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Less Than Zero

Why deflation isn't a problem

It's not every day that first-rate economists such as Paul Krugman and Berkeley Professor Brad DeLong offer the same economic advice as a knee- jerk Wall Street booster like Robert Novak. But that's pretty much what happened earlier this month, when all three men criticized Alan Greenspan for failing to lower interest rates amid mounting deflationary pressure. Krugman went first in his August 16 New York Times column, distilling the conclusion of a recent Federal Reserve study into the following advice: "'[I]f you think deflation is even a possibility, throw money at the economy now and don't worry about overdoing it.' And yet the Fed chose not to cut rates on Tuesday. Why?" Three days later, in his nationally syndicated column, Novak likewise pronounced himself incredulous that the Fed had failed to lower rates, complaining, la Krugman, that "the Fed still seems oblivious to problems of deflation and credit unavailability that are compressing the real economy." Finally DeLong entered the fray in the August 21 Financial Times, noting, "If you do the math, you conclude that by the summer of 2004 the U.S. will have an inflation rate--at least as measured by the GDP deflator--that is less than zero [i.e., deflation]. ... It is in this context that the Federal Reserve's failure to cut interest rates so far this spring and summer is very puzzling."

You'd think that if Krugman, DeLong, and Novak all agree on something, it must be so obviously true as to be utterly uncontroversial. Alas, that's not the case. While deflation may be a concern, lowering interest rates today won't do much to address it. The basic Krugman-DeLong argument (Novak doesn't make an argument so much as a series of curmudgeonly assertions) goes as follows: Even though the economy is no longer in recession, GDP growth is still barely creeping along at a 1 percent to 2 percent annual rate—which is to say, several percentage points below potential GDP growth, the maximum sustainable (i.e., noninflationary) rate of economic growth. We know that inflation tends to fall anytime such an "output gap" arises. Since inflation is already very low—between 1 percent and 2 percent per year, depending on which measure you use—there are probably only so many months of output gap we can endure before falling inflation turns into outright deflation. And that would be disastrous for the economy. When the average price level is falling, the value of people's savings increases over time, giving them an incentive to put off purchases. If unchecked, this trend can lead to a vicious cycle in which falling demand leads to unemployment, and rising unemployment further erodes demand.

The best way to fend off this grim eventuality, Krugman and DeLong conclude, is to lower interest rates preemptively. As DeLong puts it in his Financial Times piece, "[I]f the central bank pushes short-term interest rates near zero, businesses are faced with the choice between investing in their business or watching the real value of their cash on hand shrink by [roughly the current inflation rate]"—an offer they're "unlikely to refuse." But the catch is that the central bank has to move while there still is an inflation rate. Once inflation turns into deflation, businesses won't spend their cash—regardless of how low interest rates are.

ONE CAN CERTAINLY quibble with the assumptions DeLong and Krugman use to generate their deflation scenario. DeLong argues that the economy could have grown by four percentage points more than it did over the last two years; others, such as Ohio State University economist Steve Cecchetti, put the output gap at well below three percentage points, since the "economy was operating above potential" prior to the recent slowdown. But the real problem with the Krugman-DeLong analysis is less that it overestimates the likelihood of deflation than that its proposed solution would either be ineffectual or actually make things worse. Krugman and DeLong propose counteracting deflationary forces by lowering interest rates, which would stimulate demand and ultimately raise prices. This is, in fact, a basic axiom of macroeconomics. Unfortunately, it's also one that unravels once you consider the current economic outlook.

Despite the collapse of the tech sector and the stock market over the last year and a half, consumption has held up remarkably well. Retail sales rose 1.2 percent in July, following a healthy 1.4 percent increase in June. If consumers stop spending now, it won't be because interest rates aren't low enough; it'll be because exceptionally low interest rates have allowed them to amass too much debt already, debt that gets tougher and tougher to service as jobs become scarcer. (The average American credit-cardholder has nearly $10,000 in credit- card debt.) Likewise, the housing sector has been very strong this last year and a half—so strong, in fact, that it has become one of the most inflationary sectors in the entire economy. Nationwide, median home prices shot up 7.4 percent in the second quarter, after rising 8.1 percent in the first three months of the year. If people suddenly stop buying, it'll probably be because they fear that the market is getting overheated and could collapse, not because interest rates aren't low enough. (A better time to lower interest rates would be after the housing bubble bursts.)

That leaves investment by businesses. It's true, as DeLong implies in his article, that business spending is probably the most important still-depressed item in our national accounts, having now contracted for seven of the last eight quarters and falling again in the current one. But it's not at all clear how lowering interest rates would help on that front either. Businesses haven't been buying much new equipment even though interest rates have been at 40-year lows for almost one year now. The reason is that firms in many sectors—audio equipment, semiconductor equipment, sporting goods—face excess capacity and falling prices. In this context, any firm that buys equipment to expand capacity would simply shoot itself in the foot: It would generate more output and further drive down prices.

In June Fortune magazine interviewed the CEOs of DuPont and UPS, who explained that while they were modestly upgrading their stock of information technology, they were either not expanding or scaling back capacity. CEOs are retrenching at an even faster pace in more deflation-plagued industries. A recent Washington Post article reported that the Big Three domestic automakers will likely retire some 1.5 million units of auto-making capacity—about seven assembly plants' worth—when labor contracts expire next year. Meanwhile, in an industry like telecom, where there is too much capacity because there are too many players, lowering interest rates could exacerbate the situation by keeping marginal companies afloat and delaying a similar restructuring (see "No Pain, No Gain," July 22).

On his website, DeLong is adamant that there is no such thing as excess capacity in the economy as a whole, only lackluster demand. That's true, as far as it goes. And if you think it tells the whole story, then cutting interest rates is the obvious response to the current situation. But the idea that demand is the problem breaks down once you look at distribution of prices across sectors. Generally speaking, there is steady deflation in manufacturing, where capacity is more difficult to adjust and where global competition can lead to oversupply. On the other hand, there is steady inflation in services-- in everything from car insurance to sporting events—whose capacity is either easy to contract (the former) or was difficult to expand in the first place (the latter), and where competition is more localized. Now that could certainly change—the latest consumer-confidence numbers show a sharp decline. But for the moment, it looks like our biggest problems are on the supply side. And those problems wouldn't have been solved by anything the Fed considered doing at its mid-August meeting.

[Editor's Note: The overline that now appears on this article, "Why the Fed Can't Stop Deflation," is different from the one that appeared in the magazine's print edition, "Why Deflation Isn't a Problem." The change was made to better reflect the article's thesis.]

This article originally appeared in the September 9, 2002 issue of the magazine.