Recessions are bad enough. Add serious deflation and you can end up in an
economic depression, although not necessarily one as bad as the Great Depression
of the 1930s.
The dictionary tells us that deflation is a persistent decrease in the value of goods and services, combined with the increased value of money because of a reduction in the money supply, in part because of a shutoff of credit.
The current financial crisis certainly features a shutoff of credit. And the prices of at least some goods and commodities are falling. Does that mean the world faces a round of deflation?
RFE/RL correspondent Andrew F. Tully put that question to William Niskanen, who served as acting chairman of former U.S. President Ronald Reagan's Council of Economic Advisers and is now chairman of the Cato Institute, a private policy research center in Washington.
RFE/RL: What is deflation?
William Niskanen: Deflation is the general reduction of the price indices. What we're experiencing now is a deflation of [only] commodity prices, oil being the most conspicuous of them, but it's happening across the board in commodities, and that's not unusual.
The short-run supply of commodities is quite inelastic, which means that it's terribly dependent on short-run changes in demand. And we've had a drop in demand, and it's led to a substantial drop in the price of commodities, particularly oil. An increase in demand, with the anticipation that that represents a turnaround from the current conditions, will lead prices to go back up in commodities rather quickly.
But I don't think there's any prospect for a reduction of the general price level [of goods and services] in the near future. [In the United States] we're running an inflation rate at the moment of about 5 percent, even given the big reduction in commodity prices.
RFE/RL: But the value of housing in the United States is rapidly falling. This, of course, and their link to badly designed home loans, is at the heart of the current worldwide financial crisis. Does their drop in value indicate deflation, since a home is the most expensive asset most families own?
Niskanen: The housing market, remember, peaked in the first quarter of 2006. So we've experienced over 2 1/2 years of declines in housing starts and [a] decline in relative housing prices. And I think we may have another quarter or so of some decline in housing prices, but I think we're close to the end of that.
In any case, our general price indexes are the prices of current goods and services. They do not reflect changes in the price of assets. If you have a reduction of the price of assets, that does not lead to a reduction in the general price level by itself. It is not deflation, [but] it is a problem.
RFE/RL: Many people around the world are now putting off much of their spending because they either can't afford to spend or fear they may lose their jobs. This decline in demand can lead to lower prices, and some economists argue that it may influence some people -- those who can afford to spend -- to delay purchases in the expectation that the prices for what they want to buy will decline even further over time. Can this feed deflation?
Niskanen: The last phenomenon you described is a real phenomenon: People can believe that a fall in the price of stocks or new cars or houses and so forth can delay their purchase for a while, with the expectation that they'll get a better deal in 90 days than right now. And that can lead to a reduction of total demand in the economy, and that's a problem by itself. But it is unlikely to lead to deflation in the sense of a reduction of the general price level.
RFE/RL: You mentioned earlier that the United States now has an annual inflation rate of about 5 percent. That sounds a little high. Should the Federal Reserve Board act like other central banks and keep it's eye primarily on inflation, and not deflation?
Niskanen: Well, yes, it should keep its eye more on inflation, but also on the total demand in the economy. The Fed's authority from Congress is somewhat mixed. They're supposed to maintain a steady growth of demand and a steady level of inflation, and sometimes the Fed has switched between one or the other. At the moment, the Fed's more concerned about restoring a general growth of demand than they are about inflation.
But there are some puzzles. The dollar has strengthened relative to the European currencies and the Japanese currency. That is a puzzle to me. But it has not strengthened necessarily with other countries, and that implies to me that the strengthening of the dollar relative to the euro or the pound and the yen reflects conditions in these other countries more than it reflects conditions here. So there are some puzzles in this business, but I don't expect any general reduction in the price level in the United States.
RFE/RL: But aren't American consumers -- who make up at least two-thirds of the country's gross domestic product -- now spending less?
Niskanen: The morning headlines in the business section [of the newspaper] today is that Wal-Mart [a low-cost retail chain] is booming. What they're [consumers are] doing is they're buying, but they're buying from a lower-price retail outlet. It is not deflation, it just means that consumers have become more price-conscious because of the concern about being laid off.
But that has not led so much to a reduction of total purchases, but a change in what they buy. They're putting off buying new cars, and they will put off buying housing until they see the drop in housing prices end, and they will buy current goods and services from Wal-Mart rather than maybe from a higher-price store.
RFE/RL: Is the problem here not so much failures in the economy, but simply too much frightening talk about what could happen, as opposed to what is actually happening? I don't necessarily mean only the news media, but also experts who speculate about what may happen.
Niskanen: I'm not prepared to make that judgment, I don't want to blame other people on this matter. I think that the journalists, even the journalists of business sections of newspapers, aren't all wise, and sometimes I think they overreact. But all of us overreact in some capacity.
... Payvand News - 03/25/16 ... --