Day: January 8, 2009

Who’s Afraid of Deflation?

According to the Federal Open Market Committee’s (FOMC) minutes, released on Tuesday, some members think inflation targetting would be a useful way to persuade people that prices will not fall, i.e., forestall deflationary expectations.  WSJ.com seems to have the interpretation about right,

“The added clarity in that regard might help forestall the development of expectations that inflation would decline below desired levels, and hence keep real interest rates low and support aggregate demand,” according to the minutes.

In other words, a commitment to an inflation target, say annual growth of 1.5% to 2%, would help keep prices from falling outright and prevent the kind of economic chaos that plagued Japan in the 1990s and the U.S. during the Great Depression.

The Congressional Budget Office thinks there is still time to prevent deflation (or perhaps it is the new measures already in the works that will keep inflation positive).  Their forecast for 2009 (see Table 1 in today’s testimony) predicts low inflation, e.g., the PCE price index is expected to be 0.6 percent for 2009 – but note that the CPI is seen as barely positive, at 0.1 percent, over the same period.

Meanwhile, the financial markets (e.g., inflation swaps) predict minus 4 percent inflation in 2009 (part of which is likely due to lower commodity prices) and then a small degree of deflation over the next few years.  According to this view, we should next see today’s price level again in about 5 or 6 years.

Of course, the financial markets could well be wrong.  It may be that the markets haven’t fully digested or understood the size of the fiscal stimulus, and it may be that further news about other parts of the Obama approach (including the directly on housing and banking) will significantly change inflation expectations.

But it is striking that financial market inflation expectations – e.g., over a five year horizon – have barely moved from their low/near deflation level since it became clear that Mr Obama would win the election or since we first realized that a massive fiscal stimulus would soon arrive (see slide 2 in my presentation from Sunday; the scale is hard to read, but the decline is from around 2% through the summer to around 0% currently).  At least for now, whether or not we are heading for deflation remains the key open question.

China and the U.S. Debt

I’m warming up for a longish Beginners-style article on government debt, which will come out next week or so. In the meantime, the New York Times has an article today about China’s diminishing demand for U.S. dollar-denominated debt. Theoretically this could make it harder for the U.S. to borrow money and thereby push up the interest rates on our debt (now at extremely low levels).

China’s voracious demand for American bonds has helped keep interest rates low for borrowers ranging from the federal government to home buyers. Reduced Chinese enthusiasm for buying American bonds will reduce this dampening effect.

However, the article doesn’t mention one compensating factor. The fall in China’s buildup of its foreign currency reserves is linked to the rise in the U.S. savings rate, which is projected to rise to as much as 6-10% (it was over 10% in the 1980s). Some of that new savings will go to pay down debt, but a lot will go into savings accounts, CDs, money market funds, and mutual funds – which means that depresses interest rates across the board. On the back of the envelope, 6% of personal income is about $600 billion a year in new domestic savings to compensate for reduced overseas investment. Whether this will be enough to compensate entirely I don’t know. But if we were all one global economy in the boom, we’re still one global economy in the bust.

Causes: Economics

We are not short of causes for our current economic crisis.  The basic machinery of capitalism, including the process of making loans, did not work as it was supposed to.  Capital flows around the world proved much more destabilizing than even before (and we’ve seen some damaging capital flows over the past 200 years.)  And there are plenty of distinguished individuals with something to answer for, including anyone who thought they understood risk and how to manage it.

But perhaps the real problem lies even deeper, for example, either with a natural human tendency towards bubbles  or with how we think about the world.  All of our thinking about the economy – a vast abstract concept – has to be in some form of model, with or without mathematics.  And we should listen when a leading expert on a large set of influential models says (1) they are broken, and (2) this helped cause the crisis and – unless fixed – will lead to further instability down the road.

This is an important part of what my colleague, Daron Acemoglu, is saying in a new essay, “The Crisis of 2008: Structural Lessons for and from Economics.”  (If you like to check intellectual credentials, start here and if you don’t understand what I mean about models, look at his new book.)  To me there are three major points in his essay. Continue reading “Causes: Economics” →