The current deep recession calls for some serious rethinking of many widely accepted economic ideas. Right now, one of the most important is the notion that inflation is always bad. We all know the reasons bankers and policymakers think this: lenders are swindled by inflation; debtors make out like bandits; inflation adds to uncertainty; and it has the potential to ratchet upward to higher and higher levels, ending in hyperinflation and wheelbarrows of cash being exchanged for an apple.
But the truth is that a little inflation would be welcome at the moment. Otherwise, we run the risk of the price level falling significantly for a long while, because deflation ratchets downward just as certainly as inflation does upward. And, to understand just how awful that can be, look at the Great Depression, when prices fell by 23% from December 1929 to December 1933, or at Japan in the 1990s — when prices were stable and GDP growth fell from 6% a year over the previous three decades, to barely 1%. Just two weeks ago, San Francisco Fed Bank President Janet Yellen joined the chorus of U.S. monetary policymakers voicing concerns about deflation.
There are five reasons why deflation wreaks havoc.
First, it destroys demand. That's because it makes sense to wait for prices to fall and postpone every purchase as long as possible. It is as though the after-Christmas-sales discounts got deeper and deeper every week: it always pays to wait another week.
Second, cash becomes too attractive. Its purchasing power rises so that the real return to holding cash is positive — and at the same time there is zero risk. Is it any wonder today that banks demand high rates of interest to lend?
Third, capital markets sometimes cannot clear. Savings exceed investment at any nominal interest rate.
Fourth, it destroys credit capacity as a small debt grows in relation to income over time.
And finally, around price stability, a little uncertainty becomes a big uncertainty. So, for example, a 1% difference in possible future interest rates is a 20% margin of uncertainty when rates are around 5%. When rates are around 1% it is a 100% margin of uncertainty. All in all, a deflationary world is a very unfamiliar and uncertain world in which rational individuals hunker down.
What should be done? We should raise taxes on goods and offset the effect on demand with direct income transfers.
So, first of all, we should raise indirect taxes to push up the Consumer Price Index. The most obvious way would be the federal gas tax (or a federal carbon tax). Last year the United States consumed about 143 billion gallons of gas. If the recession and the effect of economizing on high-priced gas took out 10% of consumption, a $4-per-gallon tax would add 130 billion x $4, or $520 billion to the cost of most things in the economy — or about 4% of GNP or 6% of consumption. So it might be reasonably expected to kick-start inflation at a rate of 3%-4% a year — not 6%, because it takes a while for price increases to work their way through the economy.
Secondly, we need to make sure that there is an offsetting surge in household incomes. So the federal government needs to turn all that revenue around and give every penny back to the U.S. consumer in new purchasing power. That is about $1,500 per person — or about $3,000 for the bottom 50%. For a poorer household of three that would represent a very nice average supplement to income of $9,000 a year, or a little more than the Bush tax rebate last year — but it would be a sustained addition to income rather than a one-off, one-month payment.
Finally, we need to do something to offset the adverse effect of a gas or carbon tax on the domestic auto industry. Demand for gas guzzlers would collapse permanently and demand for green cars would undoubtedly outstrip supply for a long while to come. With so much to adjust to, a case could be made for short-term federal adjustment assistance. We should maintain employment and purchasing power in Detroit through generous subsidies for redesigning, retooling, and retraining. But these adjustments themselves are overdue already, and anything that accelerates them is fundamentally a good thing.
Does this really have a lot to do with banking? The answer to that is definitely yes. Our current problems cannot be solved one by one. Deflation will be the last nail in our highly levered financial system unless it is decisively turned around. Some may worry that inflation might take hold and accelerate as demand takes off. To them I would say, we would then know what to do: tighten monetary policy. Let's pray that particular problem is not too long in coming.