Canova response to Weisbrot column on Deflation

["Tim Canova" <tim.canova@xxxxxxxxxxxxxxx>]

> -----Original Message-----
> From: Canova, Timothy
> To: 'Mark Weisbrot '; 'weisbrot-columns@xxxxxxxxxxxxxxx '
> Sent: 7/10/03 4:57 PM
> Subject: RE: [weisbrot-columns] Threat of Deflation Is Exaggerated
>
> "Let's Not Exaggerate the Federal Reserve's Capabilities", by Tim Canova
>
> I was quite surprised to read Mark Weisbrot's recent column ("Threat of Deflation is Exaggerated", July 3, 2003) in which he downplays the threat of deflation.  First, as he points out, even disinflation has its down side (and as the Boskin Commission from a few years back notes, even the offical Consumer Price Index (CPI) overstates actual inflation).  Arguably, we're already there, and if not, there are plenty of factors pushing the global economy in that direction (only some of which you acknowledge), from deflation in Japan, recession in Germany, falling oil prices, weak consumer confidence, weaker business investment, austere fiscal policies in almost every state, and the possibility of a bursting housing bubble (and maybe also a bearish government bond market).
>
> Weisbrot places far too much hope on the Federal Reserve being able to get the U.S. out of any deflationary cycle.  He states that the Fed  "can create all the money that it wants to create, and thereby drive prices back up."  Just what does that mean?  That the Fed can purchase long-term government bonds, at any price, to push long-term yields to zero.  Yes, the Fed has that power (as in "the pegged period" of 1941-1951), but driving long-term bond yields to near zero won't get a deflationary economy back up on its legs (recall the dirty 1930's and present day Japan).  Hence, the Keynesian description ("pushing on a string") of the futility of monetary policy during a liquidity trap.  As every deflationary episode suggests, the central bank can make cheap money available; but it cannot force anyone to actually borrow or spend the money, and that is exactly the problem when business and consumer confidence collapses.
>
> Over the past six months, several Fed officials have attempted to quiet fears in the financial markets by referring to the Fed's power to
> purchase long-term bonds (one Fed official even referred to the pegged period).  I was therefore quite surprised to see Weisbrot buy into the Fed's own public relations campaign.  It is a sign of the Fed's fears of deflation that Fed officials have engaged in such heresy as speaking well of the pegged period (previously only a shining moment in monetary history for New Deal progressives like me).  But when the consumer and business sectors are demoralized, pegging interest rates at near zero will only be effective if it's to accomodate massive government spending.
>
> Of course there's another impediment to the Fed creating lots of money through long-term government bond purchases -- namely, the precarious value of the dollar on international exchanges.  The dollar has already fallen more than ten percent against the euro in the past year, and hopefully such an orderly decline will give U.S. manufacturing a lift.  But a full-blown run against the dollar would be a disaster.  That could swamp Fed policy, collapse the bond market, push up long-term yields (against the Fed's wishes), and utterly destroy the housing bubble.  No one knows for sure, because we are in such unchartered territory.  But to be cavalier about such risks is not responsible behavior by Fed officials or by progressive economists.
>
> Downplaying deflationary risks (at a time when it's knocking on the CPI doorstep) plays into the hands of the do-nothings:  no need for a federal jobs or spending program, no need for a federal revenue sharing program for state and local governments, no need for much of anything but tax cuts and hollow optimism of the Fed's ability to push money on investors and consumers, even when they refuse to invest or borrow at near zero percent. >
>
> Weisbrot's analysis is far too optimistic that the Fed's policy tools are sufficient, and that the only question is political (i.e., getting the
> Fed to dig into its policy bag of tricks).  The problem and the solution is political, however, in another sense:  the only way out of a
> liquidity trap is a massive fiscal stimulus, such as the U.S. spending on the Second World War.  Tax cuts are not necessarily a very effective way to restore growth in output and prices.  History suggests that only significant increases in government spending will do in a time of deflation.  And there will always be great political impetus for balancing budgets during times of fiscal crisis (resulting from a recession in tax revenues).
>
> Maybe we will dodge the deflation bullet.  But making light of it is akin to saying that the threat of nuclear weapons is exagerrated.  All
> it takes is one nuke in the wrong hands (an Islamicized Pakistan or the Ayatollahs of Iran) and we'll have a day far worse than September 11th.  And all it would take is a genuine U.S. deflation for this world to get much more dangerous quickly and for the economic pain to spread exponentially.
>
> Weisbrot's column was surprising and hopefully he will re-think such naive optimism about Federal Reserve capabilities.  For Fed officials, it's a thin mask covering a cynical game of talking up the financial markets while accepting income tax cuts targeted for the top percentiles of households.
>
>
> Tim Canova
> Professor of Law
> University of New Mexico
> (still the 1st university to formally join the World Bank Bonds boycott)
> Tel:  (505) 277-5654
>
> Visiting Professor of Law
> University of Arizona, James E. Rogers College of Law
e-mail:  tim.canova@xxxxxxxxxxxxxxx
> Tel:  (520) 626-6451
>
>
>
> -----Original Message-----
> From: Mark Weisbrot
> To: weisbrot-columns@xxxxxxxxxxxxxxx
> Sent: 7/3/03 8:45 AM
> Subject: [weisbrot-columns] Threat of Deflation Is Exaggerated
>
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> This column was distributed to newspapers throughout the
> U.S. by Knight-Ridder/Tribune Information Services.
> If anyone wants to reprint it, please let me
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> _________________________________________
>
> Threat of Deflation Is Exaggerated
>
>          A specter is haunting America (and Europe) --
> the specter of deflation. Talk of deflation has moved
> financial markets, influenced the statements of the
> Federal Reserve, and gotten a lot of people worried
> that the United States could be headed toward a
> prolonged period of economic stagnation. The most
> feared example is that of Japan, which has been mired
> in a slow-growth swamp since its stock market and
> real estate bubbles burst in 1989.
>
>          What is deflation and how much should we be
> worried about it? Deflation refers to a sustained fall in
> the general price level, the opposite of inflation. Most
> of us are not old enough to have lived through the
> Great Depression, so although we have seen falling
> prices for individual products (for example,
> computers) we have not experienced a prolonged drop
> in overall prices.
>
>          There is no doubt that deflation, were it to
> happen here, could create problems for our economy.
> But the threat has been exaggerated, and
> misunderstood, in several ways.
>
>          First it is important to realize that if the
> Consumer Price Index were to turn negative for a few
> months or even a year, this would not necessarily
> spell doom for the U.S. economy. The scary scenario
> that is often presented is a vicious cycle: the Fed can't
> lower interest rates below zero, so that weapon is
> gone when prices are falling. Consumers postpone
> purchases that they know will soon be cheaper,
> further reducing demand. Debtors (most consumers
> and home buyers) see the value of their debts rise
> relative to their incomes and other prices.
>
>          But most of this scenario is true when there is
> no deflation but inflation is falling -- for example,
> when the rate of inflation drops from 4 percent to 2
> percent. And with short-term interest rates now at 1.0
> percent, the Fed is already at the point where it
> doesn't have much left in the way of stimulating the
> economy through lower short-term rates.
>
>          The real danger comes if deflation persists --
> then the problem of falling demand and increasing
> debt burdens become cumulatively worse. But there's
> no need to panic: it's not that difficult for policy
> makers to make prices rise if they really want to do
> so. The central bank (our Federal Reserve) can create
> all the money that it wants to create, and thereby drive
> prices back up.
>
>          The Japanese Central Bank was not aggressive
> enough in doing this, but that doesn't mean that our
> Fed would have to make the same mistakes. It's true
> that central banks tend to err on the side of slow
> growth -- most of our recessions in the post-World-
> War- II period (including the one before last, 1990-
> 91) were actually brought on by the Fed raising
> interest rates at the wrong time, or too much.
>
>          But that is a different problem -- a political
> one. It means that if deflation were to start, our
> elected officials and the public might have to pressure
> the Fed to do the right thing. It does not mean that
> deflation is inherently a vicious cycle that, once
> begun, is difficult to break out of.
>
>          Prolonged deflation is not all that likely
> anyway, at least for now. The Fed recognized that in
> their May 6 meeting, seeing it as "only a remote
> possibility," partly because the dollar's decline against
> foreign currencies will raise the price of our imports.
> Interestingly, the Fed's public statement at the time
> was different, giving the financial markets the
> impression that the Fed saw deflation as a more
> serious danger.
>
>          Of course, our economy still faces serious
> weaknesses: business investment has yet to recover,
> and consumers can only add so much to their debt,
> which is already at record levels relative to income.
> The weak labor market adds to the problem of lack of
> demand, as do the massive spending cutbacks (and
> some tax increases) by financially strapped state
> governments.
>
>          And perhaps worst of all, there is a bubble in
> housing prices -- similar to the stock market bubble
> that burst in 2000 -- that could "disappear" some $3
> trillion in homeowners' wealth.
>
>          So there are plenty of rocks in the road to
> economic recovery. No need to be overly alarmist
> about the dangers of deflation.
>
> Mark Weisbrot is co-Director of the Center for
> Economic and Policy Research, in Washington, DC
> (www.cepr.net).
>
> Name: Mark Weisbrot
> E-mail: <weisbrot@xxxxxxxx>
> Co-Director
> Center for Economic and Policy Research
> 1621 Connecticut Ave NW, Suite 500
> Washington, DC 20009-1052
> Phone (202) 293-5380 x228
> Fax (202) 588-1356
> (202) 333-6141 (home)
> (202) 746-7264 (cell)
> www.cepr.net
>
>
>
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