Europe, Deflation Fears, and Us

This morning’s New York Times carries a very disturbing report on the Spanish economy. In particular it highlights what appears to be the onset of a bout of deflation. Apparently retailers throughout the country are now having to cut prices in order to encourage any kind of spending, and the rate in the reduction in price levels is now reaching an alarming pace. The most disturbing aspect of the Spanish situation is that their unemployment rate is now up at 15.5% and is heading higher: it might easily reach 20%. The combination of unemployment at those levels and falling prices is exactly the combustible mix that characterized the Great Depression so events in Spain bear considerable attention.

And Spain is not alone: other European countries are facing disastrous economic declines as well, not least Ireland which is arguably worse off than even Spain.

So the obvious question becomes: could we also fall into this deflationary and high unemployment trap?

A quick answer would be no.

The reason is that the US has taken some extraordinary measures that the Europeans have not. For instance, the Federal Reserve Board has pursued a very aggressive monetary policy from the beginning of the crisis. It started by reducing interest rates quickly and when that failed to produce the normal or expected response it adopted a series of highly unusual, some might say unorthodox, policy steps such as beefing up its own balance sheet by buying securities from private investors. Such purchases have the effect of putting more cash into private hands and therefore increasing the nation’s money supply,i.e. the total amount of cash and cash equivalent money in circulation. In theory this should boost economic activity, or more likely prevent further contraction.

In conjunction with the Fed’s creative activities, the US has also gone on a binge of deficit spending, which is the classic ‘Keynesian’ response to a fall in demand in the private sector – recall that ‘recession’ is simply a term used to describe an economy that is shrinking, and that the shrinkage is, in turn, usually caused by a drop in demand for goods or services by private consumers.

Traditional economic theory teaches that the Fed’s ‘normal’ monetary policy, cutting interest rates, should be sufficient to return a shrinking economy to growth. This is because lower interest rates encourage a new bout of borrowing, which means that cash is freshly available for boosting spending.

A moment’s thought of that traditional policy will immediately lead you to see the reason the current crisis is so difficult to deal with.

It relies on lending.

Without healthy banks the drop in interest rates will have little effect due to the fact that there are no banks prepared to lend. So the recovery effort stalls at the first hurdle.

Plus, this time consumers are so snake bitten by declining home values and collapsing stock prices, both of which are wiping our household savings, that the amount of effort needed to get people out borrowing and spending again is beyond the reach of normal policy.

This is particularly true because we went into the crisis with interest rates already fairly low: so there was not much leeway for aggressive interest rate cuts before we reached zero. And interest rates cannot go below zero.

All this is familiar on both sides of the Atlantic.

What is different in Europe is their resistance to running a Keynesian style fiscal policy, i.e. going into deficit spending to stimulate demand; and this is coupled with a level of denial, until quite recently, about the true situation in the larger European countries like France and Germany. Since the European Union acts as a single entity for monetary policy purposes, through the European Central Bank, countries like Spain are left to fend for themselves. They have to comply with the central monetary policy and so have to rely heavily on fiscal policy at their local levels.

It is easy to get a little haughty at this point and criticize the centralization that seems to have caught Spain in a terrible vice. But we should all recall that the US also has huge regional differences in its economic performance: just look at the damage being wrought in Michigan by the auto industry collapse; or in Nevada, California and Florida by the real estate collapse and our air of superiority should evaporate quickly.

In fact much of the beneficial effect of the Federal stimulus package is being entirely offset by highly restrictive policies being enacted at the state level. Just as cash is pumped into the economy by the Feds local jurisdictions are cutting back on spending and therefore negating the Fed stimulus.

In this regard, the only reason that California is not being touted as an economic disaster of Spanish proportions is that no one sees it as an independent country! Its budgetary crisis, which is of epic proportions, gets treated as a local disturbance rather than a national implosion.

With home and stock prices still falling [or at least remaining weak]; with lower demand reducing commodity prices – things like oil are costing less because consumption has fallen faster than output; and with unemployment likely to rise well into next year the scene is set for deflation here too.

And that fear has been sufficient for some, myself included, to urge the Fed to induce a bout of inflation. Some of you may have noticed that Ben Bernanke actually went on record as saying the Fed was targeting a 2% inflation rate over the medium term. This was his way of letting the credit markets know that he was prepared to stoke inflation rather than allow deflation set in.

How would he do that?

By pumping tons of cash into the economy. If the money supply grows faster than the potential growth rate of the economy we normally get inflation. As of now the economy is running well below its potential, so all the cash being injected will simply lift activity towards that potential rather than result in inflation. The tough part comes when the economy starts growing again and the money supply remains higher than needed – as it would given all the Fed’s extraordinary efforts of late. The ‘neat trick’ the Fed is trying to pull off is to signal its intention to produce modest inflation, and hence calm deflationary fears, while at the same time attempt to judge the right moment to rein in money supply to prevent inflation exploding.

Rather them than me.

Unfortunately for Spain they are tethered to the less expansionary policies of the European Central Bank and the highly conservative fiscal policies of its largest trading partners. It is in awful trap. And deflation is an almost inevitable result of it having to contract its economy severely to achieve a rebalancing rather employing the kinds of tools we have here.

So, coming back to the question of whether we can expect a Spanish style crisis here, the long answer is also no.

But there is no room for complacency: our political willpower to pursue the necessary bailouts and stimulus has been wafer thin at times. Raging on about the future costs of ballooning Federal deficits, or about the cost of saving the banks, and debating the efficacy of government spending at times like these are corrosive to that willpower.

In other words, we could easily become like Spain.

We dodged the big one because we did the ‘right thing’. Let’s hope we have the sense to keep on doing it.