July 16, 2010 12:07 am

It is time to face down the threat of deflation

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Central banks will have to announce price level targets, writes John Makin

“When inflation is already low and the fundamentals of the economy suddenly deteriorate, a central bank should act more pre-emptively and more aggressively than usual in cutting rates.”

Ben Bernanke, the chairman of the Federal Reserve, would be well advised to heed his own advice from 2002. The current environment is more unnerving than the one he described then as a governor of the US central bank. Cutting rates is no longer an option. Inflation is now low and falling in the US and Europe (year-over-year core inflation at 0.9 and 0.8 per cent) and has firmly taken hold in Japan at minus 1.6 per cent year-on-year.

There are sound economic reasons for the persistence of disinflation and the appearance of outright deflation in the aftermath of the 2008 financial crisis. Financial crises are ultimately deflationary because they create a rise in the demand for cash that depresses aggregate demand at a time when substantial excess capacity exists. The excess capacity is created in the run-up to the crisis, when underpricing of risk expedites a substantial build-up in the capital stock.

Demand for cash is driven first by a sharp rise in uncertainty – Keynes’s “precautionary motive”. Next, falling inflation and, ultimately, deflation reinforce this precautionary demand for cash whose value is enhanced – tax free – in direct proportion to the pace of deflation. Falling prices thereby become self-reinforcing.

The deflationary impulse has been inflamed by the failure of the banks to resume their role as financial intermediaries since 2008. In the US, banks have preferred to utilise the zero cost of money provided by the Fed to finance purchases of Treasury securities instead of supplying loans to households and small businesses. After a financial crisis, banks too become much more risk-averse, as is manifest in their willingness to lend only to the government. That development has resulted in virtual stagnation of broader monetary aggregates at a time when the demand for money is rising. The sharp drop in credit growth, to a negative 9.7 per cent annual rate over the three months ending in May, suggests that US households are adding to cash balances by deleveraging and paying off debts. Ultimately, this process turns disinflation into deflation and probably will do so in the US by late 2010.

At this point in the post-bubble transition to deflation, fiscal rectitude and monetary stringency are a dangerous policy combination, as appealing as they may be to the virtuous instincts of policymakers faced with a surfeit of sovereign debt. The Group of 20’s shift toward rapid global fiscal consolidation, a halving of deficits by 2013, threatens a public-sector Keynesian “paradox of thrift” whereby, because all governments are simultaneously tightening fiscal policy, growth is cut so much that revenues collapse and budget deficits actually rise. The underlying hope or expectation that easier money, a weaker currency and higher exports can somehow compensate for the negative impact on growth from rapid fiscal consolidation cannot be realised everywhere at once – especially when a move towards deflation is increasing the demand for cash.

Policymakers need to recognise more clearly that, while the acute phase of the financial crisis may be over, the chronic trend toward deflation that has followed it is not. Two things should happen in this dangerous environment to prevent a relapse back into crisis. On the fiscal front, deficit reduction measures must be undertaken to reduce expected future outlays. Legislation to raise retirement ages for public pensions and index pension outlays more conservatively can be enacted now to take effect in the future. On the monetary front, central banks – led by the Fed, as the European Central Bank and the Bank of Japan are just not going to do it – will have to announce firm price level targets that imply rapid money creation through more aggressive asset purchases.

Protests from my conservative colleagues notwithstanding, such measures are needed. They are clearly implied by Mr Bernanke’s 2002 argument for aggressive monetary policy measures when inflation is low and growth slows suddenly. He spoke then of cutting rates to effect this goal. Let us hope that now he is prepared – it has to be said – to print money “more pre-emptively and more aggressively than usual”.

The writer is a visiting scholar at the American Enterprise Institute

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