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February 16, 1999

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Subject: Re: Question for Rimpinths: The Deflation Trap.
Author: Rimpinths

IFindKarma wrote in post:
Rimpinths, I have a question about deflation. Can it be possible that the U.S. economy is in the risk of inflation and deflation at the same time?

No, that's impossible. Inflation is a rise in prices; deflation is a decrease in prices. They're opposites. I think the question that you are trying to ask is: Can it be possible that the U.S. economy is overheated and at risk of deflation? The reason that inflation is watched so closely by economists is that it is often the first sign of an economy becoming overheated. The theory goes that if the economy starts becoming overheated, then workers will demand higher wages, which will manifest itself as inflation. An overheated economy is a bad thing because it causes oversupply and excess capacity, which will in turn cause a recession to diminish the supply. Inflation is usually the first sign that an economy is becoming overheated, thus I think it's more appropriate to ask the question: Can it be possible that the U.S. economy is overheated and at risk of deflation?

The answer is a resounding yes as it has happened many times before. One of the reasons that the Japanese bubble went on so long is that consumer price inflation remained very low, thus there was no justification for raising rates. It's also notable that the only period of deflation that the United States has had this century is during the 1930's. Bubbles are usually accompanied by deflationary pressures.

However, deflation is contradictory to some basic assumptions in economics. A basic assumption is that unemployment and inflation are inversely related. That is, when unemployment is high, inflation is low. When inflation is low, unemployment is high. This theory is demonstrated by the existence of the Phillips curve. If you plot history rates of inflation against concurrent rates of unemployment, you will see a very distinct concave curve. You want to keep unemployment as low as possible without triggering inflation. The job of the Fed is to find that optimal balance between unemployment and inflation. They will control the money supply to get unemployment rates as low as possible until the first signs of inflation show up.

"So you bulls are going out on a limb when you talk about all this "new era" stuff because it is contradicts commonly held beliefs, such as the relationship between stock prices and earnings."

Because there is very little consumer price inflation, the Fed has not tightened the money supply at all in order to throw some cold water on an overheated economy. In my opinion, the Fed pays too much attention the CPI and the M1 measure of the money supply, without considering asset inflation (e.g. stocks and property) and the growth in M3 money. (M1/M3 -- ask if you don't understand.) Moreover, I think the CPI is understated due to deflationary pressures and that our economy is actually seriously overheated.

So you bulls are going out on a limb when you talk about all this "new era" stuff because it is contradicts commonly held beliefs, such as the relationship between stock prices and earnings. In my opinion, this is where many of we bears are going out on a limb: we are claiming that the economy is overheated in spite of the absence of inflation. I think this is true and think that this is one of the causes of the bubble. If inflation remains low, then the Fed will keep the floodgates of liquidity open, perhaps much longer than they should.

I think that many of the events overseas (recessions, devaluations) are the result of an oversupply of goods in the global economy. The oversupply has caused prices to be cut dramatically, resulting in deflation overseas and deflationary pressures here. American firms, as competitors in a global market, have also had to cut prices in order to retain market share. We're having trouble keeping up with them, as indicated by our growing trade deficit (new numbers coming out this week, BTW.)

The dramatic turn of events overseas is causing inflation to be understated here, thus Easy Al and the Fed is allowing the economy to overheat by flooding the markets with excessive liquidity. They are concentrating too much on the CPI because that is what they are commissioned to do. If the Fed did raise rates without an increase in the CPI, then that would be a very politically unpopular move, since it would undoubtedly bring the market to its knees. That's the deflationary trap.

So assume all the things I wrote above and you can begin to see how the "deflationary trap" comes about. The global market is flooded with goods causing deflationary pressures. Even though the American economy is overheated, the excess supply doesn't show up in the form of consumer price inflation as measured by the CPI. Moreover, much of the inflationary pressures of an overheated economy is being directed towards the asset markets, such as stocks and property, which the Fed largely ignores. The result is that the Fed continues to keep interest rates low (thus encouraging borrowing and growth) rather than raising rates to slow the economy down (to diminish the excess supply.)

The economy is growing at breakneck speeds and inflation remains low, everybody's happy, everything seems perfect - why on earth would the Fed want to discourage this by raising rates? That's the deflationary trap. That's the same trap the Fed was caught in back in 1929, and the Bank of Japan was caught in during the late 1980's. Easy Al is in the same trap.

"...this is where many of we bears are going out on a limb: we are claiming that the economy is overheated in spite of the absence of inflation. I think this is true and think that this is one of the causes of the bubble. If inflation remains low, then the Fed will keep the floodgates of liquidity open, perhaps much longer than they should."

Also, do you believe that any macroeconomic policies at this point could avert disaster. . .

No, unfortunately I don't. Bubbles always end badly. We've already spent the money, there's no way to get it back now. You all think it's still there in the form of those pieces of paper known as stocks, but it's already gone and it's not coming back. There's no way that we're going to be able to sort out how to divide the money evenly without lots of people ending up losers. Bubbles always end badly and the longer they go on, the worse they end, so it's best for the Fed to just put an end to it now.

. . . or is it best to just let the business cycle take its natural course, as manipulations can only affect things for a while, but they always fail longer term?

It depends on what you mean by "manipulations". Other people, such as TMainzer, have already presented an excellent analysis of the two schools of thought in economics. One school of thought is the Keynesians, who believe that the government should smooth out the bumps in the business cycle by saving surpluses during expansion, and running deficits during recessions. Many people (including myself) disagree with the Keynesians because this is dabbling in socialism and, moreover, it's politically infeasible to manage a budget this way. On the other hand, it's largely a moot issue as our government controls about 40% of our economy as it is. If we enter a recession, I think that our government will have even bigger budget deficits, as the tax base will decrease and the expense of running social programs will increase. Like or not, our government follows the Keynesian model.

On the other hand, the other school of thought is that of the Monetarists (or what TMainzer calls the Austrian school.) The Monetarists believe that we should leave the economy alone, except for more subtle manipulations of interest rates and the money supply. This is why I put "manipulations" in quotes earlier. I don't know if you would call these kinds of things manipulations. The Monetarists don't believe in a centrally-planned economy, so in that sense they are not managing the economy. On the other hand, they are managing the economy via interest rates and the money supply. However, this is necessary if you wish to maintain a currency that is not backed by gold, so the Monetarists will always have a role in our economy as well. The Monetarists control the Fed (ineptly, I might add) and the Keynesians control the legislature.

The two schools of thought are almost always presented as opposites, but IMHO that's more from a political point of view than economic point of view. Economic policy is going to have elements of both: Keynesians philosophies to determine how the government should manage its budget, and Monetarists philosophies to determine how the government should manage the money supply. Because the Monetarists place an emphasis on the money supply rather than government spending, they are often associated with laissez-faire policies and thus come across as political opposite of the Keynesians.

Personally, I am very much in favor of libertarian policies and I'm a big admirer of Milton Friedman. I guess I would call myself a Monetarist, but so would Greenspan, and I adamantly disagree with the way that he is managing the economy. Even though we both belong to the same school of economics, it doesn't necessarily mean I agree with his approach. (There's always room for disagreement in economics.) I believe that the Fed should increase interest rates now and put an end to the bubble. Would this be manipulating the economy? It's a matter of opinion. I think it's just correcting an earlier mistake.

Rimpinths

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