deflation is the worst

Deflation is the situation where prices in general are falling. It’s a strong candidate for the biggest factor behind the economic devastation of the 1930s Great Depression.

The general idea is this:

I earn $1000 a month. I borrow to buy a house. The interest on my bank loan is $900 a month.

Prices, including the price of labor, are falling by 5% a year.

Three years in I’m making $857 a month and am forced to default on my mortgage.

My employer has borrowed to open the business where I work. The same thing happens to him–operating margins are squeezed by falling prices, meaning bank loan payments eat up an increasing amount of operating income. At some point, operations don’t generate enough to make loan payments and my employer declares bankruptcy.

Voila …depression.

1970s runaway inflation in the US

A decade of excessively loose money policy in the US in the 1970s created inflation (prices generally rising) that was high at 7% a year, and accelerating, with 11% in prospect, when Washington was forced, kicking and screaming, to address the problem. People and firms were doing all sorts of crazy things–hoarding, buying any sort of physical asset… The Fed Funds rate rose from 6% to 16% by 1981, when inflation was 14%, and did not return to 6% for a decade. It took that long to change the inflationary mindset. Inflation didn’t stabilize at around 3% until the early 1990s.

what came next

What’s less talked about is that the economic establishment began to think that the country, while clearly past the danger of economic distortions induced by hyperinflation, would be better off with inflation at 2%, a goal that was achieved by the late 1990s.

Two problems emerged:

–during the financial crisis of 2008-09 economists began to have second thoughts when they worked out that there wasn’t much scope to lower rates to counter anything more serious than a garden-variety slowdown (which this was way worse than) and that the move to 2% inflation might have been a horrible mistake; and

–perhaps more worrying, they couldn’t manufacture a rebound no matter how hard they tried. In vintage form, Congress was little help.

why this matters now

Although economists won’t say acknowledge this, they realize–and are acting on their belief–that we’re in uncharted waters with little growth, no inflation, the external shock of the pandemic and the traditional economic toolkit not working so well.

We do understand inflation and how to tame it, however. So there’s absolutely no percentage in the Fed raising rates until we’re clearly in a part of the pool we can navigate in. Yes, a surge in inflation–not that one is on the horizon so far–might do some harm. But at least this is a problem we know how to fix. But the alternative might be to turn into a new version of Japan, whose economic stagnation is in its fourth decade. This is not a side of the bet anyone wants to take.