Deflation, Not Deficit, Is the Real Threat
July 30, 2010
The economic specter stalking Barack Obama is not the nonsense debate that captivates deficit hawks and witless political reporters. It is the threat of a full-blown monetary deflation that would truly put the US 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.
Depression was the fate that befell Herbert Hoover after 1929 and the outlines of this larger catastrophe are present again. It is easy to dismiss deflation warnings from curbstone critics, including from me. But it is more significant—and truly scary—when senior policy makers of the Federal Reserve begin to express the same fear, as the New York Times reported today. The Fed has done quite a lot in the last two years to prevent this disaster from unfolding, but some officials are now worried the Fed hasn't done enough.
The central bank understands this danger far better than the over-confident technicians of the Obama administration because deflation led to the Federal Reserve's historic disgrace after 1929. Fed officials then did not understand their wrong-headed policy moves were directly driving the economy into the Great Depression of the 1930s. Today's central bankers do not wish to experience the same shame again.
The Times story reveals a rump group of decision makers within the Fed who are focused on the threat and urging their colleagues to consider more dramatic measures to reverse the deflationary pressures.
Most notably, James Bullard, president of the St. Louis Federal Reserve Bank, warns that Fed policy is putting the US economy at risk of "a Japanese-style deflation within the next several years." This is striking because the St. Louis Fed is traditionally the home of "hard money" monetarists. Their intellectual mentor, Milton Friedman, famously assailed the central bank for its historic failure to reverse the deflation eighty years ago. Liberals and conservatives who compare notes on this subject can come out at roughly the same place. more