May 24, 2003
Fear of a Quagmire?
uddenly the d-word is on everyone's lips. Last weekend the International Monetary Fund released a rather ominous report titled "Deflation: determinants, risks and policy options." The report made headlines by suggesting that Germany is likely to join Japan in the falling-price club. Alan Greenspan hastened to reassure us that the U.S. isn't at imminent risk of deflation. But alert Greenspanologists pointed out that he seemed to hedge his bets, and the fact that he even felt obliged to discuss the issue showed that he was worried.
Though talk of deflation fills the air, most of that talk is subtly but significantly off point. The immediate danger isn't deflation per se; it's the risk that the world's major economies will find themselves trapped in an economic quagmire. Deflation can be both a symptom of an economy sinking into the muck, and a reason why it sinks even deeper, but it's usually a lagging indicator. The crucial question is whether we'll stumble into the swamp in the first place — and the risks look uncomfortably high.
The particular type of quagmire to worry about has a name: liquidity trap. As the I.M.F. report explains, the most important reason to fear deflation is that it can push an economy into a liquidity trap, or deepen the distress of an economy already caught in the trap.
Here's how it works, in theory. Ordinarily, deflation — a general fall in the level of prices — is easy to fight. All the central bank (in our case, the Federal Reserve) has to do is print more money, and put it in the hands of banks. With more cash in hand, banks make more loans, interest rates fall, the economy perks up and the price level stops falling.
But what if the economy is in such a deep malaise that pushing interest rates all the way to zero isn't enough to get the economy back to full employment? Then you're in a liquidity trap: additional cash pumped into the economy — added liquidity — sits idle, because there's no point in lending money out if you don't receive any reward. And monetary policy loses its effectiveness.
Once an economy is caught in such a trap, it's likely to slide into deflation — and nasty things (what the I.M.F. report calls "adverse dynamics") begin to happen. Falling prices induce people to postpone their purchases in the expectation that prices will fall further, depressing demand today.
Also, deflation usually means falling incomes as well as falling prices. In a deflationary economy, a family that borrows money to buy a house may well find itself having to pay fixed mortgage payments out of a shrinking paycheck; a business that borrows to finance investment may well find itself having to pay a fixed interest bill out of a shrinking cash flow.
In other words, deflation discourages borrowing and spending, the very things a depressed economy needs to get going. And when an economy is in a liquidity trap, the authorities can't offset the depressing effects of deflation by cutting interest rates. So a vicious circle develops. Deflation leads to rising unemployment and falling capacity utilization, which puts more downward pressure on prices and wages, which accelerates deflation, which makes the economy even more depressed. The prospect of such a "deflationary spiral," rather than the mere prospect of deflation, is what scares the I.M.F. — and it should.
A decade ago all of these fears might have been dismissed as mere theoretical speculation. But in Japan the whole nasty scenario is playing out, just as the theory predicts. And about five years ago I and other economists began writing academic papers pointing out that what can happen in Japan can happen elsewhere. (Part of the I.M.F. report draws on my work on the subject.)
So how seriously should we take the risk that something similar will happen in the world's other major economies? Neither the United States nor Europe, outside Germany, is likely to experience serious deflation in the next year or two. But that's the wrong question — and we should bear in mind that Japan's economic malaise took a long time to turn into all-out deflation.
In fact, it's striking how gradually Japan's catastrophe unfolded. When the stock bubble of the 1980's burst, Japan's economy didn't fall off a cliff. By and large the economy continued to grow, if slowly, and the nation didn't have a severe recession until 1998. But year after year, Japan underperformed, growing less than its potential. Though the Japanese government tried to stimulate the economy using the usual tools — deficit spending, interest rate cuts — it was never enough. By 1995 or so the economy had slid into a liquidity trap; by the late 1990's it had entered into a deflationary spiral.
Our own situation is strikingly similar in some ways to that of Japan a decade ago. Like Japan circa 1993 or 1994, the United States is now facing the aftermath of a huge stock market bubble — the Nikkei and the Standard and Poor's 500 both tripled in the five years before their respective peaks.
Also like Japan, we face a problem not of sharp downturn but of persistent underperformance — an economy that grows, but too slowly to prevent rising unemployment and falling capacity utilization.
What's different is that we have Japan as a cautionary example. Is forewarned forearmed?
Whatever reassurances Mr. Greenspan may offer, the staff at the Fed is very worried about a Japanese scenario for the United States — a concern reflected in their research agenda. In a major study of Japan's experience published last year, Fed economists reached two key conclusions. First, Japan could have avoided its current trap if policymakers had been aggressive enough, soon enough. But by the time they realized the danger, it was too late. Second, the Japanese weren't stupid: their relatively cautious policies in the first half of the 1990's made sense given not only their own forecasts, but also those of independent analysts. But the forecasts were wrong — and the Japanese had failed to take out enough insurance against the possibility that they might be wrong.
The Fed has taken these conclusions to heart. Once the U.S. economy began to falter, it cut rates early and often, trying to get ahead of the problem. Those cuts certainly helped moderate the slump; but at this point, with the overnight interest rate down to 1.25 percent, the Fed has almost run out of room to cut. (Fed officials believe, for technical reasons, that going below 0.75 would be counterproductive.) And the economy remains weak.
The Fed still has some tricks up its sleeve. Now would be a very good time to announce an inflation target. But it's also clear that the Fed could use some help, at home and abroad. Alas, it's not getting that help.
The Fed's European counterpart, the European Central Bank, has been far less aggressive in cutting rates. There are economic, institutional and psychological reasons for this passivity, but the central bank's immobility is one main reason why Germany seems set to follow in Japan's footsteps. European governments aren't much help, either. Bound by the "stability pact," which limits the size of the deficits they are allowed to run, they have been cutting expenditures and raising taxes even as their economies falter.
The Bush administration is, of course, notably unconcerned about deficits. Aren't the tax cuts in the pipeline exactly what the economy needs? Alas, no. Despite their huge size — if you ignore the gimmicks, the latest round will cost at least $800 billion over the next decade — they pump relatively little money into the economy now, when it needs it. Moreover, the tax cuts flow mainly to the very, very affluent — the people least likely to spend their windfall.
Meanwhile, state and local governments, which are not allowed to run deficits — we have our own version of the stability pact — are slashing spending and raising taxes. And both the spending cuts and the tax increases will fall mainly on the most vulnerable, people who cannot make up the difference by drawing on existing savings. The result is that the economic downdraft from state cutbacks (only slightly alleviated by the paltry aid contained in the new tax bill) will almost certainly be stronger than any boost from federal tax cuts.
In short, those of us who worry about a Japanese-style quagmire find the global picture pretty scary. Policymakers are preoccupied with their usual agendas; outside the Fed, none of them seem to understand what may be at stake.
Of course, it's possible, maybe even likely, that their nonchalance will be vindicated. Most analysts don't think we'll find ourselves caught in a liquidity trap. And even the Fed believes — or is that hopes? — that a surge in business investment will save the day.
But few analysts saw the Japanese quagmire coming either, and there is now a significant risk that we will find ourselves similarly trapped. Even so, we won't have deflation right away. But by the time we do, it will be very hard to reverse.
Like the Fed, I hope that doesn't happen. But hope is not a plan.