13th annual Municipal Finance Conference


13th annual Municipal Finance Conference



How Much Should We Worry about a U.S. Deflation?

June 4, 2003

In early May the Federal Reserve signaled its concern about what it called the “minor risk” that today’s one percent inflation could turn into a deflationary period of falling prices. Testifying before Congress later in the month Fed Chairman Alan Greenspan reiterated that concern. And just a few days ago, he told a group of world bankers that while the development of deflationary forces was a low probability event, the Fed will lean over backward to make certain they are contained.

Why the Concern About Deflation?

The combination of weak demand for goods and services and competitive pressures from an overhang of excess capacity can squeeze profit margins and force price discounts. The accompanying slack demand for labor will tend to slow the pace of money wage increases and lead to further price weakness. This is how recessions and sluggish recoveries painfully bring down the rate of inflation. And when inflation is already low, prices can actually begin falling.

Falling prices and the expectation of further declines can, in turn, exacerbate the weakness of demand. Consumers may delay some purchases in hopes of getting better prices. Potential home buyers and business investors are discouraged from borrowing for fear they will have to repay their debts out of earnings and revenues diminished by the decline in prices. A reduction in interest rates could overcome this barrier to investment. But, since interest rates can’t fall below zero, many of those who worry about deflation fear that the Federal Reserve will have little power left to support demand and fight deflation if interest rates are already low when deflation begins.

What can we do about it?

The breathless tone of some of the media discussion about deflation reflects exaggerated fears. There are a number of monetary and fiscal tools available to stimulate demand and fight deflation, even after the short-term interest rate targeted by the Fed has been pushed down to zero (it is now 1-1/4 percent). Fed governor Ben Bernanke discussed some of these tools in a November speech. For example, the Fed could act to push down the interest rates on longer term government securities, thereby promoting lower rates on private loans and bonds, which are still significantly above zero. One powerful way to do this, he suggests, would be for the Fed to announce that it stood ready to make unlimited purchases of medium or even long-term Treasury securities at a price that would achieve some targeted low interest yield. Bernanke also suggested that, among other measures, the Fed could make interest-free loans to banks, accepting as collateral private debt obligations, and if it became necessary, could ask the Congress for authority to purchase such obligations itself. (This latter approach, however, would have to be very carefully crafted because the Fed would then be allocating capital among individual private firms).

If such monetary policy measures were not enough, the Federal government could generate additional demand with a large, temporary stimulus of tax relief and spending measures. Since households are likely to spend a smaller fraction of a temporary than a permanent tax cut, the size of the reduction should be calibrated accordingly. As Bernanke suggests, the addition to the deficit created by the stimulus could be financed by direct Fed purchases of Treasury securities, so as to prevent the added deficit from raising interest rates and to avoid a large increase in the publicly held federal debt.

While likely harmful in a prosperous or rapidly recovering economy, these measures could be safe and highly useful in an economy with low inflation or deflation, and plagued with chronically weak demand.

Is Japan a model of what inflation can do?

Japan’s decade-long stagnation has, in the last four or five years, been accompanied by falling prices . But Japan should not be taken as an example of what inevitably follows from a modest deflation. In the first place, as economist Adam Posen has pointed out, Japan has used only some of the range of monetary tools available to fight deflation, and those belatedly. And with respect to fiscal policy, the Japanese have for some time been reluctant to undertake aggressive stimulus, on grounds that their debt has already grown sharply relative to GDP. But this objection could be overcome by having the Bank of Japan buy the government securities needed to finance the stimulus—as suggested above for the U.S.

Japan also has some deep structural problems that are inhibiting the growth in investment desperately needed to help end stagnation. While Japan has developed a number of world-class export industries, a recent study (2000) by the McKinsey Global Institute showed that a substantial fraction of domestic output is produced by firms with productivity far below those in corresponding U.S. industries. The study documented the regulations, restrictions, land policies, subsidies, and tax incentives that have provided an anti-competitive shelter for inefficient business practices and firms. The potential for modernizing “catch-up” investment in a wide range of domestically oriented industries has been inhibited by this web of protective devices, and political opposition has kept the pace of liberalization slow.

Since the bubble burst more than ten years ago, the Japanese banking system has become saddled with a massive volume of bad loans. Successive efforts to get the bad loans off the books and re-capitalize the banks have been frustrated or watered down by entrenched interests within the Japanese Diet, because that process might force many protected “zombie” firms into bankruptcy. It is difficult to determine the extent to which productive new investments have been deterred by an inability to get bank financing, rather than by the combined effects of stagnant aggregate demand and the protections afforded to existing business establishments. But it’s probably much more the latter than the former.


Deflation, while not a likely forecast for the U.S, needs to be recognized as a downside risk, and the Fed is right to do so. But let’s keep it in perspective. In particular, what has happened to Japan is not a model. The U.S. financial system is not hamstrung with a debilitating burden of bad loans. Compared to Japan, it shelters many fewer sectors from competition and imposes smaller barriers to investments that challenge existing industry structures. From a macro-economic standpoint, the Federal Reserve has made explicit its intent to move promptly to counteract faltering demand and its willingness to adopt innovative monetary tools should short term interest rates fall to zero. Most important, it seems quite likely that the appearance of deflationary forces would lead to a substantial further economic stimulus. Indeed, in the current political climate, the main concern is not that the response would be insufficient but that it would go beyond the needed temporary stimulus, providing yet another permanent tax cut, and loading more debt burdens on future generations.