Taming the Deflation Dragon

The Deflation Dragon is roaring and Keynesians are licking their chops. Like those who promote fad diets and weight loss pills, Keynesians are appealing to your inner anxiety and love of easy solutions rather than telling you the truth about what ails the world economy. A typical article on this topic is one that appeared at Bloomberg.com last week --  http://www.bloomberg.com/news/2014-10-22/currency-wars-evolve-with-goal-of-avoiding-deflation.html

This Bloomberg article does a few things. First it does a nice job of reporting deflation changes in various spots around the world. There is plenty of it. I have no argument there. Second, it connects exchange rate depreciation wars with these deflation occurrences. Finally the article concludes that if exchange rate depreciations will not successfully end deadly deflations, then we should deal with it with “whatever means is necessary.”

Clearly more people are coming to the conclusion that widespread deflation needs to be reckoned with and that typical Keynesian approaches that boost aggregate demand must be administered. These approaches include depreciating your exchange rate, goosing money and credit, and having larger government deficits and debt.

The intuition is simple but deceptive. Draw a supply and demand curve diagram. Shift the demand curve downward. Notice the resulting lower equilibrium price. Now shift the demand curve rightward. Viola – the equilibrium price rises back to normal. Furthermore, equilibrium output (and presumably employment) increases. QED. Demand is the problem. The problem is evidenced by deflation or falling prices. The problem is rectified by increasing demand. Don’t you just love economics! Now I can drink my JD and spend the rest of the day watching leaves fall.

I agree with the whole Supply and Demand story but disagree with how the world can best push that lagging Demand Curve back to a better position.  Conventional Keynesian wisdom reflexively wants the government to manage the Demand Curve through exchange rate, monetary, and fiscal policies. But in 2015 world economic problems require a very different potion. Even the master of all this theory – J.M. Keynes, if alive today would have looked at today’s situation and balked at the traditional Keynesian remedies.

Why would Keynes balk with Keynesianisms? Because Keynes lucidly and powerfully expressed the idea that confidence and fear were important motivators. When writing about the Great Depression it was Keynes who explained that monetary policy would be like “pushing on a string.” This meant you could push money into the system but because of lacking confidence, banks or firms or households would simply hold onto the money. They would save or hoard it. They would not spend it. He called that “the liquidity trap.”

So Keynes established why fear made monetary policy ineffective. Living today and seeing how governments have backed themselves into huge debt corners, he might also conclude that fiscal policy won't work in an environment where governments were defaulting on debt. I am not sure what Keynes would say today about exchange rate policy but such policy is not one that every country can employ. This is a zero-sum game. If one country depreciates its currency to stimulate demand for its products, then another country has to endure an appreciation and a reduction in demand for its goods and services. Already the US is getting unhappy with Japan and other countries that are making gains at US expense.

Larry you are so depressing! I am not. I am fun! There is a solution to deflation but it involves not calling the 800 number for another fast acting pill. Think about what most countries have been through in the last years. Think about the real credit and financial problems faced by household, firms, and governments. It might sound humane and nice to tell US families that they can now borrow 97% of the price of a new house with less stringent income requirements. But surely all those stories about under-water mortgages are still fresh enough to make potential home buyers know that this is not an attractive option.  Basically it is snake oil.

The solution is the same one the doctor gives to the patient undergoing rehab. Keep at it. Keep doing those exercises and someday you will regain better use of that limb. There is no easy way. There is no pill or diet. Just keep sweating and grunting and pushing to get stronger.

Today the sweating and grunting has a lot to do with reducing previous levels of debt among households, firms and governments. Either under- or over-regulation of what the IMF calls legacy problems are also part of the problem of uncertainty and insufficient demand. Under-regulation means that governments should do more to clear up financial, housing, and other problems. Over-regulation means they have done too much and have handicapped the very patients doing the rehab. Do those exercises with a 100 pound sack of potatoes on your back!

Nutshell. Deflation does exist and is a challenge. Aggregate demand is deficient in many places and needs to be prodded upward. Aggregate demand will only be worsened by policies that do not address fundamental problems. Most Keynesian remedies fall into that category. Policies that are tough but will make us stronger are what we need. We need to cleanup debt. We need to give workers and companies stronger incentives and remove impediments to work, innovate, and produce. The IMF pays lip service to such “restructuring” policies but alas in the real world the snake oil salesman seems to have more influence.