Are Americans' worries over the direction of prices inflated?

During the Great Depression, when thousands lined up in New York and elsewhere for the chance at relief jobs, the federal government was eager to encourage inflation.
During the Great Depression, when thousands lined up in New York and elsewhere for the chance at relief jobs, the federal government was eager to encourage inflation. (Associated Press)
By James Ledbetter
Sunday, August 8, 2010

As political bogeymen go, deflation must be one of the strangest. Very few living Americans have experienced deflation firsthand. It's a reasonable bet that many Americans would have difficulty defining deflation, and the majority would wonder why lower prices for everything should be considered bad.

No matter how obscure deflation may be, however, it is apparently the biggest threat to our country right now, according to some. Writing in the Nation, William Greider warns of "a full-blown monetary deflation that would truly put the U.S. economy in ruin. In a general deflation, everything falls -- prices, output, wages, profits. Unchecked, this can lead to another Big D -- the Depression Obama claims he has avoided." James Bullard, president of the Federal Reserve of St. Louis, recently publicly expressed his fear that "the U.S. economy may become enmeshed in a Japanese-style, deflationary outcome within the next several years." Some major investors are not waiting to find out whether Bullard is right. The Wall Street Journal reported last week that such financial heavyweights as Pimco's Bill Gross and major hedge funds are stocking up on securities that they think will perform best in a deflationary environment.

Leave aside the question of whether deflation is really about to descend on the land, and the fact that some economists believe there may be such a thing as "benign deflation." The biggest problem is that Western governments and central banks are so obsessed with preventing inflation that they have no playbook for battling deflation. So strange politics have seeped in to fill this policy vacuum.

For much of the modern American era, inflation has been viewed as an evil demon to be exorcised, ideally before it even rears its head. This makes sense: Inflation robs people of their savings, and the many Americans who have lived through periods of double-digit inflation know how miserable it is. But sometimes a little bit of inflation is valuable. During the Great Depression, government policies deliberately tried to create inflation. Rising prices are a sign of rising output, something that would be welcome in the current slow-motion recovery. As economist Casey Mulligan has argued, some inflation right now could have some salutary effects: "Specifically, inflation would raise prices of homes, among other things. Higher housing prices would pull a number of mortgages out from under water . . . and thereby reduce the number of foreclosures."

But don't hold your breath waiting for America's political leaders to preach the virtues of inflation. Indeed, for all the fretful talk about deflation, it is unfortunately the fear of inflation that still haunts political and economic decision-makers. For decades, politicians and pundits on the right have told us that we need to balance the federal budget in order to keep inflation low; this remains a staple of libertarian thinking (even though economic research demonstrates that except in wartime, there is effectively no relationship between the size of government spending and the existence of inflation).

Infected by such myths, the national debate remains focused on reducing deficits and debt; no matter what the diagnosis is, that's always presented as the cure. The Obama administration may have added to unprecedented levels of government debt (by mandating health-care coverage for millions of Americans, stimulus spending, continuing the wars in Iraq and Afghanistan), but rhetorically it is committed to restoring the surplus of the late '90s. Secretary of State Hillary Rodham Clinton has gone so far as to say that getting the nation's debt and deficit under control is a national security issue, which is not an argument you'd associate with any Democratic administration of, say, the last 100 years.

This posture may be politically expedient in the age of the "tea party"; a July opinion poll found that two-thirds of the public opposes the idea of a second stimulus. But that very opposition to government spending may cause the deflation that will be disastrous for all. If government doesn't juice demand with more spending, housing prices may fall, consumer demand may sag more, and full-on deflation may descend. Complain all you want about the inefficiency of government spending, but government is the only mechanism for the foreseeable future that is capable of jump-starting the broader economy. Hedge-fund manager Alan Fournier told the Journal that a major reason he's betting on deflation is the presumed inability of elected officials to spend more on stimulus.

There's an additional absurdity here: The consensus of Gross and other mega-investors is that the best, most reliable returns in a deflationary climate are to be had by buying -- have you guessed? -- U.S. government debt. Over half of Gross's Pimco Total Return fund, for example, now consists of U.S. Treasury bonds, up from less than 33 percent at the end of March, according to the Journal. The bet seems to be that if economic demand slumps and profits tank, Treasury bonds will lose less than just about everything else.

So the market message generated by our current collective hate for government debt is: Economic growth will slow down, and private-sector demand for government debt will go up.

-- The Big Money

Ledbetter covers business and finance for Slate.


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