Arkansas Democrat-Gazette, Aug. 11, 2001, THOUGHTS ON DEFLATION, By: Greg Kaza
Federal Reserve Chairman Alan Greenspan referred recently to a topic rarely discussed anymore in Arkansas: asset-price deflation. His remarks, touching on the business cycle, are worthy of serious reflection.
"A central bank can contain inflation over time under most conditions," Mr. Greenspan told a congressional committee. "But do we have the capability to eliminate booms and busts in economic activity? Can fiscal and monetary policy acting at their optimum eliminate the business cycle, as some of the more optimistic followers of J.M. Keynes seemed to believe several decades ago? The answer, in my judgment, is no, because there is no tool to change human nature.
"Too often people are prone to recurring bouts of optimism and pessimism that manifest themselves from time to time in the buildup or cessation of speculative excesses. As I have noted in recent years, our only realistic response to a speculative bubble is to lean against the economic pressures that may accompany a rise in asset prices, bubble or not, and address forcefully the consequences of a sharp deflation of asset prices should they occur."
It is rare for Fed leaders to mention deflation, which can take many forms. One of the few times Mr. Greenspan has during his 14-year tenure was a January 1998 speech in Chicago to the American Economic Association. "Some observers," Mr. Greenspan said, "have begun to question whether deflation is now a possibility and to assess the potential difficulties such a development might pose for the economy. Even if deflation is not considered a significant near-term risk for the economy, the increasing discussion of it could be clearer in defining the circumstances."
Falling prices or asset values are a characteristic of deflation. The asset-price deflation referred to by Mr. Greenspan is different than a negative consumer (CPI) or producer price index (PPI), a very rare occurrence. The two are not necessarily synonymous.
Perhaps the best contemporary example of asset-price deflation is the NASDAQ, which peaked at 5,132 on March 10, 2000 and has fallen below 2,000. Japan, the world's second largest economy, has experienced asset-price deflation in real estate and stock markets since its financial bubble burst in 1989.
Some equate deflation with depression. But market-oriented economists tend to see good and bad deflation. "It's pretty clear that deflation doesn't mean depression," Nobel Laureate Milton Friedman observed. According to Mr. Friedman, the greatest period of U.S. economic growth (late 19th Century) occurred under good deflation: falling prices; greater returns on capital; and expanded output and productivity increases from technology.
Deflation's identification with recession is a Great Depression legacy. But are recession and deflation synonymous? No. Deflation occurred in only four of the 20 U.S. recessions last century. These were 1907, 1920-22, 1930-35 and 1938-40. Bad deflation is the result of a credit structure and culture that scorns prudence and tolerates extreme financial leverage. Debtors, including financial institutions, who borrowed easily, are forced to repay with more expensive dollars.
Economists of all schools agree deflation redistributes income from debtors to creditors. Keynesian Paul Samuelson wrote, "Creditors and fixed-income receivers tend to gain at the expense of debtors and profit receivers ... The schoolteacher who keeps her job and whose pay is not cut too deeply finds that her real income has increased. The widow who withstood the temptation to buy common stock during the boom and instead put all her money into gilt-edge government bonds finds herself better off." Classical Austrian economist Ludwig Von Mises wrote, "(Deflation) was a boon to all those who had lent during this period and a blow to all those who had borrowed."
Mr. Greenspan noted deflation "is being used to describe several different states that are not necessarily depicting similar economic conditions." Or asset values, which are, after all, highly subjective. Is a $500,000 house bought with 90 percent margin appreciating asset or folly? A daytrader who bought a now-defunct Internet stock with no earnings two years ago may not find much value today in the only Arkansas publicly-traded company that sells in the market for less than its cash on hand.
Tne point is clear: thinking about deflation could lead many to carefully examine their own balance sheets and assumptions about credit and the economy.
Policy makers have a duty to communicate ideas to the public in a fair and open manner. One possible response to deflation is reduction of debt. "Both rapid or variable inflation and deflation," Mr. Greenspan said, "can lead to a state of fear and uncertainty that is associated with significant increases in risk premiums and corresponding shortfalls in economic activity." The public interest would not be served by such a troubling development.