Friday, December 12, 2008

Deflation, Recession, and Aggregate Supply

There has been a lot of talk (some of it from me) about the possibility of deflation in the US. Deflation would be a problem for a couple of reasons: first, deflation would make it more difficult to engineer an economic recovery; second, deflation could result in a “death spiral” like what happened (according to one interpretation) during the early 1930’s. The latter problem is a lot scarier, if you think it’s a serious possibility. There is, in my opinion, a good chance of some deflation, but, as I will argue, I don’t think the death spiral scenario is something we need to worry about today.

The death spiral would occur because of a positive feedback loop (vicious circle) between deflation and economic weakness. Even mild deflation deters long-term capital expenditures by making them less profitable. (Why build a factory, for example, if you expect product prices to go down year after year?) Moderate deflation deters even short-term capital expenditures. (Why buy a computer if declining revenues will barely allow you to recoup the cost?) When deflation becomes severe, even expenditures for consumer durables are significantly reduced. (Why replace your refrigerator this year, when it’s going to be cheaper next year?) Because of these effects, deflation reduces aggregate demand, and does so more rapidly as the deflation rate increases. Weaker demand, as everyone knows, tends to lead to lower prices. Thus it’s possible to imagine an economic implosion where deflation and economic depression feed on each other and become ever more severe.

As I said, that is, according to one interpretation, what happened (or began to happen) during the early 1930s. President Roosevelt managed to put an end (at least temporarily) to the deflation, in part by devaluing the dollar. It’s not clear whether devaluing the dollar would be an option today, because other countries might counter with intervention designed to nullify any US attempt to intervene against the dollar. Fortunately, however, there are many other tools we can use to avoid the kind of severe deflation that faced Roosevelt when he took office. Working against the positive feedback loop of deflation and depression, there is a negative feedback process: the worse the deflation becomes (or is expected to become), the more authorities will be willing to use unconventional policies to stop it.

Stopping deflation should not be very hard at all, if you’re willing to accept the side effects of your deflation cure. Most discussions of this topic have focused on the demand side: the Fed could get people to start buying things by dropping money from a helicopter; or it could buy stock and increase demand by corporations and stockholders; etc. But when it comes to stopping deflation, demand policies are the hard way. To continue my side effects metaphor: if you insist on using the less powerful drug that has fewer side effects, you may have to give ridiculously high doses before the patient responds. The easy way to stop deflation – the drug to try once hair loss and vomiting become less of an issue than the disease itself – is to reduce supply rather than increase demand.

During normal times, economists and policymakers spend a lot of time trying to figure out ways to increase supply. It’s not an easy task. Cut taxes, to improve incentives for private investment? Raise taxes, to stop consumer spending from crowding out private investment? Invest more in public infrastructure to make the economy more efficient? Invest less in public infrastructure, to make the resources available to the private sector? It’s a tough game.

The game gets a lot easier when your objective is to let the other guy win. One obvious way to reduce supply, for example, is to encourage the formation of cartels. That’s something that Roosevelt tried, though some of his programs were struck down by the Supreme Court. Scholars can debate what the overall effect was on economic growth, or whether, after already devaluing the dollar, such additional measures against deflation did more harm than good, but it’s hardly open to question that encouraging cartels will tend to raise – and in the context of a deflation, stabilize – prices.

One particular form of cartel encouragement, which would certainly go over well with some of the current government’s constituents, would be to strengthen labor unions (one thing that Roosevelt did). Under normal conditions, some economists might argue that labor unions, despite their cartel aspect, often increase supply by such means as improving morale and decreasing unnecessary turnover. But it’s certainly true that unions are particularly loath to accept cuts in wages. In the context of a deflation, the stabilization of wages would tend to stabilize prices, since it would make it unprofitable for firms to cut prices. (Paul Krugman touches on this issue in some recent blog entries. He mentions a recent academic paper, but I like to give credit to Brad DeLong and Larry Summers – in a paper that I read nearly 20 years ago before it was published – for making intellectually respectable the idea that labor unions can help the economy by helping protect against deflation. I should also acknowledge James Tobin, who worked out the theory underlying the “death spiral” concept as discussed above.)

Another way to reduce aggregate supply is by inducing inflationary expectations to replace deflationary ones, so that producers are less willing to sell at low prices. This is largely a psychological issue, but if the Fed shows a willingness to take demand-side policies to extremes, even if the extremes are still not enough to solve the demand problem, they may affect supply. For example, when James Hamilton suggests (somewhat whimsically and just for the sake of argument) that the Fed could buy up the entire national debt, one might think of it as a demand-side policy, but I would suggest that its supply-side impact would be more important. With Treasury interest rates, even for long-term bonds, already quite low, it’s not clear that reducing them to zero would have much effect on demand. But when people observe the Fed buying up the entire national debt, the perception that “Helicopter Ben has gone wild” can’t help but make an impact.

And so on. Figuring out ways to produce less, rather than more, shouldn’t be very difficult. Naturally, reducing aggregate supply – trying to make the economy produce less at any given price – is not going to be directly conducive to economic recovery. But by reversing deflation and thereby making traditional demand-side tools more effective, it could be indirectly beneficial.

The death spiral should be pretty easy to avoid. The problem is that, once you get to the point where you have to make avoiding the death spiral a priority, you end up with this conflict between policies that reverse deflation and policies that increase production. It’s not the 1930’s, but it’s an experience I would hope to avoid.


DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

152 comments:

Billy the Kid said...

This was a great post. You´re a very pedagogical economist. Please, keep writing posts like this one.

Larry Byzantine's Blog said...

First of all deflation is good for the poor as their purchasing power increases.

Secondly, many economists think they can centrally plan the economy. Haven't we already seen throughout history that that doesn't work?

Why not let the bubble burst, the recession linger for a year or two and then let the market and entrepreneurs get us out of this hole? They always have in the past.

Stevie b. said...

Just discovered your blog. Very thought-provoking. Billy the Kid says keep writing posts like this one - I'd say keep writing posts like this one and the previous one as well!

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p.s. to clarify "previous post", I mean of course the Dec 8 post
on monetizing debt and inflation - not the blogkeeping stuff.

Ardent Economist said...

Interesting and thought provoking post, please keep more of this type stuff coming! The idea about labor cartels is certainly one I've never heard of and quite a unique approach.

I was hoping you could discuss the long-term t-bond and if you think this fall in the long-term interest rate is sustainable over the short to medium term? You also mentioned that its not clear that reducing it will spur long-term investment, but presumably at some level, investors that have liabilities in the very long-term (pensions? insurers?) would be much better off investing in the long-term in other forms as opposed to in 30 year bonds?

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How about giving some real life examples of decreasing aggregate supply? Did it work? What little I know about FDR's attempts in this direction was to put a floor under prices in 1937 and the stock market crashed, again. Personally, I think that any kind of governmental intervention extends the problem. Japan is still in a Depression with all of their spending and our 1929-1942 Depression was never arrested by the most active (to date) of governments. Its hard enough to plan your own way when things are tough but with Congress writing bills the road out gets more complicated.

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