Deflation

Employment, Interest, and Money: Deflation, Recession, and Aggregate Supply

Stopping deflation should not be very hard at all, if you’re willing to accept the side effects of your deflation cure. Most discussions of this topic have focused on the demand side: the Fed could get people to start buying things by dropping money from a helicopter; or it could buy stock and increase demand by corporations and stockholders; etc. But when it comes to stopping deflation, demand policies are the hard way. To continue my side effects metaphor: if you insist on using the less powerful drug that has fewer side effects, you may have to give ridiculously high doses before the patient responds. The easy way to stop deflation – the drug to try once hair loss and vomiting become less of an issue than the disease itself – is to reduce supply rather than increase demand.

During normal times, economists and policymakers spend a lot of time trying to figure out ways to increase supply. It’s not an easy task. Cut taxes, to improve incentives for private investment? Raise taxes, to stop consumer spending from crowding out private investment? Invest more in public infrastructure to make the economy more efficient? Invest less in public infrastructure, to make the resources available to the private sector? It’s a tough game.

The game gets a lot easier when your objective is to let the other guy win. One obvious way to reduce supply, for example, is to encourage the formation of cartels. That’s something that Roosevelt tried, though some of his programs were struck down by the Supreme Court. Scholars can debate what the overall effect was on economic growth, or whether, after already devaluing the dollar, such additional measures against deflation did more harm than good, but it’s hardly open to question that encouraging cartels will tend to raise – and in the context of a deflation, stabilize – prices.

One particular form of cartel encouragement, which would certainly go over well with some of the current government’s constituents, would be to strengthen labor unions (one thing that Roosevelt did). Under normal conditions, some economists might argue that labor unions, despite their cartel aspect, often increase supply by such means as improving morale and decreasing unnecessary turnover. But it’s certainly true that unions are particularly loath to accept cuts in wages. In the context of a deflation, the stabilization of wages would tend to stabilize prices, since it would make it unprofitable for firms to cut prices. (Paul Krugman touches on this issue in some recent blog entries. He mentions a recent academic paper, but I like to give credit to Brad DeLong and Larry Summers – in a paper that I read nearly 20 years ago before it was published – for making intellectually respectable the idea that labor unions can help the economy by helping protect against deflation. I should also acknowledge James Tobin, who worked out the theory underlying the “death spiral” concept as discussed above.)

Another way to reduce aggregate supply is by inducing inflationary expectations to replace deflationary ones, so that producers are less willing to sell at low prices. This is largely a psychological issue, but if the Fed shows a willingness to take demand-side policies to extremes, even if the extremes are still not enough to solve the demand problem, they may affect supply. For example, when James Hamilton suggests (somewhat whimsically and just for the sake of argument) that the Fed could buy up the entire national debt, one might think of it as a demand-side policy, but I would suggest that its supply-side impact would be more important. With Treasury interest rates, even for long-term bonds, already quite low, it’s not clear that reducing them to zero would have much effect on demand. But when people observe the Fed buying up the entire national debt, the perception that “Helicopter Ben has gone wild” can’t help but make an impact.

And so on. Figuring out ways to produce less, rather than more, shouldn’t be very difficult. Naturally, reducing aggregate supply – trying to make the economy produce less at any given price – is not going to be directly conducive to economic recovery. But by reversing deflation and thereby making traditional demand-side tools more effective, it could be indirectly beneficial.

The death spiral should be pretty easy to avoid. The problem is that, once you get to the point where you have to make avoiding the death spiral a priority, you end up with this conflict between policies that reverse deflation and policies that increase production. It’s not the 1930’s, but it’s an experience I would hope to avoid.

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