Deflation and Wages
It’s a rare moment when Paul Krugman agrees with someone like Martin Feldstein, they represent very different parts of the political and economic spectrum. But agree they do. What is the miracle factor that binds them? Their fear of deflation. Nothing is as threatening to the way in which we all conduct business in the modern economy as a bout of deflation.
How real is the risk?
Well Feldstein was prompted to write about deflation by the appearance of an Economist magazine survey in which forecasters from around the world predicted that consumer prices in the US and Japan may actually fall in 2009. That sets the stage for a possible period of deflation, especially when we add in the factor that started Krugman writing: wages are falling in many parts of the US.
Consumer prices are bound to fall for a while during a recession if they are already fairly stable at its beginning. The drop in demand alone takes pressure off of commodity prices – things like oil and raw materials – which subsequently feeds through to the consumer as lower retail prices. If the fall in demand is sharp enough, as it has been this time, prices in stores will also be driven down by retailers and manufacturers use of discounts and incentive pricing. Before long, as the contraction gathers pace, this downward pressure becomes self-fulfilling as consumers start to bargain hunt and avoid anything that appears ‘fully priced’. This is exactly what we have seen so far in this recession. The modest pick up in sales volumes reported back earlier this year were largely a result of discounts encouraging spending.
The fact that fears of unemployment are so rampant that workers are now accepting pay cuts in order top retain their jobs exacerbates this trend even further.
As workers wages start to drop the potential for a vicious downward spiral rises. Lower wages create particular difficulty for anyone with fixed expenses. The relative cost of those fixed expenses goes up. Put another way: the number of hours work it takes to pay the mortgage is higher. This is exactly equivalent to a rise in the cost of debt. Which, as Krugman points out, is something Keynes spoke about during the Great Depression.
One possible reaction that policy makers can have is to stoke up inflation. Which is what the authorities in the US, the UK and Japan have been doing. In all three countries the central banks have been printing money furiously to offset any deflationary tendencies. Here in the US the result has been a very modest rise in the inflationary expectations embedded in long term interest rates.
Nonetheless deflation lurks as a major threat.
An extended period, say several years, of deflation could undermine our economy as no other factor could. Business investment would become unattractive; debts would slowly increase in their burden and stifle consumption; and the mentality of the economy would slowly shift towards a defensive posture: the attractiveness of credit disappears and prevents growth in major sectors of the economy such as housing and auto manufacturing.
In short, deflation sucks.
We all appear to want to try all the wrong options before we are forced, at great cost, to try the right ones. This is truly perverse behavior.
Oddly, we have a very recent historical example to study: Japan during the 1990’s. That example is salutary because it also includes a major bank crisis. As we look back on Japan’s experience three things strike me as relevant:
- The Japanese failed to deal with their banking crisis quickly enough. It took the best part of a decade for the government to ‘do the right thing’ and demand that the banks take government bailout money. It also finally forcibly reorganized the weaker of its banks.
- But the cost of delay was huge. Japanese wealth was no greater at the end of the decade than it was at the beginning. So the timidity of the Japanese government cost its population a vast amount of lost opportunity. Things may have felt relatively stable, but they should have been so much better.
- Deflation is extraordinarily pernicious. In the end Japan only started to recover because the worldwide growth in trade created export markets for Japanese goods. Domestic growth remained weak and savings far too high.
Since this evidence is easily at hand, and since we also have the benefit of Keynes analysis from the Great Depression I find it strange that practically every government in a major country now affected by the recession, and that means just about everyone, is behaving exactly the same as the Japanese did early in their ‘lost decade’. In fact judging by the policy options taken here in the US and in Europe on both fiscal stimulus and banking issues we all seem hell bent on avoiding learning anything from Japan. We all appear to want to try all the wrong options before we are forced, at great cost, to try the right ones. This is truly perverse behavior.
Nonetheless that’s what we’re doing.
And one consequence of timidity is the ugly possibility of deflation which is scary enough to get folks like Krugman and Feldstein to agree.
That alone should jolt the administration from its tentative ways. Should it not?
