Deflation: Too Late to Stop It When We Experience It

Posted March 17, 2009 at 5:23pm

Class, today’s reading assignment is “Inflation Is Better Than Deflation,— a paper by my colleague John Makin.

Here is a relevant passage:

[IMGCAP(1)]“Most of the lessons from past crises arise from painful demonstrations of what not to do in a crisis. The most compelling message to emerge from the experiences in postbubble economies centers on the need to avoid deflation and intensifying deflation expectations. Those are two necessary conditions for recovery. … The awkward but compelling conclusion from postbubble periods is this: it is better to risk a period of higher inflation than it is to risk an episode of self-reinforcing deflation.—

In a follow-on note to me, Makin added:

“The most important thing for policymakers to remember is that deflation is like many serious diseases. Once the symptoms are clearly evident, it is too late to arrest the disease. In fact, policymakers must risk some inflation in order to pre-empt the emergence of deflation. The Bank of Japan never understood these basic realities and so doomed Japan to prolonged deflation and recession.—

Makin is by every standard a conservative who has as strong a grasp of economic history and of international economics as anybody. I hope his piece is read by lots of Members of Congress, but especially by Republicans such as Reps. Paul Ryan (Wis.) and Eric Cantor (Va.) and by Democrats such as Sens. Evan Bayh (Ind.) and Ben Nelson (Neb.). I also hope it is read by Treasury Secretary Timothy Geithner. And it sure would not hurt to have it read and absorbed by European leaders, like German Chancellor Angela Merkel, who are resisting any uptick in spending. The idea that we need a spending freeze now, as the world teeters on the edge of global deflation and depression, is bizarre and dangerous.

At the same time, while it is commendable to keep fiscal discipline in the forefront of our objectives and work to reduce wasteful and unproductive outlays, this is not the time to delay government action or to err on the side of putting on the brakes. South Carolina Gov. Mark Sanford’s (R) pitch to take $700 million of stimulus money and use it instead to pay down his state’s debt reflects, I believe, a misunderstanding of the current danger. If the public is drawing back from spending because people anticipate prices dropping, it is appropriate and urgent for government to spend to inject the needed adrenaline into the economy.

That is not to say that all the stimulus has to be on the side of government spending — or that the stimulus package passed by Congress was a good one. There are some tax cuts that can lead to consumer spending and increased immediate investment by businesses. Unfortunately, the biggest one incorporated into the stimulus package, the fix in the alternative minimum tax, was not one of them. If we had taken that $70 billion and put it into a payroll tax reduction or payroll tax holiday, a good deal of the money would have gone to those in the society having the most difficulty just staying above water right now — the money would be spent now, not saved for a better day.

Of course, the fact is that the stimulus package was too small — it should have been a trillion dollars, given the dimensions of the problem and the failure of Europe or Japan to provide any comparable economic boost. At the same time, spending that could have been done quickly, including some school construction, was foolishly taken out.

Makin also examines carefully the three most analogous situations to learn from — the Depression, the Swedish banking meltdown and the Japanese lost decade of deflation and drift. As he lucidly points out, all have unique characteristics and are limited in their application to today. But one lesson seems clear from the Japanese experience: The one-step-too-slow, timid approach to dealing with banks and the financial crisis contributed mightily to the inability of the Japanese to get out of the ditch for 10 years. On the financial front, as on the fiscal front, we seem way too close for comfort to the Japanese model. And I now fear that the populist backlash against the arrogant fools running American International Group and other financial institutions may make a bolder move more difficult.

Two other points on this front. I met last week with a group of local government officials who are going to be administering the stimulus money — getting it out there in projects as quickly as possible to get the jobs filled and the economy moving. That means accelerating the pace by several months from the normal, which in turn means doing things like waiving or expediting environmental impact statements and other paperwork. The problem for them is that, in the agencies where this work is done, the career officials in charge do not have the authority to do such things — and there are no political appointees in place to get them done.

The collateral damage from a clogged presidential appointment process is thus even greater than most of the stories have suggested. We badly need reform of this process, including not just changes made in the law, a subject to which I will return in coming weeks, but changes in culture and behavior. One of those changes should be to stop the avenging angel syndrome in the Senate Finance Committee and elsewhere that has ratcheted up the investigation of nominees’ backgrounds to a level that we have never seen before.

Second, we need some creative thinking to go beyond bailout plans. Consider the auto industry. We know the problems are not just the failings of General Motors Corp. and Chrysler LLC — even Toyota Motor Corp. and Honda Motor Co. are suffering badly in the U.S. market. There is an excessive inventory of cars and not enough demand. People are holding on to their old cars longer in tough times. It is time to try a variation of a plan employed in parts of Europe, which we could call a clunker rebate. Basically, give a $5,000 voucher to anyone turning in a car more than, say, 10 years old, which could be used to buy a car less than 2 years old. Pay for it with some of the money that we would otherwise dedicate to bailing out the auto companies.

This is a twofer — get gas guzzlers off the road and replace them with more fuel-efficient models, and clear out the inventories and get the auto companies building more new cars. The clunker rebate has been introduced in a bill sponsored by Sens. Dianne Feinstein (D-Calif.), Susan Collins (R-Maine) and Charles Schumer (D-N.Y.), but only with an environmental focus. Retool it, and we have got something very good to get out on the legislative road.

Norman Ornstein is a senior fellow at the American Enterprise Institute.