Central Banks and Deflation

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

The Federal Reserve is very nervous about deflation.  The reason for
this is more than its awarenes of the grave danger of deflation on the
economy.  The real reason is is that central banks in general, and the
Fed in particular, do not have the power or operative measures within
their discourse to deal with deflation. The exclusive dependence of
central banks on interest rate policy to fight inflation does not work
for fighting deflation, as a decade of data in Japan has shown. The Fed
is now following Japan's lead in trying to manage an exchange rate
policy (talking is not pushing the dollar down) to export deflation to
its trading partners.

The Chinese economy has been accused by some Japanese economists as
exporting deflation by stripping non-Chinese companies of their pricing
power. That is an obvious fact, but the cause of this does not origninal
from inside China.  As I pointed out in an earlier post (Dollar's slide
and PPP), the Chinese currency, the RMB, is actually depreciating
against the dollar on a PPP adjusted basis, despite a nominal peg.  Thus
with the US pushing the dollar down, it will only exacerbate China's
deflation export.

The problem is not the relative value of the dollar, but the dollar's
role as the dominant reserve currency for trade.  The use of exchange
rates to manage trade is a destructive move, regardless who does it.
Exchange rates need to be stable and to change only gradually and
infrequently.  Trade needs to be structured to increase domestic wages
rather than to push domestic wages down.  Pushing wages down decreases
purchaing power domestically which directly contracts international trade.

Central banks must change their theology of protector of the value of
money and start promoting full employment and rising wages worldwide and
alter an economic system that rewards corporate policies of layoffs and
cost cutting, to one that rewards job creation and expansion.


Henry C.K. Liu