Tag Archives: deflation

Is Deflation on the Horizon?

There has been a great deal of talk regarding deflation recently. Today, Nouriel Roubini predicted that deflation will be the main concern of policy makers in the next six months. James Hamilton disagrees. Nevertheless, the drastic fall in housing prices and the recent crash in the money multiplier warrant a closer look.

At the onset of the Great Depression, the Fed was already in contractionary mode. The subsequent banking failures of 1930 – 1933 caused a flight to cash as many removed their money from banks. This flight to cash resulted in a severe monetary contraction as money moved from banks to mattresses (or so the saying goes). This monetary contraction led to the worst deflation in U.S. history with percentage price declines in the double digits. Now we have talked about irrational fears of deflation before, however, when deflation is the result of an excess demand for money, the effects can be quite disastrous.

The recent discussion regarding deflation begs the question as to whether we are currently in the midst of a monetary contraction.

On the supply-side, we are clearly not in a contractionary environment. However, as our friend David Beckworth points out, the money multiplier of the monetary base has declined substantially since June. Beckworth (as well as Hamilton) attribute this decline to the fact that the Fed is now paying interest on excess reserves. While Beckworth’s accompanying graph provides ample evidence that bank reserves have drastically increased, a closer look at the data suggests that the spike in reserves began in August (two months after the decline began in the money multiplier).

I draw two conclusions from the previous analysis. First, we are entering (or have entered) a contractionary monetary environment. Keynes’s theory of the liquidity preference is proving as poignant as ever as individuals are fleeing the stock market and other investments for the security of cash. Second, foreclosures are squeezing bank balance sheets and counter-party risk remains elevated (as is continually evident from the LIBOR-OIS spread). Given that the Fed is introducing new facilities each day to ensure that it has to tools necessary to combat the crisis, this implies that cautious banks are simply building excess reserves (and the Fed is now rewarding them for doing so). The result is a massive reduction in the money multiplier.

Thus far, the Fed has been very responsive. The reduction in the money multiplier has been met by a significant increase in the monetary base. So long as the Fed remains proactive, I am prepared to agree with James Hamilton that deflation is not on the horizon.

Hamilton on the Liquidity Trap

James Hamilton on the liquidity trap over at Econbrowser:

Some of my colleagues still talk of the possibility of a liquidity trap, in which the central bank supposedly has no power even to cause inflation. Their theory is that interest rates fall so low that when the Fed buys more T-bills, it has no effect on interest rates, and the cash the Fed creates with those T-bill purchases just sits idle in banks.

To which I say, pshaw! If the U.S. were ever to arrive at such a situation, here’s what I’d recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we’re at it! Print an arbitrarily large quantity of money with which you’re allowed to buy whatever you like at fixed nominal prices, and the sky’s the limit on what you might set out to do.

Of course, the reason I don’t advocate such policies is that they would cause a wee bit of inflation. It’s ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we’re flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.

More on this topic later…

Fannie and Freddie: Cause or Effect?

Our friend David Beckworth writes:

(1) Fannie and Freddie (the GSEs) gained market share beginning in the 1980s from the saving institutions (presumably from the Saving & Loan debacle fall out); (2) Fannie and Freddie lost market share beginning around 2002 to the asset-backed security issuers. As noted by the above observers, this latter point supports the notion that at least some of the problems at Fannie and Freddie emerged in response to their declining market share during the housing boom. In other words, what happened to Fannie and Freddie may have been a symptom rather than a cause of the housing boom-bust cycle.

I have mentioned this before, but it is worth repeating. There is no doubt that Fannie and Freddie have played a role in elevating home prices through the subsidization that followed from the implicit guarantee of their debt by the federal government and their growth over the years. However, their share of the market declined for the better part of this decade as private issuers expanded their presence within this market. It was the pyramid schemes of collateralized debt obligations (CDOs), CDOs comprised solely of CDOs (CDO-squared and subsequently CDO^n), regulatory forbearance (not solely de-regulation), the unbelievable assumptions regarding risk (see here, here, here, and here for a discussion of uncertainty) and credit default swaps, an irrational fear of deflation that caused the Federal Reserve to keep interest rates at historic lows for far too long, etc. that caused the current financial crisis.


The latest EconTalk podcast is a discussion with Tyler Cowen that centers on monetary theory and policy. While the podcast as a whole is worth a listen, I found myself quite disappointed upon hearing Cowen’s views on deflation. Cowen not only rejects modest deflation as an optimal policy, but actually advocates a low, stable rate of inflation. 

In my view, this largely stems from a misunderstanding of deflation prevalent in monetary theory that I have previously detailed here.  Thankfully, David Beckworth, who has done great worth on the topic of malign versus benign inflation, presents a great counter-point to Cowen’s analysis.

Deflation Isn’t All Bad

Our friend jk over at Three Sources laments:

While I’m willing to defend all the Fed’s actions to date as protection from deflationary shocks, I’ll join Mr. Kudlow in suggesting no further cuts.

Not to pick on jk (as it is not clear from the post whether he fears deflation from world economic growth, excess demand for money, or both), but deflation gets a bad rap — as it should in some cases. Deflation, however, is not all bad. Rather it depends on the cause of deflation.

There is a stark difference between what we will call benign and malign deflation*. Benign is deflation that is caused by an increase in growth. Malign deflation on the other hand is that which is caused by an excess demand for money. In order to understand the difference, recall the equation of exchange:

MV = Py

where M is money, V is velocity, P is the price level, and y is real output. A productivity increase will lead to an increase and y and a decrease in P (for simplicity, we will assume that the changes are equal). The decrease in the price level is quite “natural” to economic growth as the change is not due to some monetary disturbance, but rather an increase in productivity. Additionally, real incomes rise without nominal wage adjustments. This is known as benign deflation and is perfectly healthy (and perhaps desirable) in a growing economy.

By contrast, consider a change in money demand (where money is understood as money holdings). In this case, people will tend to hold more money, which decreases velocity (V). If the central bank does not respond with a corresponding increase in money (M), the pressure falls on the right-hand side of the equation. Thus, there is downward pressure on nominal output (Py). This is known as malign deflation and is necessarily harmful to the economy. As individuals hold more money, they are forgoing potential purchases. This puts downward pressure on the price level. However, prices are sticky and therefore do not fall simultaneously, but rather they fall sequentially. Thus, the downward pressure on prices results in downward pressure on output in sectors where prices are relatively sticky. The result is a reduction in real output as well as a fall in the price level.

As should be obvious, the differences are stark. When deflation results as a consequence of economic growth, this fall in the price level is quite desirable. However, when deflation results due to a monetary shock or central bank mismanagement, the results can be quite startling.

This difference was recently traced by David Beckworth, who finds that in the postbellum United States, there is ample evidence of a difference between benign and malign deflation.

So fear not deflation — as long as it is the result of economic growth.

* This terminology is consistent with that used by Beckworth (2007) and others.