Friday, 08 November 2002 8:30 am
Why does deflation have a bad reputation?  The reason is that rapid deflation would bankrupt all debtors, causing an economic collapse.  This is one explanation of what caused the Great Depression, which is why deflation is linked in most people's minds with a depression. But there have been deflationary periods in the US  and elsewhere that were not accompanied by depressions. Some have argued that the total public and private debt levels were much lower in those situations, while they were at historically high levels in the 1930's. Unfortunately, today public and private debt is once again at levels similar to the 1930's, a worrisome fact. 

My interpretation of Wednesday's unexpectedly large rate cut by the Federal Reserve is that the Fed now sees deflation as a serious threat and is attempting to preempt it.  The stock market appeared to confirm that view by selling off on the announcement. 

How is it possible to have deflation when the system is being flooded with liquidity?  Economist Frank Shostak offered in an interview yesterday the best explanation I have seen.  Here are some excerpts from his interview (for the full text, visit www.mises.org - I added the chart):

“If you read the Fed's statement, you see that creating money is the goal. If you look at the money base, the latest figures for October, increases were running 6.7 percent year on year. In September, the increases were running 5 percent. So already, the Fed was pushing quite a bit of new money into the system. It won’t surprise me to see them really step it up now. ”

“While the Fed is going to do its best to inflate the money, it can happen that money supply won’t increase - depending on the behavior of banks. If banks stop lending, due to tighter credit standards or fewer borrowers, the money supply will not respond. This is what happened in the 1930s.”

“Consumer and real estate loans by commercial banks are still strong. But business loans have been declining on a yearly basis for 15 months in a row. Credit standards are tightening and many businesses have difficulties to obtain credit. Also, the debt-to-asset ratio in business is at the highest level as far back as we have data.”

“In short, banks are happy to lend to consumers and on real estate and mortgages. But in the business sector, the credit crunch is real. The possibility that the US could end up like Japan is quite high. Given the record high consumer debt-to-assets ratio I envisage that banks will slow their lending to consumers in the months ahead.”

“This raises a question. If you have had such aggressive lowering of interest rates for so long, from 6 percent to less than 2 percent, and nothing has happened to industrial production, that immediately raises the possibility that we are dealing with something more serious than people realize.”

“The analogy between the US and Japan is increasingly conspicuous. In both cases, the central bank has lowered rates to virtually nil, and not revived the economy. Most of the recent indicators in the US have been declining. ”

“Prices have not responded because businesses do not have pricing power. The reason is that people don’t have as much real income as they used to have. If you don’t have the means to spend, it is hard for business to raise prices. ”