The Shadow of Deflation
SIGN OF the times: A local auto dealer is not only offering deep discounts on its swollen inventory of sport-utility vehicles and luxury cars, it's giving away 100 shares in General Motors to anyone who buys a vehicle.
This is the sort of thing that happens when the markets for assets of all kinds -- from Cadillacs to stock in the company that builds them -- begin to spiral downward. Last week's devastation on Wall Street is part of the same phenomenon, as are the precipitous drops in the price of oil and other commodities. Economists call it "asset price deflation," and it is driven by the worldwide shrinkage of credit and the corresponding scramble to turn anything that can still be sold into cash. Lower prices may sound appealing, but as consumers get into the habit of waiting for them to go down even further, they buy less, which causes producers to cut back on production. Jobs vanish, banks fail and the economy stagnates. Historically, deflation has caused misery whenever and wherever it strikes, whether in the United States during the Great Depression or in Japan during the 1990s.
Years of entrenched deflation are a disaster scenario, but there is still time to avoid it. The Federal Reserve has cut interest rates drastically; it can and probably will cut them more, but it has already reached the point of diminishing returns in terms of growth stimulated. Fiscal policy will have to do more of the job now, despite the long-run risk to federal debt. There is a near-consensus among economic experts that the U.S. government must enact a large package designed to free up as much consumer and business spending as possible. A program of infrastructure improvements calculated to improve the long-run productivity of the economy should form a part. Judging by comments in his radio address yesterday, this is the sort of stimulus plan President-elect Barack Obama intends to present as soon as he takes office. To prevent irreparable harm to the nation's long-term financial standing, the stimulus should contain a plan for restructuring entitlement programs that will take effect once the immediate crisis has been arrested.
The government will also have to devise a comprehensive strategy for ensuring the banking sector's solvency, including not only aggressive use of the existing Troubled Assets Relief Program but possibly a separate agency to recapitalize strong banks and shut down weak ones. This is roughly what the United States advised Japan to do during its deflationary crisis, and it cannot afford to ignore its own advice.
Rapid and sweeping policy responses, however, may not be feasible during a moment of presidential and congressional transition. They may have to wait, alas, until the Obama administration. Mr. Obama helped matters by reportedly deciding on a Treasury secretary. The markets were desperate for some confidence about the direction of policy. The reported designation of New York Federal Reserve Bank President Timothy F. Geithner, an excellent choice, provided a lot.