Some Lessons on Beating the Deflation Trap

As the United States is gearing up for additional massive efforts in both the areas of monetary and fiscal policy we need to listen to the experience of other nations who have gone through recent periods of economic distress. We need to understand, as well as possible, just how this modern recession/deflation thing works.

There was a very interesting interview with Masaaki Shirakawa, a governor of the Bank of Japan, in Sunday's Financial Times. One of the important things about this interview is the emphasis it puts on understanding what is happening in different sectors of the economy instead of just focusing on aggregate information. This has importance in understanding how recessions begin as well as for understanding the depth and length of recessions.

One of the problems with modern macroeconomics, as discussed in my review of Paul Krugman’s “The Return of Depression Economics and the Crisis of 2008,” which appeared on Seeking Alpha on December 9, 2008, is that macroeconomists want to focus on aggregates and not what makes up the aggregates. For example, capital is defined by one of the most popular textbooks on macroeconomics as “the sum of all the machines, plants, and office buildings in the economy.” And, all these component parts are perfectly and costlessly interchangeable.

The difficulty with this is, according to Governor Shirakawa, is that it does not allow for an understanding of the “imbalances” and “dislocations” that evolve during an economic expansion or during asset bubbles. Thus, when the economy is expanding the monetary authority needs to “watch carefully whether the broadly defined imbalances are accumulating or not.”

Furthermore, during these times, risk-taking and financial leverage tend to expand dramatically. It is not just aggregate demand or supply that is important in understanding the evolution of the economy but what is happening in various sectors of the economy and how the financial structure needs to unwind, is also important.

Experience has shown that these imbalances occur even when things like the consumer price index is behaving well. “Very often in recent decades we experienced a situation in which imbalances are accumulating, despite the fact that the inflation rate is quite subdued.” He continues, “Inflation targeting is one part of a good framework to explain monetary policy. But if inflation targeting creates the social presumption that the central bank can look at consumer price inflation alone, then it might have some unintended effect of helping the creation of a bubble.” That is, asset prices in different markets, housing, stocks, and so forth, must be observed also.

Why is it important to understand this?

We need to understand this because it points to the fact that recessions or periods of deflation cannot be handled by just appeals to pumping up aggregate demand. We need to understand that the previous upswing created imbalances, bubbles, dislocations, over-investment and these previous decisions cannot just be dissolved by assuming that all capital investment is alike and that stimulating aggregate demand is not the only thing that needs to be done.

However, Governor Shirakawa argues, this does not mean that monetary or fiscal policies are not needed in combating deflation and turning the economy around. Both are a part of a sound strategy to get the economy going in the right direction.

What is also important is a focus on the imbalances and dislocations that were created in the previous run-up. The policy makers need to understand how the various sectors are working themselves out and what, if any, bumps in the road lie ahead.

For example, the prime example of the ‘asset bubble’ just experienced is the housing industry. Until the summer of 2006, the housing market was ‘riding high’ with housing prices and housing starts seeming like they would never stop. Yet they did and housing prices have dropped steadily ever since. How far will they drop? Some analysts say that housing prices must drop to at least 50% of their peak value. The picture gets even darker when one observes that there are still two major clouds hanging over the future. Both are related to the ‘financial innovations’ of the 1990s…major amounts of Alt-A mortgages and the Payment-Option ARMS are going to re-price over the next two to three years. The peak in housing foreclosures and personal bankruptcies is not expected to arrive for at least a year from now.

Another example is the financial industry. Banks and others have already taken tremendous losses, yet more are expected. The reason for this is that the banks still don’t fully comprehend the extent of the write-downs they are going to have to take on existing assets. Then, there is the fact that the banks have not yet seen the extent of the write downs connected with credit cards, auto loans, high-yield securities, and commercial and industrial loans. This doesn’t even consider the possible adjustments that will need to be made in the mortgage area mentioned in the previous paragraph. Mutual funds and hedge funds are now restricting investors who want to get their money back, and we are also starting to see some of the fraud schemes surface that were a part of the recent credit inflation.

A further example is the auto industry (which also applies to other areas of manufacturing in the United States). I think everyone can agree that there are massive areas of imbalance and dislocation in this industry. Who is at fault? The auto executives? The labor unions? The politicians? The consumer? Everybody else? I don’t believe that any one person or group can be singled out as the cause of the problems in this industry.

However, I think that we can all agree that the problems are massive. These problems have to do with technology, innovation, out-of-date facilities, inappropriate pricing of resources, and other excesses that have been built into the structure over many years. Regardless of whether or not there is a bailout of this industry, it is going to take many years for the auto industry (and, I would argue many other areas of manufacturing in the United States) to really join the 21st century. Obviously, aggregate demand policies are not going to take care of the restructuring that is needed here.

Shirakawa summarizes:

Based on our experience, the world economy or the US economy needs the elimination of excesses. Of course the exact excesses vary from country to country…In today’s US for instance, housing is excessive; household debt is also excessive—I don’t know by how much, but anyways ‘excessive’ is there.

Negative feedback is now at work and I cannot give you a precise answer (to how long the global crisis is to run). What is crucial is to avoid a situation in which the adjustment leads to a serious downturn in the economy.

In conclusion, there is no quick fix. The ‘excesses,’ ‘imbalances’ and ‘dislocations’ in each sector must work themselves out. Monetary and fiscal policy may be able to soothe the pain…but they will not eliminate it.

I tend to agree with Governor Shirakawa.

Comments

[Jeff Nichols:]

I believe we will see a longer, deeper decline in business activity than most, lasting into late 2009 or, more probably, 2010 — and likely to be accompanied by some of deflation, particularly in commodities, food, autos, and a variety of consumer goods. To be honest, deflation has been with us for some time already, first in real estate markets, then on Wall Street, more recently in oil and commodity markets, and, as anyone shopping for the holidays will soon notice, in many retail stores. As I review on my blog, NicholsOnGold.com, gold is proving to be an effective deflation hedge . . . and when the economy switches into forward gear and inflation replaces deflation, gold will shine still brighter.

2008 Dec 16 09:28 AM

[carey_jim:]

This period is similar to the period from 1900 to 1930 in that we are seeing massive technological changes that are producing corresponding massive changes in social life and working conditions.

To cite only one example, the electrification of America which began in earnest after World War I, produced the electrified farm (with milking machines, etc.) and increased farm productivity exponentially.

Paradoxically, by the early 1920s this dramatic rise in productivity caused the biggest crises for farmers in the twentieth century. While the American population increased by about 15% from 1910 to 1925 the farm population decreased by 5%. Average prices dropped in America by 10% from 1920 to 1922 but farm prices dropped by 50%.

Combined with more than 500 bank failures (due to various factors related to World War I, the Federal Reserve Bank and the gold standard) farmers were plunged into a depression that was not equaled even by the 1930s depression.

We've seen much faster rises in productivity today and even greater worker dislocations have occurred and are looming on the horizon. For example, while one out of eight workers in the 1920s were automobile workers, Nobel Prize winning economists such as Paul Krugman have suggested letting the entire American automobile industry go bankrupt allowing these jobs to disappear completely from the American economy.

In the 1930s, it seemed impossible to raise wages of average workers high enough to buy enough of the cars and electronic goods being produced for the first time in our history.

Enormous changes occurred in the 1920s and 1930s, just as they are occurring now, such as electrifying and bringing running water to most buildings, providing washing machines, radios and cars for most people. More highways were built in the1930s than in the1920s. But wages fell, various union practices and demands were declared unconstitutional and 25% of Americans remained unemployed and unable to consume the new goods.

I suggest that we are facing a similar problem today. Prices are dropping and have been dropping for at least thirty years, as production methods have improved (the rationale for the "hedonic index") and entire industries are being replaced by new ones, causing massive dislocation or workers.

Ironically, in the 1920s and 1930s, automobile workers replaced those workers who raised and tended horses and carriages and today, computer workers are replacing automobile workers.

As in the 1930s, we are facing falling prices due to increased productivity, weak consumer demand due to unemployed and underpaid workers and we are facing downward pressure on wages due to weak unions and illegal immigration.

2008 Dec 16 12:46 PM

[carey_jim:]

I should have said "real" prices have been dropping for the last 30 years or more, of course! Nominal prices (inflation) have clearly been rising but misleadingly so.

2008 Dec 16 01:52 PM

[vaughn:]

Excessive credit creation in the past created the problem we are in.

The solution implemented by the Fed Reserve to pull out of this excessive is creating more excess by printing the press to pursue the nada/nil/zero interest policy.

Obviously, more excessive credit cannot solve the problem of liquidity trap, deflation trap, and the negative feedback trap. The excessive credit by 0 rate policy via the treasury bubble can and will only create the next shop to drop. If the treasury bubble is burst, then ..........

Only time can work the excess out. Only default and deflation can work out excessive debts over time.

2008 Dec 18 12:07 AM