Economist's View: "The Rising Threat of Deflation"

Mark Thoma:

As I hope you already know, conservatives (update: and some misdirected liberals) aren't standing on very firm ground with their worries about inflation and their calls for austerity. In fact, merely saying the ground they are standing on is shaky is far too generous. But if you need further evidence that they are promoting bad ideas, note that they can't even get the American Enterprise Institute to agree with them:

The Rising Threat of Deflation, by John H. Makin, AEI, July 2010: As we enter the second half of 2010--the ... United States and Europe are heading toward--and Japan already suffers from--deflation, a classic prolonger of crises that boosts the real burden of debt and crushes profit margins.

U.S. year-over-year core inflation has dropped to 0.9 percent--its lowest level in forty-four years. ... Europe's year-over-year core inflation rate has fallen to 0.8 percent... Ireland's deflation rate is 2.7 percent. As commodity prices slip, inflation will become deflation globally in short order. Meanwhile in Japan,... the ... gross domestic product (GDP) deflator had fallen 2.8 percent, reflecting an accelerating pace of deflation in a country where the price level has been falling every year since 2004. ...

The financial crisis of 2008 prompted aggressive monetary and fiscal easing by most governments. ... Many market participants and policymakers have warned that such aggressive easing will lead to inflation. Contrary to those expectations, as noted above, core inflation has steadily moved lower... By later this year, persistent excess capacity will probably create actual deflation in the United States and Europe. Moreover, the recent appreciation of the dollar, especially against the euro, exacerbates the U.S. deflation threat. ...

Perhaps it is time for central banks, the ECB especially, to take note. Financial crises are usually deflationary. Pretending otherwise ... constitutes a necessary, although not sufficient, condition for a global depression. ... A persistent failure to respond to the dangers of further deflation, such as the premature removal of accommodative monetary policy apparently favored at the ECB or a sharp fiscal contraction favored by the European Monetary Union, would sharply elevate the risk of global deflation and depression.

At this point in the postbubble 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 G20'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 link between volatile financial conditions and the real economy has been powerfully underscored by the events since mid-2007. Growth has suffered and subsequently recovered given powerful monetary and fiscal stimulus. And yet, the damaged financial sector, unable to supply credit; a jump in the precautionary demand for cash; and a persistent overhang of global production capacity have combined to leave deflation pressure intact. The G20's newfound embrace of fiscal stringency only adds to the extant deflation pressure. ...

Posted via email from Jim Nichols