The Rising Threat of Deflation

[swag]

Deflation sounds good, until your economy goes into a death spiral and everybody gets laid off.

http://www.aei.org/outlook/100971

. . .

There is a bigger risk that deflation will intensify sharply because once the price level actually starts to fall, the demand for money will be further enhanced. A deflationary spiral--a self-reinforcing, accelerating drop in the price level--can result. This is because a falling price level means that cash "earns interest" since it enhances the purchasing power of otherwise sterile cash assets that pay zero interest, just as interest on a bond adds to its value in terms of its ability to be used to buy goods and services. That is why deflation drives down nominal (market) interest rates just as inflation drives them up. The "real" return on cash rises as inflation falls, thereby further boosting the excess demand for money and, in turn, exacerbating deflationary pressure. The fact that deflationary real returns on cash are not taxed further exacerbates deflationary pressure by enhancing the demand for cash.

The "Zero Bound" Looms

The Fed's dreaded "zero bound problem," whereby interest rates even at zero percent are still not low enough to stimulate demand, results from the rising real return on idle cash that subtracts from demand growth as deflation accelerates. Once the Fed has cut interest rates to zero, as it has done on short-term loans, any rise in deflation boosts the real return on cash that, in turn, exacerbates deflation. The Fed is, and has been, forced to print money by purchasing Treasury securities and mortgage-backed securities in order to satisfy the deflationary rise in money demand.

Beyond a crisis-induced rise in the precautionary demand for cash, and the related tendency for bank disintermediation, postcrisis deflation pressures can be enhanced by an excess supply of goods and services beyond that caused by the rising demand for cash. This is because the run-up in asset prices that creates a bubble in the first place lowers the cost of capital while the bubble is inflating. Firms find it easier to borrow as prices of risky stocks and bonds rise, so they add to productive capacity. Households, encouraged by cheap credit, buy more cars and houses, thereby increasing the stock of durable sources of a stream of housing and transportation services.

Once the bubble bursts, wealth is destroyed and workers are laid off--both causes of a sharp drop in demand for goods and services, whose supply is increased by the sharp increase in investment during the rise of the financial bubble. Excess capacity adds to the deflationary pressure induced by a sharp rise in the demand for money and the disintermediation that accompanies a financial crisis and its aftermath.

. . .

[lib2DaBone]

1. They should be stepping on the gas....not the brakes

We have been in deflation. (except for necessities like food and water)

We will remain in Deflation until Timmy Geithner and Ben Bernake decide to print Billions in Funny-Money to help their cronies on Wall Street and transfer more wealth.

Then, the situation will flip-flop. Hyper-inflation will kick in and once again, the working poor in America will take it up the shorts.

We can call this a "Double-Dip Screw Job". (as opposed to a double dip recession)

[pscot]

2. The voters are hitting the brakes too

There are 2 levies on the ballot in our little bailiwick, one for schools and one for the county. Both are looking like they're going to fail. More layoffs will follow. More families will be disrupted and the tax base will shrink continue to shrink.

[Hawkowl]

3. We arrived at the zero bound some time ago

In regard to "real interest rates", i.e; corrected for inflation, we hit that milestone before the Lehman brothers meltdown, and SURPASSED IT when TARP was passed. How did we surpass a zero interest rate? Because we actually subsidized the big banks to loan money, that is in effect a negative interest rate. That's right we, the taxpayers, paid the banks to loan us back our money. The kicker is, they have yet to do so! They are simply sitting on the majority of "their" cash to build up reserves. It makes perfect sense in an expected deflationary environment, because a dollar today will be worth MORE TOMORROW!

This is why we are in for the Great Depression II or the Long Depression II (per Krugman). Deflation and less than zero interest rates means private sector won't produce, won't invest, won't hire and consumers won't buy.

This will be the death of that idiot economic school of thought variously known as "monetarism", Milton Friedman-ism, or the "Chicago School". (Strict monetarism theorizes that simply provided extra free cash to big banking institutions and easy lending standards will keep an economy growing ad infinitum. This was Greenspan's approach and is continued by Bernake)

So, by worrying about deficits, the President is buying into monetarism. How? Because theory states that huge government deficits will drive interest rates up and then it will be too expensive to borrow money and the private sector will not be able to get financing. Do you see the problem yet? The private sector is already dormant, hoarding cash and scaling back in fear of deflation (negative interest rates) so logically, it would be a GOOD thing to run a deficit and drive up interest rates back into positive territory so then the private sector would "wake" up and start investing, spending and hiring because it was no longer in fear of a great deflationary collapse.

If Obama prioritizes the deficit over spending for jobs, he will be following done the same path as Herbert Hoover, and the economy will be mired in a severe depression for at least another two years.

[Donnachaidh]

5. +1 n/t

[david_vincent]

6. Thank you for taking the time to explain it clearly

Yes, your explanation helps me comprehend the situation. Just wanted to say thanks.

[Demeter]

4. Cry Me a River, AIE!

Your policy and white papers brought us to this snafu.