Forget Inflation, Deflation Is a Bigger Danger

by Mortimer B. Zuckerman

Is this the time to worry about inflation? We are, after all, awash in money with stagnant output.

In the past year, the Federal Reserve has increased our monetary base by about 120 percent, more than double the previous highest annual increase over the past 50 years. The Fed has made huge loans to private lenders and bought over $1 trillion of mortgage securities and hundreds of billions of dollars of long-term treasury bonds. It has succeeded in lowering the federal funds rate below 1 percent--even, for most of the time, to less than half that. The goal, of course, is to force-feed money into the economy in the hope of sparking a recovery.

The mountain of reserves on bank balance sheets, which so scares the inflationary hawks, would normally encourage banks to lend and increase their profits. But while the Fed has been pumping money through the banks, little of it has entered the economic mainstream. Instead of boosting lending, the banks have just increased their reserves at the Fed by hundreds of billions of dollars.

The government may be borrowing more, but consumers and businesses are borrowing less. If anything, they are paying down their debts. Households will reduce their total debts by $200 billion this year, Forbes magazine projects, and banks and businesses by $2.3 trillion. Small-business lending will contract by at least $113 billion. Since the credit crisis began more than two years ago, credit available to consumers and the small-business sector--which employs half of the country's workforce--has contracted by trillions of dollars, mostly because of curtailment of credit card lines. The hope that new bank reserves would be available to prop up the faltering economy has not been fulfilled.

Inflation typically results from "too much money chasing too few goods." Today, too much supply is chasing too little demand. That, coupled with consumers' need to save money to rebuild their finances, raises the risk of deflation, not inflation. As workers compete for scarce jobs and companies underbid one another for sales, both wages and prices will remain under pressure. We began this crisis with household debt at its highest levels since the 1930s. Knowing that monthly mortgage payments don't shrink even if your paycheck does, families are trying to deleverage and work down what they fear is their excessive debt. On top of that, households are suffering from substantial wealth losses tied to impaired equity portfolios and dropping home values. The combination of lower incomes and reduced wealth raises the likelihood that consumers will continue to boost their savings and pay down debt rather than spend more on consumption, which has put retail spending into one of its worst declines in decades. This is evidenced by retailers slashing inventories by record amounts, causing the percentage of capacity utilization in manufacturing to drop to the lowest reading in the 50-year history of the measure.

Demand growth would need to recover substantially to reverse the deflationary effects of low capacity utilization. For this, we would need a significant improvement in employment and hence spending. But the job market is even worse than the overall economy, and the prospect is that high levels of joblessness will persist beyond the end of the recession. Companies have cut the number of their employees and slashed other discretionary costs, such as advertising. This has significantly improved profit margins, even in the face of lower demand, but the higher profits are not coming from revenue growth but from lower costs, making it easier for companies to maintain or even cut prices rather than increase them.

Reduced spending by consumers and an extended high unemployment rate mean that we can look forward to a continuation of the output gap. This refers to the difference between the actual economic output and the most the economy could produce given the capital, know-how, and people available. That gap today is estimated to be between 8 and 10 percent, the largest on record. It makes for intense competition for scarce sales and jobs and results in continued downward pressure on prices.

It will take a long time to absorb the enormous slack of unused labor and production capacity created by the deepest recession since the 1930s--and it ain't really over yet. In the meantime, the labor market is showing a continuing decline in wages and in average hours worked per week (now down to 33 hours, the lowest in 60 years), suggesting it will be a long time before labor markets are strong enough to push up hourly wages and income.

Until employment grows enough to push wages, and income and production levels increase to more normal levels, the most pressing worry will be deflation, not inflation. This is evidenced by the financial markets. In 2007, according to Forbes.com, the Treasury Department issued $237 billion more in debt than it retired. This year, just through October, it has added a stunning $1.2 trillion to its obligations, or $4 billion a day. With such a dramatic increase in supply to sell, you would think that prices would fall and yields would rise. Instead, after approaching 4 percent in June, yields on the 10-year treasury note have fallen steadily.

Despite worries that the government's huge deficit will create inflation and cause interest rates to spike, the bond market is signaling that its focus is on the dismal economy and the contraction of private-sector debt.

This does not mean we can forget about the long-term projected accumulation of debts and deficits. They can pose a danger. They can reignite inflation, especially if the quirky, unpredictably volatile "animal spirits" of entrepreneurs begin to break through. Foreigners may also become apprehensive about their purchases of too many dollar-denominated debt instruments, since they fear that the most politically acceptable way for the United States to handle its growing debts to other countries is through inflation. So far, though, we have still been able to export T-bills (even if we can't export goods) to finance our fiscal deficits.

In any event, inflation is easier to put right than deflation. The Federal Reserve can suppress inflation by raising interest rates as high as required to squelch those animal spirits, and the Fed can do that very rapidly. But there is a limit to the Fed's ability to confront deflation, since it cannot cut nominal rates below zero in order to induce economic growth. Therefore, risking inflation is a better bet than erring on the side of deflation.

Above all, we must avoid a repetition of an adverse feedback loop that would run from the declining real economy into the financial sector. While banks are broadly stabilized, they have yet to begin to operate as adequate lenders to U.S. households and corporations. That is why premature monetary tightening could push our economy into an even deeper decline.

Of course, when the economy really turns, monetary authorities must have the will to reverse policy quickly, tightening instead of easing. It is not something politicians like doing. Hence, they have been prone to running up huge and long-term fiscal deficits--deficits that, at some point, risk the financial stability and economic strength of America.

We cannot afford to let political leaders fudge and muddle along. We must find a way to mandate the appointment of strongly independent budget monitors who would be charged with the obligation to pass public judgment on the fiscal condition of our nation, in both the short and long terms and program by program. The Congressional Budget Office should be expanded to provide these cost and budget estimates, as it did for the healthcare debate. The CBO must be made even more independent and nonpartisan, with a regular obligation to make public its assessments. This is critical to prevent politicians from digging a bigger and bigger fiscal hole through deficit spending and the excessive accumulation of national debt in order to promote their re-election. That is the real danger emerging out of our present discontents.

Economy: Forget Inflation, Deflation Is a Bigger Danger - Mortimer B. Zuckerman