The Economist and Benign Deflation

I had the privilege today of meeting Zanny Minton Beddoes, the economics editor for The Economist magazine. She was a presenter at at a regional economic outlook conference held in nearby Austin, Texas. Her part of the program was to deliver an assessment of the national economy. She did a great job describing the major shocks that have recently hit the U.S. economy--high oil prices, frozen credit markets, housing market bust--and the potential outcomes of these shocks. After her talk, I was able to chat with her for a few minutes. Among other things, I complemented her and The Economist for taking seriously the implications of benign deflation for the U.S. economy during the 2003-2005 period. As I have argued before, the Fed's misreading of the 2003 deflationary pressures as being malign when in fact they were benign led to an overly accommodative monetary policy at that time. As a consequence, interest rates were pushed far beneath their neutral level and the stage was set for the biggest housing boom-bust cycle in U.S. history. The Economist recognized this was happening and was one of the few observers sounding the alarm over this development (Andy Xie was another, see here). Only now are other observers (here, here) beginning to see how prescient The Economist was in its calls to reign in monetary policy during this time. It was a real treat, then, for me to meet Zanny, and briefly discuss these issues with her.

In case you missed The Economist's coverage of benign deflation and its implications for the U.S. economy during the 2003-2004 period, I have posted below an edited version of an article that appeared in 2004.

Inflated expectations
Jul 1st 2004

From The Economist print edition

A new paper questions whether inflation will really turn out to be America's main economic problem... Most commentators have cheered Alan Greenspan and his colleagues at the Fed for being so aggressive in warding off the deflationary threat caused by huge corporate debts and the popping of the stockmarket bubble... Mr King is not among those cheerleaders. He argues that the Fed was wrong to cut interest rates so much, because much of the deflationary pressure was of an altogether more benign sort: a reduction in overall prices caused by rapid technological change, improvements in the terms of trade and other factors. Britain had long periods of “good” deflation in the late 18th and 19th centuries, when nominal interest rates and growth were both strong. In recent years, argues Mr King, there has again been deflation of just that sort, and for similar reasons. Technological change and the integration of China, and increasingly India, into the global economy have pushed down the price of traded goods in America, thus pushing up real incomes. “And, because of these real gains, any rise in real debt levels will not be a source of potential ongoing instability,” writes Mr King. Alas, because the Fed's perceptions of deflation have been coloured by the experiences of America in the Depression and Japan in its lost decade, it reacted by reducing interest rates sharply, a response that is more likely to bring about the debt deflation it most feared.

High real growth—so long as deflation is of the good sort—requires high real interest rates. If rates are too low, people borrow too much and spend it badly: what Mr King calls “happy investment rather than good investment”. For a given level of nominal interest rates, a fall in prices will deliver the appropriate level of real interest rates. But by cutting nominal rates to prevent deflation, the Fed has reduced the real rate of interest too much.

Evidence that this has been the case comes in two forms. The first is that borrowing has ballooned in America in recent years. Any reduction in the indebtedness of American firms (under immense pressure from the capital markets) has been more than matched by borrowing by consumers and the government...

[T]he second piece of evidence [can be seen in] what Americans spend their money on. If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years. Companies have been slow to hire workers even as the economy has bounded along; and workers' share of national income is very low. The low cost of capital has, moreover, encouraged speculation in risky assets, such as emerging markets, or—closer to home, as it were—property. And, yes, with all that money sloshing about, it has also pushed up inflation a bit...

There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think—and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid.

If you want more, see Unnaturally low.