Inflation or Deflation

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The United States may be heading perilously close towards a period of deflation. While we have been experiencing disinflation since the housing bubble burst, the effects haven’t been full blown. If the deflation spirals out of control, the United States could experience a hindering major liquidity trap, or a liquidity trap is a Keynesian theory that describes a situation in which deflation is so bad that monetary policy cannot reverse it.

As Lorimer Wilson from Veterans Today writes:

The inability to lend, actually the result of prior excess lending, results in a net drain of money from the economy. The drain effect, in turn, leads to further defaults as cash strapped consumers and businesses fail to service existing debt, and as debt defaults impact bank balance sheets, putting a damper on new lending and completing the cycle of debt deflation. Keynesian economic policies, i.e., government deficit spending, are irrelevant vis-à-vis excessive debt levels in the economy and bailing out banks is not a solution, since it cannot stop the deterioration of their balance sheets. The process is self-perpetuating and cannot be stopped by any government or monetary policy because it is not a matter of policy, but rather one of mathematics.

Is there any foundation for the belief that a period of such severe deflation could occur? Two major economists have very different beliefs about the impending economic crisis. On one hand, there is the optimistic Richard Berner of Morgan Stanley and, on the other, the cynical Jan Hatzius of Goldman Sachs. Both men represent respected financial institutions and both predicted the current financial crisis; this is why the world looks to them for clarity.

Overall, it looks like Hatzius’ assumptions are more grounded. Nelson D. Schwartz of the New York Times writes:

For months, Mr. Berner has been sticking to a more optimistic forecast, despite growing evidence in favor of Mr. Hatzius’s view. Last week, Mr. Berner was caught by surprise when the federal government reported that the economy grew at a 2.4 percent pace in the second quarter, well below the 3.8 percent he had forecast a month before. Mr. Hatzius came closer to hitting the mark, having projected a 2 percent growth rate.

A sluggish economy and lackluster consumer spending are both good indicators of deflation. People spend less, prices drop with demand, companies begin firing workers they can’t afford, and all the while existing wages and discretionary incomes depreciate. Berner acknowledges that Hatzius’ predictions are more accurate: “I’d say at this point the data and the sentiment in the marketplace have certainly gone more Jan’s way than mine.” However, Berner is still defiant, stating that the risk of real deflation is perhaps a 1 in 10 probability. What are some of the major assumptions on which these men base their forecasts?

One interesting point of discussion is all the extra slack in the economy created by the recession. The New York Times elaborates:

According to a recent report by Nomura, “The U.S. economy continues to operate with a staggering amount of spare capacity—unemployed workers, idle trucks and factories, etc.” Mr. Hatzius agrees, adding that all this extra capacity will restrict the ability of companies to raise prices, thus raising the risk of deflation. “It’s plain to see there’s a ton of slack in the economy,” he said. “We’re not managing to generate enough demand to absorb all these productive resources in the economy.”

On the other hand, Berner believes that the extra capacity created by the recession is being reduced more quickly than Hatzius believes. As a result, he thinks companies will once again begin hiring and that in the second quarter of 2010 we will see a 3% growth rate.

A second major issue of contention between these two men is the prospect of further Washington, D.C. stimulus packages. Hatzius thinks that the only way we will fend off another deflation is through another stimulus package, whereas Berner believes that additional mortgage rules are necessary to combat foreclosures. Additionally, he believes that job training corps should be created for unemployed workers and additional payroll tax credits be established.

Deflation would truly be devastating at this time. Overall, I believe the Fed has taken the necessary steps toward deflation. James Mackintosh of the Financial Times writes:

If I sound skeptical, it is not just because my British accent would automatically cast me as a villain in Hollywood. The Fed has already pumped more money into its quantitative easing than Japan, home of the deflation monster, has in the past 20 years. The result? The U.S. has one of the weakest recoveries ever and deflation is still a risk. Of course, had it done nothing, we would probably be in depression.

Ultimately, however, the U.S. no longer has the political capital, will, or revenue to pass another stimulus package. Nor do I think it should; the banking industry is in much better shape, and the ability to give loans is what generates economic growth. If we can, we should move toward a kind of austerity by taking slow, pragmatic steps. The options Hatzius advocates may be pragmatic, but they are long-sighted policy objectives when the United States economy truly needs immediate relief. Unfortunately, we are in such a situation that if deflation is going to occur, there is not much more we can do about it.