairman Alan Greenspan warned of the risk of a "substantial fall in inflation." Shortly afterward, the ECB said that it would from now on aim for an inflation rate that was "close to, but below, 2 percent." You could be forgiven for missing the point.

The core inflation rate (which excludes food and energy) has now fallen to less than 2 percent in the United States and in the euro-area economies taken as a group. So when the Fed says it is on guard against a "substantial fall" from current levels, it is really talking about inflation of less than zero: deflation, that is.

The ECB's statement was even more subtle. The key words were "close to." The central bank's inflation objective is expressed as an upper limit of 2 percent. Taken literally, this means that the ECB would be fine with prices in Europe falling by 10 percent a year. In case anybody thought the bank could be so stupid (and few would have excluded that possibility), it signaled to the markets that it regards deflation as bad. Hence the "close to" formula. In effect, the ECB has said that if Europe's low inflation threatens to turn into outright deflation, it might do something about it.

Before asking what that something would be, a first question is whether deflation would really be such a problem. What's so bad about falling prices? The answer is nothing, if only some prices were falling. But deflation means that all (or most) prices are going down. Wages have to fall as well. Otherwise, unemployment will surge. America's deflation of the 1930s brought both: collapsing incomes and massive unemployment. Because of its effects on wages and jobs, deflation causes the deepest kind of recession.

It has particularly grim results for people who owe a lot of money—as many American firms and households do. Inflation erodes debts; the fixed money value of a debt grows smaller in real terms as prices rise. In the same way, deflation builds debts up; the value of a loan in cash terms gets bigger in real terms as prices fall.

Lower interest rates cannot soften this blow if they have already fallen to nothing: Zero is as low as interest rates can go. No matter the deflation rate, nominal interest rates cannot turn negative. If prices were falling at 10 percent a year, as they did for a time in the 1930s, interest rates in inflation-adjusted terms would stand at 10 percent or more. Debts that can be carried with today's real interest rates of roughly zero would be crushing with real rates at 5 percent, let alone 10 percent or more. That kind of burden would start an epidemic of bankruptcies and a really savage decline in output and incomes. Orthodox monetary policy could do nothing about it.

The danger is not just theoretical. After deflation started in America in the 1930s, nothing less than the Second World War (with its colossal increase in defense spending, and the consequent expansion of demand for goods and services) was required to shake the country out of it. There is no reason why deflation could not happen again—if the government lets it. But that, an optimist might say, is the point: A modern government never would. For one thing, policy makers understand economics better than they did back then. For another, voters in a modern democracy would never stand for deflation.

The first point is essentially correct: The lessons of earlier deflations and subsequent recoveries are now pretty clear. True, interest rates cannot be cut to less than zero, but even with interest rates at that minimum, central banks can still expand the money supply by buying government bonds or foreign currencies, thereby pushing extra domestic currency into the economy. In most circumstances, this action would add to demand either by expanding credit (since banks would be flush with cash), or by depreciating the dollar (which would buoy demand for American exports), or both.

Even if monetary expansion failed, governments could cut taxes or raise public spending, directly stimulating demand in either case, and then finance the resulting increase in the budget deficit by selling bonds to the central bank. Economics textbooks call this "printing money." In ordinary times, such a policy would be recklessly inflationary. In deflationary times, however, there's your cure of last resort.

So modern governments do have the tools to deal with deflation. The problem is, they also require the will and the political means to use them. Ask Japan about this. Its endless recession is instructive. Its inability to prevent a deflationary economic decline, or to reverse it once it started, has been most of all a failure of politics.

Special policies may be needed to turn the economy around when it is on the brink of deflation, and even more so once deflation has actually begun. The most effective last-resort remedy—fiscal expansion financed by money creation—is one that no policy maker would ordinarily wish to use. Also, making a success of this approach calls for close coordination of policy between the central bank on one side and the fiscal authorities (in America's case, Congress and the Treasury Department) on the other. Again, in normal times, collaboration of that sort is neither necessary nor even very desirable. Deflation therefore makes heavy demands both on policy makers' flexibility in unusual times and on their willingness to cooperate when the situation demands it.

Both have been totally absent in Japan. The finance ministry and the central bank have been sluggish to the point of paralysis in recognizing the seriousness of the country's problems and in adapting their policies to suit them. On top of that, the two institutions are fierce rivals. Not only have they failed to cooperate, they have actually conspired to undermine each other's efforts (with the central bank, for instance, responding to fiscal loosening by tightening monetary policy). You see the results.

Weighing the politics and the economics side by side, deflation gives less cause for concern at the moment in the United States than in Europe. America's economy is sluggish, to be sure, but the recent fall in the dollar is helping to prop up the country's exporters, and makes it less likely that prices will start falling. Europe's big economies are already growing a lot more slowly than America's, and there the currency markets are making things worse, not better. The euro is appreciating (partly because of Europe's relatively high interest rates). Europe's exporters are therefore coming under new pressure, and inflation will keep drifting lower.

Politics gives America an even bigger advantage. Why are Europe's interest rates so high—too high, as most of the region's economists would argue? Partly because the ECB has set itself such a demanding target for inflation: less than 2 percent, rather than, say, 2.5 percent plus or minus a margin for error. It has a stricter target for inflation than other central banks, even though Europe's current circumstances (including the imminent accession of new fast-growing members) probably call for a softer one. It chose to interpret its "price stability" mandate in this unduly rigorous way for essentially political reasons.

So far as most people are concerned, the Fed and its long-serving chairman have nothing to prove. The ECB, a freshly minted institution, sees things differently. It has no stock of credibility to run down. Its officials wanted most of all to establish impressive anti-inflation credentials from the outset, and to underline their independence from European governments. In ordinary times, those would have been worthy aims. With deflation a growing risk, such priorities are decidedly hazardous.

If prices should start falling across large parts of Europe, with all the dire consequences that would follow, what then? The close cooperation between central bank and fiscal authorities that one can imagine taking place in America in such circumstances is far harder to picture in Europe. The reason, again, is politics. Japan's problems of institutional rivalry and lack of coordination would seem as nothing: In the European Union, those same difficulties would be multiplied by the fact that 15 governments (12 in the euro area plus three outside it) would need to reach agreement with the ECB on what should be done, and then apportion the fiscal measures across the different national authorities. For this maneuvering, allow 10 years. If deflation does take root in Europe, stopping it—even though economists know how—could prove even harder than in Japan.