June 12, 2003
The Technology Deflator
By ROBERT J. SHILLER
After a glorious history as the driving force of economic progress, new technology is showing it can have revenge effects as well. Our biggest economic problems of today may ultimately be traced in large part to a cascade of consequences from recent advances of information technology like the World Wide Web, which became available to the public in 1994. Ultimately, technology bears responsibility for the emerging risk of a bout with deflation in a number of countries, including the U.S.
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The sequence of events is clear: Technology and the Internet drove the spectacular stock market boom between 1995 and 2000, because investors overreacted to it, believing in a "new era." The boom extended to most advanced countries of the world -- the Internet was excitement without borders. It was this accelerated technology and its attendant ability to infiltrate all corners of the globe that brought our current woes. Alan Greenspan and the president did not bring us these problems, and they cannot be expected to provide perfect solutions either.
A stock market boom has its own internal dynamics, and ultimate collapse, a collapse that brings business confidence down with it. The overcapacity generated by the 1995 to 2000 boom, and the disruption of business plans caused by the subsequent crash, have by now reduced capital goods orders and shipments, slowing the economy. With the higher productivity brought on by the new technology, firms, desperate to restore profit margins, are taking the opportunity to economize on workers. As a further repercussion, workers, growing fearful of the job situation, are not consuming as much as they otherwise would. The ultimate result: Our uneven response to new technology has brought on a long weak period for employment and the economy.
An economic decline, if it persists, tends to have as a consequence lower inflation rates. At this time, lower inflation rates mean deflation, since there is not much further down for inflation to go without falling below zero.
Because of greater vigilance against inflation since 1979, when Paul Volcker took over as Fed chairman, there has been a long-term downtrend in the inflation rate. Inflation measured by the CPI was 13.3% in 1979, and has been on the decline, more or less, ever since: In the last 12 months inflation was only 2.2%. With the trend toward lower inflation, there is less latitude for short- or medium-run fluctuations in inflation without bringing on deflation. We are not used to hearing about deflation, outside Japan, but we had better get used to it, so long as trend inflation stays low: There will be episodes of deflation.
A period of deflation is not the end of the world. The longest deflation since the Bureau of Labor Statistics started keeping records in 1913 was in fact in the "Roaring Twenties." In the 41 months from November 1925 to April 1929, a period over which the stock market doubled, U.S. consumer prices fell 1.8% a year. This rate of consumer price deflation exceeds the rate of deflation in Japan since 1998, which has been only 0.7% a year. But the deflation of the 1920s did not damage confidence or derail the economy.
The risk of deflation now differs from the 1920s, because it comes with a weak economy in which confidence, though recently buoyed by the end of the war, remains vulnerable. It is most unlikely that any future deflation will be as long or severe as it was in the Depression, from November 1929 to March 1933, with prices falling at a rate of 9.1% a year. On the other hand, people in advanced countries today, sensitized to the parallels with the long-term sluggishness and deflation since 1998 in Japan, might see even a mild deflation as a blow to their confidence as severe as the stock market drop since 2000 was.
The Fed, it has often been noted, does not have much latitude for conventional expansionary monetary policy. It cut the federal funds rate from 6.5% in January 2001 to 1.25% today, a total decline of 5.25%, and that did not cure the economy. Since interest rates cannot go below zero, the latitude for further cuts is markedly reduced. Bringing the federal funds rate down below 1% itself will have a negative psychological impact, raising further public comparisons with Japan.
The Fed can conduct heterodox monetary policy, expanding the money supply by buying such things as long-term bonds. And ultimately, such a policy will stop the deflation. But there is a question whether the Fed or any other central bank can smoothly execute such a policy. There is no science about how to conduct such a policy to control the inflation rate accurately, given potential lagged feedbacks and hard-to-gauge expectation effects.
There is a risk that Mr. Greenspan will make the same mistake that Masaru Hayami, the governor of the Bank of Japan until March, made: going too slow. Mr. Greenspan understands where Mr. Hayami went wrong, but in the difficult environment, he might make the same mistake for fear of expanding too fast and causing a bout with higher-than-desirable inflation. Given the lack of knowledge about heterodox monetary policy, there is a variety of possibilities, including a deflation of short duration, a deflation of several years, or a sudden increase in inflation.
The Fed ought to start experimenting with such heterodox policies now. Given the vulnerability of economic confidence, it is probably wiser to risk erring on the aggressive side, pushing policies toward inflation. But even if the Fed does this as well as can be expected, a problem of deflation might be transformed into a problem of stagflation for a while -- not a nice option either. The economic problems, rooted in the human response to the nascent information technology of our age, will not be so easily vanquished.
We merely have to consider that such economic dislocations are the price of progress. We will get over this rough period, and, so long as our economic policies protect us from the greatest risks of such a transition, new prosperity is still to be expected from our new technology in the longer run.
Mr. Shiller, a professor of economics at Yale, is the author of "The New Financial Order: Risk in the 21st Century," (Princeton, 2003).
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