Avoiding the Deflation-Debt Trap
24.01.2003
Annual Meeting 2003
Since the end of World War II, monetary policy-makers have focused their attention on controlling inflation - with greater or lesser success. More recently, however, a spectre from the 1930s has re-emerged, in the form of generalized price deflation. Japan has already fallen prey to this resurrected threat. The aftermath of the Nasdaq bubble has raised fears that the United States may be next. How real are the dangers? What, if anything, can be done to avoid them?
Moderator Pamela D. Woodall, Economics Editor, The Economist, United Kingdom, outlined the economic dynamics that make deflation such a fearful word. When prices are falling, and are expected to continue to fall, consumers have an incentive to postpone purchases, slowing economic activity. Corporate cash flow declines, even as debt values increase in real terms. As interest rates fall near zero, central banks lose the ability to stimulate the economy with conventional monetary policy. Demand falls even more, prices decline at an even faster rate - creating a downward cycle that can be difficult to break.
In Japan, this cycle is already well entrenched, noted Alan S. Blinder, Professor of Economics, Princeton University and a former Federal Reserve Vice-Chairman. In the United States, on the other hand, deflation is a potential, not an actual, threat - and is likely to remain that way, assuming the economy remains reasonably healthy. The caveat: "With inflation at current levels, one serious-sized recession would be enough to take us down to zero, maybe a little bit below," Blinder said. "The odds of deflation are not high, but they’re certainly not negligible."
Haruo Shimada, Professor of Economics, Keio University, Japan, offered some lessons from the Japanese experience of the past 15 years. Economic leaders in other countries, he said, would do well to study the steps taken by Japanese policy-makers - and then make sure they don’t repeat them. Japanese officials, Shimada argued, were slow to recognize the deflationary threat and even slower to respond to it. After deliberately popping Japan’s stock market bubble in 1989, the Bank of Japan left interest rates high even as the economy weakened dramatically, he said. Initial efforts at fiscal stimulus were miserly. Subsequent efforts were poorly designed, relying too heavily on pork-barrel construction spending. Now Japan is in a trap and has no easy way out, despite the Bank of Japan’s increasingly desperate measures, such as directly purchasing Japanese equities. Only supply-side reforms that stimulate growth in Japan’s stunted service sector can pull the country out of stagnation, Shimada concluded.
With US interest rates at their current levels, the Federal Reserve already faces the risk of losing control of monetary policy, said Lawrence H. Summers, President, Harvard University and a former US Treasury Secretary. "How likely is it that the Fed might need to cut interest rates by 200 basis points over, say, a year’s time? Historical experience suggests it wouldn’t be that unusual. But they can’t do it now." While some Fed officials contend they could resort to other measures to stimulate economic activity - such as purchasing longer-term Treasury notes or corporate bonds - Summers said he remains sceptical of their efficacy. To have much impact, such operations would have to be of a truly "staggering" size. Even then the results are uncertain. Fiscal stimulus, Summers said, offers the more likely remedy.
Caio Koch-Weser, Secretary of State of Finance of Germany, said Europe faces an unusual combination of risks. Consumer inflation is close to non-existent in Germany, and may already have tipped into deflation in some sectors and regions. At the same time, though, inflation rates remain relatively high in other euro-zone countries, such as Spain. This creates the risk that the European Central Bank will leave interest rates at levels that will intensify deflationary pressures in Germany and other low-inflation countries. On the other hand, low relative inflation is gradually improving German wage competitiveness. Germany has also been given special dispensation to avoid binding EU limits on budget deficits. This should permit Germany to avoid serious deflationary problems. But with the global economic environment so uncertain, German policy-makers are mindful of the risks, Koch-Weser said.
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