Deflation the Easy Cure

The Federal Reserve, alarmed at the relentless downward pressure on business' ability to profitably price its products and services, recently declared its concern about deflation. Our central bankers are casting worried glances at Japan's debilitating deflationary experience of the past 12 years and are anxiously wondering if we're in for the same.

The worries of Greenspan & Co. are welcome--but about five years overdue. Our deflation began in the late 1990s, when the Fed inadvertently tightened monetary policy. Commodity prices collapsed, and deflation then began to work its way through the economy. That's why retailers have been sponsoring an unending cycle of discounts and sales; why auto manufacturers seem to be offering two cars for the price of one; why we've been reading stories about companies' lack of "pricing power." Political repercussions have been real: Hard times in the Farm Belt led to that awful agricultural bailout bill; deflation contributed mightily to steelmakers' distress, which led to those destructive tariffs; the high tech/telecom bust was all the more painful as customers (and the rest of the business community) found themselves under relentless pressure to slash costs. Businesses in general have been achieving profit goals only by repeatedly cutting expenses. The stock market slide as well was exacerbated by deflation. And the sudden drying up of capital gains is a critical cause of states and municipalities being in such fiscal hot water, even though the economic downturn has been rather mild by historic standards.

What's worrisome is the Fed's failure to recognize the causes of this illness--as well as its own complicity. The cure is remarkably simple: Print more money so that the economy has sufficient liquidity and people again feel safe putting that liquidity to work. Up to now, the Fed has been misled, thinking that liquidity was sufficient because companies and investors have been feverishly working to increase their cash balances. Money market funds now hold some $2.2 trillion versus $1.1 trillion held five years ago. But the cash does not represent ample liquidity.

This phenomenon can best be understood by thinking about what would happen if there were a water shortage. People would hoard as much water as they could for fear of not having enough in the future. For too long the Fed looked at this monetary equivalent of water hoarding and concluded there was no shortage.

The real test of the Fed's antideflation mode will come if Congress opts for a House-like tax cut. The resulting economic activity would increase demand for liquidity. Would the Fed then provide it? How to know: Watch the price of gold--still the best barometer of monetary weather changes. Its price collapse in the late 1990s was a storm flag flying. Its surge in recent months is enormously positive. If the price of gold stays around $350 an ounce, even if Congress passes a sensible tax cut, you can breathe easy. If the price plunges, clutch your cash because deflation will be coming back.

If the Fed gets it right, gold will stay steady, stocks and corporate bonds will surge. Mortgage rates will then go down again, perhaps even touching the 5%-to-5.25% level.

Dumb Debate

Treasury Chief John Snow has kicked off another round of worries about the dollar. The message conveyed by the Administration's body language: We sure don't mind the once-muscle-bound buck's getting weaker. This, Treasury mandarins, many economists and a number of CEOs believe, will boost exports, which would help the economy.

The entire strong-versus-weak-dollar debate is utterly wrongheaded. The dollar should be steady in its true value. Deliberate attempts to weaken it by excessively printing money will lead us to a sorry, destructive period like the 1970s. The Treasury Department should simply say that it wants a sound currency and hopes the Federal Reserve will keep it that way.

Actually, the dollar's recent weakness is not so much a result of mis-mouthing by Secretary Snow as it is of very healthy moves by the Fed to provide more liquidity. The dollar has been too dear in recent years. There has been a shortage of greenbacks. The European Central Bank is doing to the euro what the Fed mistakenly did to the dollar--making it scarce relative to market demands. This is bad news for European economies. Japan has relentlessly been doing this to the yen for more than ten years, with calamitous results.

What about the almost nonexistent interest rates in Japan and the low levels in the U.S. and Europe? Low-priced money is not necessarily available money. Countless U.S. companies can testify that they've experienced a bank credit crunch even as interest rates have plummeted. Central bankers have done the equivalent of cutting the price of gasoline to 50 cents a gallon and then telling customers they can't buy any.

The notion of politicians manipulating monetary policy is morally repulsive. If you've worked a dollar's or a euro's or a yen's worth of time, your compensation shouldn't arbitrarily be increased or decreased by political whim. It's the equivalent of earning $15 an hour but having the government change the length of an hour from 60 minutes to 70 minutes. The worker would feel cheated, and rightly so. Currencies are meant to be a measurement of value, not political toys.

Ping.....

Arthurus should read the second part of Mr Forbes piece. They agree on the fact that the $$$ value should be constant. He then goes on to say the value of the $$ has "been too dear"

How can it be both constant and too dear??

We are over-worried about deflation.

Inflation can occur at the beginning of a downturn: If inflation is too much money chasing too few goods, then it follows that when firms falter and produce less goods, inflation ensues.

Conversely, deflation can occur at the beginning of an upturn: Firms produce more goods, and thus prices fall.

Especially if this printing money were incjected as one/two time grants directly where it can create consumer demand. (one time tax credits targeted at the lower incomes, unemployed, public works, grants to states to balance part of their deficit etc. ) bypassing the banking/credit system (to avoid the increase of debt and skewing the direction of injection).

Deflation has been pictured as a much greater curse than inflation, even runaway inflation. But when there are too many goods being pursued by too few dollars, this is but a means to take up slack in the market. Deflation is simply not in the lexicon for minds habituated to thinking there shall always be greater dollar value on goods and services tommorow than there is today. And over the very long range, this is correct. If the real currency, the worth of the person's time, is measured agains the volume of goods and services purchased, it still takes a certain ratio of hours of productive earnings to the level of the delivery of goods and services. This does not substantially change.

Inflation is built into the monetary system, otherwise, banks could not pay interest on deposits, or even collect interest on loans. Deflation is essentially a negative rate of interest, that is, the dollar value is LESS tomorrow than it is today. But the ratio of hours worked to obtain a specified level of goods and services remains about the same.

How can it be both constant and too dear??

It cannot. "too dear" is a value judgment based on a feeling that things are "unfair." There is no too dear or too cheap except in that the level is differedn from a previous level at which the valuer thought his side was doing better. The only useful value for optimizing economic performance is stability at whatever level pertains. Inflating or deflating to reach a supposed better level is itself harmful because it increases perceived and reas risk for foreign money invested in the economy which acts as "matching funds" and multiplies investment of domestic funds in its effect on the economy. Why on earth would we deem it useful to stifle foreign money that expands our economy and makes jobs and enhances American prosperity?

Central bankers have done the equivalent of cutting the price of gasoline to 50 cents a gallon and then telling customers they can't buy any.
Is Forbes argueing that money isn't easy enough to get? I think one only has to look at increasing bankruptcy rates to see this isn't the case.
The latest insane financing thing I've heard about is getting a 2nd mortgage to pay for your house down payment. So you pay no money down and have two loans for 20% and 80% of the value of your house.
Course this isn't done by "central bankers" but rather outside players in the market. But if they can do it, it means that the centrals are pretty loose.

That would help but improving liquidity alone does nothing for the underlying structural problems if we do not have Americans working at porductive jobs priming the economy will merely make imported goods more expensive.

We still need such things as tax free minimum regulation enterprise zones where the companies that locate there agree to do so with no offshore outsourcing or using offshore contractors. We still need to end the H1B and L1 visa programs. We still need to eliminate any and all subsidies and foreign aid to any nation that is actively competing with us and demanding investment in their economy to sell in thier economy.

That would help but improving liquidity alone does nothing for the underlying structural problems

You are right - it would a short term solution - a true stimulus or a jump-start. But as you say the underlying structural problems have to addressed. The economical policy should be modified to protect domestic production and to decrease the trade deficit.

I M Stupid but it seems to me that liquidity has become a raging torrent that has nowhere to go except stocks, bonds, and real estate. There is a genuine lack of productive investment in manufacturing due to so many closures and movement of factories overseas. The armament industry is a growth industry but that is about all and even it is saturated with parts from overseas. I am afraid that our MBA overseeing this operation went to the wrong school of business.

"Inflation is built into the monetary system, otherwise, banks could not pay interest on deposits, or even collect interest on loans."

Nonsense. Interest is charged and paid because a dollar paid today is worth more to a person today than a promise to pay them a dollar tomorrow. Inflation simply adds a constant to the interest rate.

"Deflation is essentially a negative rate of interest, that is, the dollar value is LESS tomorrow than it is today."

Wrong again. Deflation means the dollar gains value.

Deflation, however, doesn't simply subtract a constant to the nominal interest rate, like inflation adds one . If the dollar is appreciating X% annually, someone with cash can get an X% return just by sitting on it, without lending it or doing anything productive. Conversely, even a very safe borrower has to pay at least X% in real interest. The effect then is to contract the total volume of credit extended or taken on, rather than a simple adjustment to the nominal interest rate.

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