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 \u201csafety and soundness\u201d of the U.S. banking system evaporated, the Federal Reserve\u2019s mandate expanded.\u00a0 No longer does it merely set the short-term \u201cpolicy rate\u201d \u2013 the Fed Funds rate. Now it manipulates bond yields with \u201cquantitative easing\u201d 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\u2019s 2% target; supposedly this means we\u2019re headed toward the same deflationary sinkhole that swallowed the U.S. in the 1930s and Japan in the 1990s.<\/p>\n
In a recent speech Chair Yellen explained, \u201cThe 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.\u201d\u00a0 Yellen thinks low inflation poses two risks. It raises the \u201creal\u201d Fed funds rate and, secondly, \u201cpersistent 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.\u201d Another central banker gone wild, IMF head Christine Lagarde, agrees, warning, \u201cIf inflation is the genie, then deflation is the ogre that must be fought decisively.\u201d<\/p>\n
Meet the Whacky Marx Brothers<\/strong><\/p>\n The logical flaw in central bankers\u2019 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:<\/p>\n Manny, a graduate student in Boston<\/strong>: \u201cHigh 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.\u201d<\/p>\n Moe, a middle class father<\/strong>: \u201cThis low inflation is killing me. It\u2019s 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.\u201d<\/p>\n Jack, a small business man<\/strong>: \u201cI love these inflationary pressures. Obamacare, a rising minimum wage, and Obama\u2019s war on coal are sending my costs through the roof. I have to try to raise prices, but I\u2019ll lose some customers and my profit margins will be squeezed. I\u2019m holding off any new hires until my costs stabilize.\u201d<\/p>\n The point is that often inflation (soaring tuitions that render higher education unaffordable, rising costs due to over-regulation) impedes<\/em> economic growth and, conversely, deflation (cheaper energy, cheaper information via the Internet) unambiguously promotes<\/em> economic growth.<\/p>\n Deflation \/ Inflation: the Cause Matters<\/strong><\/p>\n Like many economists, Yellen and Lagarde\u2019s Olympian 35,000 foot perspective ignores nitty gritty micro-economic reality<\/strong>\u2014i.e., what causes<\/strong> high or low inflation.In the real world, there are two types of deflation, one \u201cbad\u201d and the other \u201cgood:\u201d<\/p>\n 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.<\/strong> That means \u201cstructural reform\u201d<\/strong> to promote economic growth, thereby shrinking the debt\/GDP ratio:<\/p>\n 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\u2019s and bonds.\u00a0 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.<\/p>\n A Blast from the Past (1998): \u201cBenign Deflation?\u201d<\/strong><\/p>\n We have been here before. In 1997 and 1998 deflation stalked the world economy as one \u201cLDC\u201d after another\u2014Thailand, 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 \u201crocket scientists,\u201d 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 \u201cstructural reforms\u201d 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.<\/strong> Despite \u201cdeflation,\u201d median real household incomes increased<\/em> 8.4% between 1996 and 1999; by contrast, it declined<\/em> 4.2% over the three years ending 2012.<\/p>\n As this unpleasantness unfolded, I co-authored a research report for PaineWebber titled \u201cBenign Deflation?\u201d which became a reading assignment for a course at NYU\u2019s Stern School of Business. You can find it on the Web by googling \u201cdoerflinger benign deflation NYU.\u201d Here are the \u201cgood parts.\u201d<\/p>\n Excerpts from \u201cBenign Deflation?\u201d<\/strong><\/p>\n Deflation is compatible with Growth<\/strong><\/p>\n 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:<\/p>\n In the last four decades of the 19th<\/sup> century, value added by U.S. manufactures grew at a pace of 5-7% annually. From the 1870s to the 1890s\u2014a period of rapid population growth driven by heavy immigration from Europe\u2014national income per capita expanded by a remarkable 88%. It is quite possible that the deflation of the late 19th<\/sup> century to some degree caused<\/em> this spate of technological innovation. Unable to raise prices in order to boost profits, businesses had no choice but to cut costs via innovation.<\/p>\n Increasingly, technological innovation will involve creative use of the Internet, which is doing for information what the railroads did for physical products\u2014dramatically 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.<\/p>\n Copyright Thomas Doerflinger 2014. All Rights Reserved<\/p>\n","protected":false},"excerpt":{"rendered":" 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 \u201csafety and soundness\u201d of the U.S. banking system evaporated, … Continue reading \n
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