Inflated Deflation

The prospect of a damaging deflation has been highly exaggerated. Deflation is unlikely today. Even if it did occur, our economy today is better positioned to adjust to it.

Deflation occurs when the prices of most goods and services fall – that is, most things cost less now than they used to cost. Deflation is the opposite of inflation, which is when the prices of most goods and services rise. A large and sustained deflation occurred during the Great Depression, and some economists blame much of the Great Depression’s poor economic performance on that deflation.

DEFLATION IS A GENERAL PRICE DECLINE

For most of our lifetimes, there have been some prices that have fallen, even while many prices rose. For example, the Bureau of Labor Statistics reports $20 buys more toys today than it did 30 years ago. Although some toy manufacturers may be worse off because toys sell so cheaply now, most of us are happier that we can either buy more toys or spend our incomes on other things.

Some prices have fallen during the last month or two, such as the prices of oil and raw materials. Because most of us do not obtain much (if any) income from the ownership of oil wells, aluminum mines, and the like, we should be glad – not concerned – that these prices are falling. Remember that we have been reading since 2005 how the American consumer – and the American economy in general – has suffered from high oil prices. Finally now some of that suffering eases.

Housing prices fallen a lot over the last two years, and will continue to fall. Most of us do own houses, and falling housing prices have created a number of problems. But falling housing prices is different from a general deflation; it takes a lot more than falling housing prices to create deflation, even over a short period of time.

Indeed, it was less than six months ago – when we were all quite aware of the housing price reductions – that the Federal Reserve and other commentators expressed concerns about inflation. The inflation concerns were present because housing is only one of many goods and services that we consume and those other prices seemed to be on the rise. The deflator for personal consumption expenditures rose at 3.3% per year from 2006 Q3 through 2008 Q3 – that’s inflation of 3.3% per year.

Energy was part of this increase – it increased 16% per year over that period. However, energy goods are only 4% of consumption expenditures, so this accounts for less than one percentage point of the 3.3; even if energy prices had fallen 16% per year over those two years, there would still have been inflation. My purpose here is to assess the likelihood and consequences of general deflation.

DEFLATION CAN BE FUELED BY FINANCIAL TURMOIL, BUT IS NONETHELESS UNLIKELY
Although I do not believe that the recent financial turmoil has a significant impact on the wider economy’s employment and real growth rates, I do believe that financial turmoil can affect consumer prices and therefore the rate of inflation or deflation. Financial turmoil can cause investors to seek liquid assets like insured bank deposits, Treasury Bills, and perhaps currency. If banks, the Federal Reserve, and the Treasury fail to supply the safe assets demanded by the market, then consumer prices will have to fall in order to make the existing liquid assets more valuable in real terms. Milton Friedman and Anna Schwartz were right when they blamed some of the 1930s deflation on the Federal Reserve’s failure to accommodate investors’ demands for liquid assets (see Chapter 7 of their A Monetary History of the United States).

Deflation today is unlikely because banks, the Treasury, and the Federal Reserve have accommodated at least some of these demands. Large commercial banks increased their deposits by $157 billion during the last week of September 2008 (at the height of today's banking crisis), and maintain those higher levels throughout October. An increase of $157 billion would normally have taken about 6 months. Treasury debt held by the public increased almost $800 billion from September 15 through October 30. Much of that increase was available to the non-bank public, because bank holdings of Treasury and Agency securities were pretty constant until the second half of October, at which time they increased about $100 billion. With the Treasury, the Fed, and the banking sector accomodating the increased demand for liquid assets, the bigger risk is that high inflation next year will result from failures by the Treasury and the Fed to accommodate reductions in liquid asset demand that will accompany a return to financial normalcy.

Deflation today is also unlikely because it is much better detected and understood than in was in the 1930s. Today, the Federal Reserve and the public have access to consumer price indices within a few weeks of those prices’ actually being experienced by consumers. Thanks in large part to the history written by Milton Friedman and Anna Scwartz, Federal Reserve officials are also well aware that they have the power to avoid a sustained deflation.

MORTGAGE AND PROPERTY TAX DAMAGE HAS ALREADY BEEN EXPERIENCED
Even if our economy were to experience a sustained deflation, it would survive it better than we did in the 1930s. The 1930s sustained deflation was damaging because, among other things, it dramatically redistributed wealth from persons owing mortgages to those who had underwritten them – in a way that was not anticipated when those mortgages were signed. The deflation also amounted to a un-legislated increase in property taxes, because their dollar value stayed fixed while taxpayers’ dollar incomes fell, as did the public sector’s dollar expenses.

Farmers in the 1930s found their crops were selling for half the dollar amount that they were in the 1920s, yet had no easy mechanism to cut the dollar amounts of their mortgage and property tax obligations. Today, because home prices are way down (50 percent by some estimates) regardless of whether we see inflation or deflation, homeowners have little equity to lose to banks as a consequence of deflation. Home mortgages already need to be renegotiated to better reflect home values and homeowner incomes. Homeowners also have a tremendous incentive to have their homes re-assessed by the property tax authorities -- even a 10 percent deflation would be only a minor change in the overall mortgage and property tax landscape today.

DEFLATION = CORPORATE TAX CUT

Corporate taxes are more important today than they were in the 1930s, in part because corporate taxes were unconstitutional until 1913. I have calculated that corporate taxes in recent times have been more than 12 percent of all capital income in the economy, as compared to about 3 percent in the 1930s. Harvard's Professor Feldstein has explained over the years how inflation amounts to an un-legislated corporate tax hike because corporate depreciation allowances are not indexed for inflation. That is, corporations make deductions for historical investments, but during times of inflation those dollars of deductions are few compared with the dollars of current revenues; an inflation-neutral tax code would recognize that the investments made in the past are worth more (to the degree that there has been inflation) than their dollar amount would suggest.


It follows that deflation amounts to an un-legislated corporate tax cut. Is there a better time than now to cut corporate taxes?!

[Added Nov 19: I changed my mind about the mortgage and property tax damage from deflation -- it could be bad if not handled propery by the Fed and the Treasury. See my post "UI on Steroids"]