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.
At least two other regional bank presidents—William Dudley of New York and Eric Rosengren of Boston—share Bullard’s concern. They will soon be joined by three new governors, Obama appointees to the Federal Reserve Board in Washington, who are much more sympathetic to liberal anxieties about jobs and the stuttering economy. Janet Yellen, president of San Francisco Fed, is the new vice chair. Peter Diamond and Sarah Raskin will be new governors.
In short, we may be witnessing the opening of an authentic economic debate—one that truly addresses the nation’s historic predicament. Let’s hope. The terrible trap of deflation gripped Japan for nearly fifteen years after its financial collapse in 1989. Japan’s economy struggled to restart, but repeatedly fell back into recession. That is one definition of Depression—an economy that cannot get out of the ditch.
Deflation essentially tells everyone to hunker down and wait. Instead of buying big-ticket items, consumers wait for prices to fall further. Instead of investing in new production, companies wait for cheaper opportunities, cheaper labor. The paralysis feeds on itself, once it gets started.
Actually, our situation is more dangerous than Japan’s was. The Japanese culture and its economic system are shaped by a functioning commitment to social solidarity that does not exist in the United States. In its worst years, Japan’s unemployment rate never rose much above 5 percent. Protective cultural values, embedded in the economic system, would not tolerate it.
The American system, by contrast, readily throws people over the side in the name of free-market efficiency. The pain is distributed first to the weak and defenseless, as we now witness, but the losses creep upward on the social ladder as the recession continues. Deflation would generate the pain more widely, more ferociously.
There is one small silver lining in this grim news. If the Federal Reserve steps up to the deflationary threat, its warnings and actions can give President Obama and Congress a strong opening to change their economic policy too. Forget the stupid deficit scare-mongering. Government must embrace more aggressive fiscal measures—bigger deficits, not little bitty gestures. New stimulus spending is needed to fight off the downward pressures.
That, of course, will require the president to acknowledge what he now denies. The nation is not out of the danger zone. The government must act because it is the only sector in the economy that can lead the way.
Right now, though people are increasingly skeptical, the president is sticking to his optimistic assurances. Prosperity is right around the corner. That was Herbert Hoover’s line and it doomed him.