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Posted: September 01, 2009

The Economist: Should I worry about deflation, inflation or both?

Tucker Hart Adams

Almost two years ago I wrote a column on inflation, quoting the photographer who’d said to me, “It isn’t inflation people worry about. It’s prices going up.” Today, the talk is about the risk of deflation.

The World Bank warns that the global economy will fall into a “deflationary spiral” unless urgent action is taken to reduce high levels of excess capacity in industry.

Deflation – a decrease in the general price level of goods and services – is a serious problem. We learned this in the U.S. during the Great Depression, when prices fell for all but four years from 1927 to 1939. Japan struggled with deflation during its decade-long recession in the 1990s. 

“Why should we worry about deflation?” my photographer friend might ask if he were around today. “Falling prices are a good thing.” Each time you go to the store, things cost a bit less.

There are at least three problems when the economy is in the grips of deflation.  First, why buy now when you’ll be able to get it cheaper next month? And don’t buy next month because it will be still cheaper the month after that. Demand falls, orders collapse, jobs disappear and the economy is trapped in a downward spiral.

Second, there isn’t a lot the Federal Reserve can do to help the economy with monetary policy. Once the overnight interest rate they control falls to zero (that’s where it is today), they don’t have a lot of other tools at their disposal. In theory they could reduce rates below zero – pay banks to borrow from them – but that is considered impractical.

Meanwhile, the third problem is that the amount we owe on our homes, cars and credit cards remains unchanged. Salaries are falling, so the debt to income level rises.  Lower interest rates may help a bit on monthly payments for those with adjustable rate loans, but the principal payment still has to be made. Defaults rise, home prices decline and spending decreases. The downward spiral in the economy accelerates.

It is a more difficult problem to deal with than the inflationary spiral we experienced in the 1980s. I’m not too worried about deflation becoming a problem in the U.S.  It is true that consumer prices fell 0.6 percent in the first half of 2009, but when you take out the energy component (remember what happened to gasoline prices in 2008?), the price index was up 2.1 percent.

I think a bigger worry is inflation, not in 2010, but looking further out to 2011 and 2012. As the economy recovers next year, excess capacity will be absorbed, the unemployed will be rehired and consumers will be more willing to spend. The reserves that have been poured into commercial banks will begin to be loaned and loaned again, creating dollars faster than goods and services are produced to absorb them. Too much money chasing too few goods is Milton Friedman’s prescription for inflation.

With a deft hand at the wheel and a meddlesome Congress turning its attention to other matters, the Fed may be able to withdraw the trillions in reserves used to salvage the financial system before they do inflationary damage. For the first time they will be able to pay interest on the accounts commercial banks hold with them, perhaps absorbing dollars that would otherwise be loaned to businesses and consumers. 

But the Treasury will be issuing trillions of dollars in new debt to finance the massive spending programs already introduced and the new ones wending their way through Congress. I’m afraid it is unlikely that other countries will be willing to purchase that debt at high enough prices to keep interest rates from soaring, which would cripple the recovery. So the Fed will be forced to step in and buy the debt, boosting the money supply at a time that there is already too much money sloshing through the system.

Even though the economy is showing signs of life as 2009 draws to an end, the recovery is fragile. Deflation and/or inflation pose a threat to its continuing.

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Tucker Hart Adams, president of the Adams Group, monitored and analyzed the Colorado economy for 30 years. She can be reached via her website, coloradoeconomy.com.

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