Deflation risk

There are plenty of things to worry about in the current economic situation. But deflation isn’t one of them.

Greg Mankiw had a great article last weekend in which he challenged the view that macroeconomists have learned enough to prevent a repeat of the Great Depression. Greg notes some disturbing similarities between our current difficulties and the problems of the 1930s:

From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today. The banking panics put downward pressure on economic activity in two ways. First, they put fear into the hearts of depositors. Many people concluded that cash in their mattresses was wiser than accounts at local banks. As they withdrew their funds, the banking system’s normal lending and money creation went into reverse. The money supply collapsed, resulting in a 24 percent drop in the consumer price index from 1929 to 1933. This deflation pushed up the real burden of households’ debts….

Deflation across the economy is not a problem (yet), but deflation in the housing market is the source of many of our present difficulties. With so many homeowners owing more on their mortgages than their houses are worth, default is an unfortunate but often rational choice. Widespread foreclosures, however, only perpetuate the downward spiral of housing prices, further defaults and additional losses at financial institutions.

Greg is certainly correct that house price declines have a potential to cause similar problems today as we saw in the 1930s. But I believe it is more than an academic distinction whether we are talking about a relative price change (house prices go down but the dollar price of most other items goes up) or a true deflation (the dollar price of almost everything you buy goes down). The reason is that the latter problem is absolutely one that the Federal Reserve could fix, whereas the former problem may not be.

In a general deflation, the purchasing power of a dollar bill goes higher and higher, and as Greg notes, this can produce big economic problems, as it did for the U.S. in the 1930s or Japan in the 1990s. But it is absolutely a problem that the Federal Reserve can fix. If you increase the quantity of dollar bills fast enough, you’re sure to create inflation, not deflation. And the Federal Reserve has unlimited power to increase the quantity of dollar bills.

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.

Notwithstanding, I think Greg is raising a very valid point. Allowing the overall deflation in the U.S. in the 1930s and Japan in the 1990s was one quite fixable policy error. But perhaps modern macroeconomists have deluded ourselves into thinking that if this policy error had not been made, the whole episodes could have been avoided. How bad would the Great Depression have been if the price level had not fallen? Not as bad as it was, I’m convinced, but maybe still pretty bad.

I still like Brad DeLong’s perspective on all this:

Is 2008 Our 1929? No. It is not. The most important reason it is not is that Bernanke and Paulson are both focused like laser beams on not making the same mistakes as were made in 1929….

They want to make their own, original, mistakes..

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137 thoughts on “Deflation risk

  1. DickF

    Great post Professor. There are two things that must be known in such a scenario. One you address, how do your inject liquidity, and your approach will do the job much better than the current inefficient, marginally effective, economic distortion laced FFR methodology.
    The second thing is the one that seems to hang most, how do you determine inflation or deflation in a timely manner? Optimally this would be a moot point if we were on a gold standard, but gold is still the most monetary of commodities and so is the best indicator. If the FED were to use your methodology reasonably using the price of gold as their guide inflation and deflation would disappear. The he price of gold would allow the FED to alter the money supply before inflation or deflation were ever manifest.

  2. David Pearson

    Is the risk of deflation a problem today? If not, why?
    And if deflation is a potential problem, then is the Fed doing enough to address it? You argued recently that the Fed should only cut by 50bp because of the risk to the dollar. Presumably the same currency risk applies to a policy of dropping the interest rate target and adopting (formally) quantitative easing. Does this mean that you don’t forecast deflation under current monetary conditions?
    Offering to buy $1.2tr of $1.4tr Commercial Paper creates the vehicle for the type of quantitative easing you describe above. Pursuing it (unsterilized), however, would drive the Fed Funds rate below even 1%, which you do not favor.
    Basically, Professor, what should the Fed do and when should it do it?

  3. Don the libertarian Democrat

    Whose Afraid Of Deflation?
    In my last post, William Gross said this:
    “They must also take another bold step: outright purchases of commercial paper. They should also cut interest rates to 1%, because we are experiencing asset deflation, and the threat of headline inflation is long past.”
    Via Greg Mankiw, who wasn’t convinced, came the following:
    “In a previous post, I expressed surprise that yields on inflation-indexed Treasury notes are rising. Readers have emailed me a variety of hypotheses, the most common of which is deflation. As one smart economist put it:
    Here’s one possible answer — the credit crunch has precipitated a massive expansion of money demand — a scramble for cash. Despite its best efforts, the Fed has not matched this with a sufficient expansion of money supply. As simple IS-LM would predict, this surge in money demand has raised real interest rates (indicating that monetary policy is perhaps still too tight).
    Rising real rates on inflation-indexed bonds and falling rates on nominal bonds also tell us that markets expect this surge in money demand to result in near-zero inflation or even deflation in the years ahead. It’s starting to look more and more like 1990s Japan, though hopefully for not as long.”
    From Michael A. Fletcher’s story today in the Washington Post:
    “The confluence of trends has some economists worried that the country could be headed for a debilitating cycle of deflation: a period in which weak consumer demand, falling prices and tight credit ignite a downward spiral of still weaker demand and still lower prices. Under this scenario, as some businesses are strangled, joblessness increases, feeding the cycle.
    “It was just a few months ago that everyone was obsessed with inflation. Now it’s deflation,” said Bill Gross, co-chief investment officer at Pimco, an investment management company. “I think it’s a possibility.”
    “Some economists note that a period of price adjustments does not necessarily signal the start of a deflationary spiral.
    “Deflation is not the problem we should be worrying about,” said Adam Lerrick, an economist at Carnegie Mellon University. “A drop in the level of prices for some goods must be distinguished from a continuous fall of prices. Oil is down to $90 from $140, but does anyone expect it will be $55 a year from now and $35 in 2010?”
    Analysts said that a few months of price declines should not be a problem for the economy.
    But if prices continue to fall across the board for a prolonged period, the declines will weigh heavily on businesses and consumers, particularly those juggling a lot of debt, which must be paid back even as money is harder to come by.
    “For a few quarters, I say bring it on, but not for too much longer,” Gross said of deflation. “Capitalism depends on mild inflation. Unless we get it, the dynamics of capitalism sort of move in reverse.”
    But then, there’s this:
    “In the United States, policymakers have been much quicker to respond to deflationary threats. Five years ago, as inflation approached 1 percent, spawning deflation concerns, Alan Greenspan, then the Federal Reserve chairman, cut the Fed’s benchmark lending rate to 1 percent and the threat was never realized. It is an outcome that gives assurance to some economists.
    “As long as governments print money and run deficits, you cannot have deflation,” Lerrick said.”
    So, in the end, doesn’t that mean inflation is the only real problem?

  4. wally

    “If you increase the quantity of dollar bills fast enough, you’re sure to create inflation”
    The distinction between price increases and inflation is simple: wages go up in inflationary times. Do you think a wage increase is in the near future for you? For anybody?

  5. JDH

    I’m claiming that prolongued deflation cannot be a reasonable forecast for the United States, because the Federal Reserve can prevent it, should prevent it, and will prevent it.

  6. Keith

    If you go back and reread bernanke’s deflation speech of 2003, you will find that all of the ‘new’ programs enacted over the past year were proposals in that speech to deal with deflation. There are still a few tools he proposed back then that they have not done yet, like manipulating interest rates further down the curve…
    But that speech has been a virtual playbook of the fed’s behavior over the past year. The only difference is that bernanke did not wait for the target rate to reach zero to begin.

  7. Ted Seeber

    Of course, doing so is a huge mistake that just pushes the real crash out further.

    If we don’t have massive deflation soon, we’re going to have continued stagflation: wages falling behind inflation in real cost of living (using Roosevelt’s, not Reagan’s, CPI). In fact, we’ve had that for 20 years now. The real cause behind falling house prices isn’t just the subprime bubble and crash- it’s that housing is now unobtanium for a large percentage of the US population when you take away con games like the subprime mortgage market.

    Food & fuel are also now quite problematic- you can’t afford to live 5 miles out in the country and have an inner-city minimum wage job, there’s no way to get to work. Food prices are increasing fast enough that we’re seeing charity organizations, last resort for the poor, running out of food in the food banks.

    Yes, you’re absolutely right that deflation is not to be feared, that the FED can control the deflationary rate. Yes you’re right that deflation is not a reasonable forecast because of this. But we’re coming very close to the point of the lack of deflation causing a civil war, it’s already to the point where a lack of deflation is causing suicide. Is that what you really want?

  8. kharris

    I take your point to be that the Fed has the power and intention to prevent deflation, rather than that deflation is unlikely in the absense of Fed action. Mishkin told Bloomberg yesterday that the risk of inflation falling too far is significant now, but that the Fed will prevent it. Is that more or less what you are arguing, as well?
    As I’m sure you are aware, the Fed is already undertaking a good bit of Bernanke’s formula for monetary expansion when overnight rates are low. Fewer matched sales or more matched sales? That is the question.

  9. David Pearson

    The question is when should the Fed prevent it? You’ve argued that they have done enough (inclusive of a 50bp cut today) for now. Yet deflationary expectations are seemingly in the process of entrenchment. There is plenty of evidence of this: the commodities crash, the TIPS yield trading above the comparable Treasury yield, record low consumer confidece, plunging velocity, etc. If this list is not sufficient, then at what point would you urge the Fed to turn to quantitative easing (which necessitates abandonment of the FF target rate)?
    This is the crux, Professor: wait too long, and expectations are much harder to turn; act to soon, and the Fed incurs the risk of sparking high inflation.
    This is the same dilemma the 1930’s Fed faced. Bernanke thinks there was no dilemma; that the policy decision should have been obvious. Is it also obvious now? When will it be?

  10. JT

    The Fed can attempt to prolong the inevitable deflation but the Fed cannot prevent it because if they did print at the level you suggest our currency would collapse to zero.
    Massive bankruptcies are our only solution but the CDS market will prevent that from happening.
    Stick a fork in us…we’re done.

  11. JDH

    JT: a currency collapse to zero is what I would describe as infinite inflation. I in fact do not suggest operating at these extremes. My only point is that the Fed can cause inflation if it wants. I use these extreme examples just to point out what I think is the silliness of the liquidity trap doctrine, insofar as that doctrine claims that the Fed could cause no inflation no matter what it did. My practical recommendation is to embark on just enough expansion so as to prevent deflation. I do not recommend going all the way to causing an infinite inflation rate.

    David Pearson: By “quantitative easing” I gather you mean undoing some of the Fed’s recent sterilization, simply buying back significant quantities of Treasury securities with newly created cash, and forgetting about what the funds rate is doing for a while. I agree that might be a good idea, and I expect the Fed may well be embarking on it already. I remain convinced, however, that it is a mistake to believe that the Fed can solve all our problems. I see a broken financial system, rather than deflation, as the core problem at the moment. The Fed can prevent deflation, it may not be able to fix the financial system.

    As for how to make this call in practice, one of the key variables I would advise the Fed to be watching closely in the current setting is the exchange rate of the dollar against the euro. As long as the dollar is appreciating, I would be willing to try further quantitative easing. If we start to see some skittishness there, I would hold up.

  12. an elected official

    I agree that the timing of Fed moves is not trivial. I believe that they are already late, the slowdown of the velocity of money is very deflationary but it will take time to measure the effects. The political pushback is already making the Feds moves difficult. The further Helicopter Ben goes the stronger the opposition from the economically uneducated. People are scared, and that changes behavior in ways that the Fed cannot control. So will it be interwar Germany or interwar US???

  13. KJMClark

    This is Bernanke’s “helicopter” argument restated, isn’t it? Here’s a problem I see. What if no one wants the money? Prof. Bernanke used a clever mechanism to distribute his dollars, the helicopter, in which there are clearly no strings attached to the money, but the usual mechanism is through providing loans. But loans require that someone out there has the confidence and wherewithal to borrow the money, and something to spend it on. Does the Fed really have a mechanism to force consumers and companies to borrow and spend money if it seems more reasonable to everyone to just save it? If not, are they really in a position to take over all of the consumer spending that’s retracting?

  14. pater tenebrarum

    re. “How bad would the Great Depression have been if the price level had not fallen? Not as bad as it was, I’m convinced, but maybe still pretty bad.”
    really? let me see. people had no money and no jobs. higher prices would have helped them in what way exactly?
    as an aside, the constant barrage of ‘the Fed didn’t inflate enough in the 1930’s’ emanating from all and sundry only proves that absolutely no-one has looked at the data. between 1929 and 1932, the Fed’s balance sheet grew by well over 400%, and base money was pumped up by an 98% annualized rate.
    the problem was and remains that no government agency can create capital. printing money can not revive the economy once a credit boom has depleted the pool of real funding to such an extent that it begins to stagnate or shrink.
    broader money supply measures fell in the 1930’s because 1. they count credit type transactions as ‘money’ and 2. in spite of the Fed furiously pumping up base money and free bank reserves, deposits got annihilated even faster due to the string of bank failures (most of which came btw. AFTER the Fed’s massive monetary pumping exercise).
    the idea that state interventions in the market, if only done ‘better’ can avert the bust is hopelessly naive. the only way one can believe this is if one believes that bureaucrats are better at allocating scarce resources than the market. if that were true, the Socviet Union would have been a utopia of riches. REAL resources and capital are both scarce, and have been consumed at a record pace during the boom. a bust is NECESSARY to rebuild the consumed capital. the state can shift those resources around (taking from those who still produce wealth and giving to those that consume it), but this will not make things better. it is completely irrelevant WHAT type of intervention is attempted – the result will in any event be worse than that a ‘laissez faire’ approach would have produced.

  15. debriefing

    Perhaps it could be summarized like this :
    From where will come the oil required to fly the Fed helo ?
    Given the size of the heap of zombies assets, the flow of cash required to maintain them alive would ruin the trade, no ?
    If so, is the inflate medecine realy available ?

  16. JDH

    KJMClark, there is a dollar price at which people are offering to sell all the assets I listed above (Treasury securities, commercial paper, equities). If that price is unresponsive to the quantity of money that the Fed creates, then the Fed can accomplish all the wonderful things I list, and more. If that price is responsive, then it is not the case that we are in a liquidity trap.

    I repeat the bottom line, which I find incontrovertible: the Fed can, should, and will prevent deflation.

  17. don

    I agree (and is seems painfully obvious) that the Fed could prevent deflation if it were willing to do so at all costs. But deflation and too much inflation may be a knife’s edge – a path difficult or impossible to tread. In particular, the debt purchases needed to prevent deflation may lead to fears of an insolvent Treasury. Is that what you refer to when you argue that if the dollar starts to tank, they should ease up?

  18. Andrew Foland

    So I come at this not as an economist, but a physicist, so I’m quite naive. But in many situations, there is some conserved quantity that can’t be gotten around. For instance, the velocity-price-money supply equation can be seen as a restatement of the conservation of economic value.
    So here’s what bugs me. You have a situation: potential debilitating deflation. There seems to be a painless solution: print dollars and use them to buy productive goods such as the capital base of Japan.
    Something seems basically unconserved in this picture, like there’s a free lunch. Afraid you’re going to have a Depression? No problem, between your printing press and Japan, make it all go away!
    It seems to me there simply must be some debilitating economic result of using your printing press this way. Like absurd interest rates that prevent anyone from ever borrowing for capital investment again. (Basically, it seems as if it must be the case that the value of capital investment must be less than that interest rate, otherwise the environment would not have been deflationary to start with–no?)
    So in the printing-press-fixes-a-deflationary-spiral world, high interest rates still act to discourage capital investment. Why buy stocks when my Treasuries are going to yield better? So I’m not sure I see where the printing press has fixed the problem.
    I feel strongly (but am willing to be told I’m wrong, if I’m wrong) that fixing deflation can’t really be a choice between a depression and a free lunch; surely it is a choice between a depression and some other bad thing. So what does that other bad thing look like, and which problem would we rather have? And perhaps more importantly, which problem would those with their hands on the levers rather have?

  19. jesse

    JDH, I agree the Fed can create inflation. The truth is, as Roubini has pointed out, that inflation or even the risk of inflation will destroy balance sheets faster than the balance sheets can be deleveraged.
    I have heard that Japan did indeed try to create inflation by holding rates at around zero but was unsuccessful. I have not heard a definitive answer as to why they have not been successful. Have not Japanese firms and citizens adequately deleveraged by now?
    The Fed needs to walk a very thin line, to pump money into the system to avoid deflation (which would happen if rates were higher) but still keep rates low enough for a relatively ordered deleveraging of balance sheets.
    A conjecture, raised by people like Mike Shedlock and others, is that the Fed can prevent deflation if they cannot make people lend or borrow. I would love to hear a rebuttal on this point in a subsequent post or this comment section, especially vis a vis Japan’s experience in the past 20 years.

  20. ronmexico

    If avoiding deflation or creating inflation is so simple, why has Japan failed? Not being argumentative–just curious.

  21. CoSG

    Professor Hamilton,
    I agree that the risk of deflation is low. What concerns me is the stability (say measured as volatility) of the economic system (e.g. GDP, exchange rate, interest rates, stock market index, inflation, unemployment). For example, how sensitive is the system to a shock to the exchange rate? Let’s say value of the dollar goes down 50% for different reasons (maybe politics or just fear). Foreigners start withdrawing money from US, stock prices go down, treasuries go down, oil goes up and inflation goes up. FED would have to raise the interest rates to keep the inflation low (

  22. JT

    You have no idea where infinite inflation begins and neither do I so to pretend to understand how to take us to the brink but not tip us over does not make much sense.
    Banks do now want to lend while businesses and consumers do not want to borrow as we are at unprecedented levels of leverage in every area of our economy.
    The pain has not even begun yet. The next two years are going to be extremely painful and the Fed and Treasury think they can drag this out without repercussions…good luck with that.
    They have no idea what they are doing and neither does anyone else.

  23. David Pearson

    Thanks for your response.
    How do your comments about the currency dictating Fed policy square with Bernanke’s conclusions about the Great Depression? Specifically, didn’t the Chairman argue that the 1930’s Fed was wrong to seek currency stability?
    I have long believed that the Chairman painted a slanted view of Fed policy decisions at the time. After the fact its clear that the Fed was wrong to defend the gold standard. What about before the fact? To the 1930’s Fed, what was the implication of a “run on gold” on the real economy? Bernanke, at least in his “Essays…”, does not delve into that topic. Too bad, because he now faces a similar choice.
    My sense is if Bernanke’s writings are to be taken at face value, the Chairman will not follow your advice to heed the dollar when fighting deflation.
    BTW, one might argue that we are not as close to deflation as the 1930’s Fed was, and therefore the current Chairman still has time to keep one eye on the dollar when making policy. I think that view places too much faith on the Fed’s ability to time policy. When an iceberg is in the path of a supertanker, the captain can’t wait until he’s upon it to turn.

  24. Mike Laird

    With all due respect, JDH, you are whistling in the dark to try to feel brave. So the Fed buys all those liabilities, as you propose, they still have to be paid off by profits and taxes. They don’t disappear. Now that we have: 12 million people in negative equity homes – soon to be 20 million, 2 million lost jobs – soon to be many more, $1.5 to 2 trillion in toxic debt and only $600B has been written off, and 5 past years where people had a negative savings rate, and the baby boom generation headed into retirement, we are headed into a period of declining consumption and increased savings. Businesses will lower prices to stimulate demand, but with the wide-spread family economic stress, people will wait for a future price reduction before they buy. That is the definition of deflation behavior.

    The Fed will not be allowed to “print money” as you describe for all sorts of reasons, but they can be summarized by the idea that the senior generation lived through “the oil shock of the ’70s” and will not go there again – especially when so many folks are going onto fixed incomes in retirement.

    Japan tried a moderate version of your scenario. As you know, it did not work, and they had many years of deflation. They are headed back into deflation. As for the US, 5 year TIPS (inflation protected US bonds) are trading with an implied negative inflation rate averaging 0.7% over the next 4.5 years. Negative inflation is, of course, deflation. So if you believe markets are smarter than any one person, the US is 1. in a recession, and 2. headed into deflation.

    But keep whistling. You may feel better. 🙂

  25. RJMacdonald

    It seems to me that the notion of leveraged multipliers to fiscal policy is nowhere near as critical as the reduction in potency to monetary policy in the current crisis. Bank hesitancy to lend against bank reserves has had a contractionary impact on the money supply at faster rate than the injections of liquidity from central banks can offset it. During less extraordinary circumstances the trillions in liquidity injected into the system, all agree, would be disastrously inflationary. Yet, risk averse behavior in the banking system seems to have overpowered whatever confidence building measures the Fed has undertaken.
    Keynes’ notion that entrepreneurial spirits drive investment and a preference for liquidity is little understood and could not be more important today. Indeed, there is a powerful feedback between those seeking to deploy investments and those seeking to fund them. During a period of value destruction — or if you will deflation — entrepreneurial spirits are depressed while the preference for liquidity among savers increases. While these forces worked in tandem during the thirties for reasons different from the current crisis– reliance on the gold standard, lack of an adequate social net few automatic stabilizers, deflationary expectations took root in the system. With the conviction that price levels were going to remain flat or decline there was a strong incentive to delay purchase of goods and services. The disastrous impact on output, employment and wealth influenced policy makers well into the latter part of the last century but the gut lessons seemed to have faded.
    Rightly or wrongly during that period, wage levels buttressed by a strong union movement were blamed for rigidities in the labor market and for ensuing high levels of unemployment and social dislocation.
    Today, union membership is a far smaller portion of the economy and social net is strong. Presumably, automatic stabilization will reduced the depth of the resulting output and employment losses to some extent. Yet, equally stubborn rigidities are built into the current labor market — exploding health care costs, ballooning pension and social security costs — which would presumably result in social dislocations if these important pillars of quality of life were removed for large numbers of families.
    At the same time, the very fear –founded or otherwise — that something like could happen at the same time as the destruction of other forms of household wealth occured would undoubtedly lead to highly risk averse consumer behavior and to further downward pressure on consumption spending and reduced expectations of investment returns.

  26. Harry Coleman

    If banks are unwilling to invest as the Fed lowers interests rates and as the add liquidity measures via the endless acronyms then how are we not facing deflation.
    I saw your series with Shadowstats regarding the CPI but just taking their information on M3 as a proxy it shows a massive deleveraging even as the Fed increases the monetary base.
    First chart
    In Paul Krugman’s essay “Who was Milton Friedman” he includes a paragraph about Keynes 1st and Milton’s retort after.
    “Before Keynes, economists considered the money supply a primary tool of economic management. But Keynes argued that under depression conditions, when interest rates are very low, changes in the money supply have little effect on the economy. The logic went like this: when interest rates are 4 or 5 percent, nobody wants to sit on idle cash. But in a situation like that of 1935, when the interest rate on three-month Treasury bills was only 0.14 percent, there is very little incentive to take the risk of putting money to work. The central bank may try to spur the economy by printing large quantities of additional currency; but if the interest rate is already very low the additional cash is likely to languish in bank vaults or under mattresses. Thus Keynes argued that monetary policy, a change in the money supply to manage the economy, would be ineffective. And that’s why Keynes and his followers believed that fiscal policy in particular, an increase in government spending was necessary to get countries out of the Great Depression.”
    “In interpreting the origins of the Depression, the distinction between the monetary base (currency plus bank reserves), which the Fed controls directly, and the money supply (currency plus bank deposits) is crucial. The monetary base went up during the early years of the Great Depression, rising from an average of $6.05 billion in 1929 to an average of $7.02 billion in 1933. But the money supply fell sharply, from $26.6 billion to $19.9 billion. This divergence mainly reflected the fallout from the wave of bank failures in 1930 1931: as the public lost faith in banks, people began holding their wealth in cash rather than bank deposits, and those banks that survived began keeping large quantities of cash on hand rather than lending it out, to avert the danger of a bank run. The result was much less lending, and hence much less spending, than there would have been if the public had continued to deposit cash into banks, and banks had continued to lend deposits out to businesses. And since a collapse of spending was the proximate cause of the Depression, the sudden desire of both individuals and banks to hold more cash undoubtedly made the slump worse.
    Friedman and Schwartz claimed that the fall in the money supply turned what might have been an ordinary recession into a catastrophic depression, itself an arguable point. But even if we grant that point for the sake of argument, one has to ask whether the Federal Reserve, which after all did increase the monetary base, can be said to have caused the fall in the overall money supply. At least initially, Friedman and Schwartz didn’t say that. What they said instead was that the Fed could have prevented the fall in the money supply, in particular by riding to the rescue of the failing banks during the crisis of 1930 1931. If the Fed had rushed to lend money to banks in trouble, the wave of bank failures might have been prevented, which in turn might have avoided both the public’s decision to hold cash rather than bank deposits, and the preference of the surviving banks for stashing deposits in their vaults rather than lending the funds out. And this, in turn, might have staved off the worst of the Depression.”
    I think you can see where this leads us. I agree with Dr. Chinn that food stamps, unemployment insurance and infrastructure spending are the only ways out of this rabbit hole.

  27. groucho

    “It seems to me there simply must be some debilitating economic result of using your printing press this way.”
    Revulsion and then revolution. Humans as are ALL primate species are a “fairness based species”. It’s in the DNA. Attempts by govt for “excessive stealing” always has and will continue to lead govt being overthrown. In the end, the printing press solution is govt suicide, so they will default instead.
    NO govt in history has EVER repaid it’s debt!

  28. Phil

    Deflation risk? You have got to be kidding in your use of the word “risk”. Whether we are discussing decreasing prices or credit deflation, there is no risk in the equation. To wit:
    1. House prices are declining with no real bottom in sight.
    2. Fed funds rate is at 1% and falling.
    3. Stock prices are falling off a cliff.
    4. Oil is less than half what it was this summer.
    5. Consumer good prices, from food to cars, are falling rapidly.
    I could go on. What in the hell data are you looking at to come up with your thesis?

  29. anon

    “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.”
    What happens if velocity declines even more quickly?
    And what happens to a financial system that no longer has any interest margins?

  30. Daniel

    Having some controlled inflation wouldn’t be so terrible. Actually, had we had inflation and all these problems we are seeing now would have been avoided. The biggest problem now is the nominal value of certain assets is falling (an so is the real value). I the nominal value of assets had been kept unchanged and the adjustment on the real value had come from higher prices, then most of the banking problems we are seeing now would have been avoided – balance sheets are nominal, and not real. Bring inflation, and might bring people to real assets markets (like the housing market).

  31. MarkS

    Dr. Hamilton- I am shocked that you would suggest inflation as the solution to the credit crisis, and that you would consider deflation undesirable in the current situation.

    As Phil pointed out, deflation is screaming along out there, precisely because assets were priced far higher than their utility and replacement cost. Deflation is GOOD… it encourages savings and reduced consumption which America desperately needs in order to achieve a current account balance, to fund social services for aging baby boomers, to repair crumbling infrastructure, and to convert the society to high energy efficiency and renewable energy.

    Was your post a hypothetical tilt at the “liquidity trap” windmill?… While it is theoretically possible for the FED to inflate the hell out of the currency, I believe the medicine would be worse than the disease! America for the last 40 years has squandered mountains of scarce resources in unproductive consumption… The future will be different with 2 billion more people competing for our standard of living, and a planet already over-exploited by our culture.

    Time for a few posts describing alternative economic theories!

  32. Rumple Stiltskin

    There are a couple of problems with Dr Hamilton’s suggestion to buy everything in a liquidity trap.
    First: to buy you need willing sellers. At a zero interest rate not everyone will sell their treasuries. In this case you might have to go negative.
    Second: Even though you may not stop deflation at this point in time, having pumped a mountain of money into the economy will leave a massive inflation overhang. Once the fear stops, even if it is a few years down the track, all that money will start to be used and Mugabe type inflation would occur.
    Hence, as well as not necessarily working the Hamilton proposal is irresponsible.

  33. JDH

    Jesse, Ronmexico, Mike Laird, and Bob Riley: Japan did not do what I and every other macroeconomist told them they should have.

    Mark S.: There are alternatives in between severe inflation and severe deflation, and that is what I advocate. Not sure what you mean by “tilting at windmills.” I am, in my opinion, solidly refuting the liquidity trap conjecture by illustrating the absurdity of claiming zero impact of monetary policy.

    JT: Of course I know where an infinite sequence begins! It begins with the first billion. If that’s not a big enough number for you, then I’ll take the second billion. If you’re claiming that an increase of the money supply of x billion is associated with severe deflation, and an increase of x + epsilon is associated with severe hyperinflation, and you then challenge me to tell you the value of x, then your view of the world is even stranger than the liquidity trap conjecture that every finite x is associated with severe deflation!

    Rumple Stiltskin: If Treasuries pay a zero interest rate (and they don’t yet), then first I’ll completely retire the outstanding federal debt, and then I’ll buy the CP and the equities. The claim that no price of any asset can be moved with a sufficiently large creation of money is completely ridiculous.

  34. an elected official

    I think the biggest reason that Japan couldn’t stop their deflation was that they were in it when no other large economy was. We are all in it together now. The carry trade that Japan had to contend with is less likely now.
    But the fed is still pushing on a string in trying to get people to continue to spend.

  35. derrida derider

    “I have heard that Japan did indeed try to create inflation by holding rates at around zero but was unsuccessful. I have not heard a definitive answer as to why they have not been successful.”
    Because real interest rates were high even when nominal ones were zero, because people expected deflation. Monetary policy was impotent because people didn’t spend the extra cash, expecting both that it could buy them more next year than this year, and that they would also have less income next year.
    Rumplestitlskin, you can’t “go negative” with nominal interest rates because your negative interest rate bonds have to compete with a whole lot of highly liquid Treasury bonds with a zero nominal rate – that is, greenbacks.
    I’m agnostic as to whether the US is in fact at risk of one (I’m sure glad I’m not Bernanke having to make that judgement), but surely there is nothing controversial about a liquidity trap being a possible pathology of capitalism, nor that one existed in the US in the 1930s and in Japan in the 1990s.

  36. Rumple Stiltskin

    Derrida: You can effectively go negative if you pay enough for the treasuries you wish to buy back.
    JDH The was no such claim (price of asset can’t be moved) but nevertheless unconstrained creation of money makes that money valueless for purchasing assets – think of Mugabe. But the important point is the inflation overhang. That is what makes the proposal irresponsible or a flight of fancy.

  37. JDH

    Rumple Stiltskin: I’m not sure what you are claiming, but here is what I’m saying: the Federal Reserve can, should, and will prevent deflation, and those who claim that a liquidity trap prevents the Fed from doing so are mistaken. The essence of a liquidity trap argument is very much the claim that there is zero effect of further money supply increases.

    Are you somehow thinking, as I attributed to JT above, that an increase of the money supply of x would cause severe deflation, and an increase of the money supply of x + epsilon would cause severe hyperinflation?

    My claim is that by changing the value of x, you change the value of inflation, and that there is a sufficiently large value of x that prevents deflation.

  38. HBL

    I have not seen you respond to the argument made in several comments that velocity falling faster than money supply expands would still result in deflation (Japan’s experience, according to some).
    It is difficult to force people or organizations to spend money. If new money is targetted to banks, then unless we force something resembling true price discovery up front (Sweden’s approach) then banks will still horde cash for future writedowns. If the new money goes to individuals in debt, they can pay off that debt and that money is destroyed (due to fractional reserve mechanics). If it goes to individuals not in debt, those individuals can increase their savings further, so money velocity decreases. If it goes to the very poorest or the unemployed this is essentially targetted fiscal stimulus/spending and it would reduce deflation, but it may face political limits to the magnitude that is feasible (and requires congress since these people don’t own the assets you propose that you would buy).
    IMHO your approach would likely have some impact but perhaps less than simple theory predicts, especially at the end of a historic debt bubble with consumer attitudes beginning to change.

  39. andiron

    the playbook of defeating deflation was already played by greenspan by inflating housing assets (& others) to disastrous effect. This patient (economy) has been already subjected to massive overdose (of printing & leverage).
    It is NOT going to respond to that any more.
    (may be FED should start sending checks in mail to every household as the best asset to transmit liquidity (housing)has already been exhausted)

  40. Rumple Stilskin

    What I am saying is that in the short run there are limits to how much you can buy regardless of how much you print. Whether you cause a bit of inflation in the short run due to the buying is of little relevance. If people are worried they won’t necessarily use any of the additional cash for additional purchases. As a result the impact on the recession or depression will be zero or negligible or even negative. Having injected all that money into the economy is a risk for when the economy eventually does pick up. Then when people feel safe enough to spend a large inflation will begin with negative consequences.
    The short message is that either the proposal won’t work and regardless if it does it the cure will be worse than the disease.
    This means that the ‘proof’ that there is no such thing as a liquidity trap is a bunch of empty sophistry.

  41. Anonymous

    Yes, most of the comments here are sophistry. This is complex topic. There are clearly limits to the printing money solution, but that does not mean it might not be a solution to defeating deflation. Wow, what a nuanced position I just made, clearly too much for the *know-it-all* crowd here. Flooding the country with fresh dollars could very likely get people spending and lending again because they wouldn’t know what else to do with the dollars. At the same time, yes, I acknowledge it might not work.
    Of course, if nominal asset prices were to rise, fixed debt burdens decrease. Do you yet get that we are different from Japan? They are savers and we are in debt. And another thing, I think I saw this on a prospectus somewhere, “past performance is no guarantee of future results.”
    BTW, comparisons to Zimbabwe seem out of place as well. They have no economy. We do. We will have an economy even if we have high inflation or low inflation. Zimbabwe will have no economy whether it has hyperinflation or no inflation. Let’s stay on topic.
    And, please, would it be so difficult to have a little respect for the complexity of the world? Maybe read a book on epistemology. It might make everyone here a little less arrogant.

  42. Steve Waldman

    JDH — I very much agree with you in this debate. But I think an interesting question is whether there is a range of money associated neither with deflation or sharp inflation, but with price stability, and whether it is an achievable goal to attain that range. It could be that there is an x such that M0 < x implies deflation and M0 > x implies a sharp inflation. Even if there is a “good” x, do we have the tools to know it and hit it?

    M0 may be an insufficient measure — outcomes may depend upon precisely what the Fed buys with its new cash (monetary policy on the asset side of the balance sheet, as you memorably put it).

    Even if there is no “good” x, or if the perfect money supply is hard to find, perhaps the Fed can dynamically achieve stability by selling assets at hints of inflation and purchasing assets when deflation looms. But again, the strategy is quite risky: we don’t understand the lags and transmission mechanisms exactly, and if we err, our policy dance might resonate with price-level oscillations rather than damping them. (Cut to high-school physics films of a bridges vibrating to destruction in a windstorm.)

    Plus, if we intend to dynamically manage the price level by buying stuff with fresh cash to fight deflation and selling stuff off to slurp back the money when inflation comes, we had better take care that whatever we buy is resellable. That is, the quality of the Fed’s balance sheet affects future policy flexibility. We might have to tolerate an inflation to mitigate the credit risk associated with some Fed assets before they become marketable, leading to expectations that leave our monetary thermostat sluggish.

    Of course, the Fed and the Treasury together have a much more powerful arsenal. Sufficiently onerous taxation can overcome an inflation (regardless of what the Fed can’t sell) and Fed-financed fiscal policy might circumvent the public’s unwillingness to lend or borrow in an deflation. It might be that in difficult times, central bank independence becomes central bank impotence, and will be voluntarily surrendered. Arguably, we have seen glimmers of that already.

  43. Rumple Stiltskin

    The claim concerning printing money is basically if you print enough money it will work, hence the liquidity trap doesn’t exist.
    I have another claim. If you hold your hand in a fire, long enough, you can take your hand out of the fire and your hand will have suffered no ill effects. Of course, so far no one has held their hand in long enough.

  44. Anon

    Roubini’s predicting deflation, he’s been right so far. No reason to doubt that claim. None of the intervention created by the FED is working. The destruction of credit has been far greater than the expansion in money supply so far. If the FED does hyperinflate, thats the end game for the dollar. Deflation allows us to stay in this fractional reserve game for longer.

  45. markg

    Your post goes a long way in helping understand reserve accounting. Operationally there is no difference between the Fed or the Treasury paying interest. Both are a matter of crediting a reserve account. However from an inflation standpoint there is a big difference. When the Treasury sells a security it drains banking reserves. That “money” is no longer available for purchasing power. The holder of the Treasury Security can always sell it to obtain purchasing power but the buyer gives up an equal amount of purchasing power. Limiting purchasing power is one step in limiting inflation.
    This is a very difficult point to get across. Govt debt does not burden future taxpayers no more than paying interest on reserves. Some day this will be common sense much like the Earth is not the center of the Universe. And post like yours will be the steps needed to get there.

  46. groucho

    “Deflation allows us to stay in this fractional reserve game for longer”
    Bingo! As the world’s greatest MILITARY power(and greatest foreign debtor ever), every incentive is in place to stiff the foreigners.
    In it’s self interest the US will continue to apply military leverage over energy while milking foreigners as much as possible. This means MAINTAINING dollar hegemony “no matter what the cost”. Excessive printing won’t play a part of this long term strategy.

  47. a different chris

    I’d like to buy this but I just can’t, I’m with Andrew Foland above – too much like a free lunch.
    I think we are in deflation or on the brink, so if you don’t think so don’t read on.
    My thoughts are as always, about wages. (mine especially!). Economists are quick to tell us that “too high” wages will lead to inflation. But they never say the seeming converse: too low wages would lead to deflation.
    Now I said “seeming” because IANAE and maybe there is some singularity they believe in that proves the converse isn’t true.
    But if it is, then maybe we should think about how wages could be “too low”. Now before you start talking about >100K policement, the people that have in large numbers and amounts that have contributed to “First World” economies are the Chinese and Indians.
    But they are paid 3rd world wages.
    I can’t wrap my head around how underpaying them led to a global savings glut in the countries they work in, but I didn’t say I had the answer.
    I’m just saying – why aren’t people really questioning the original “free lunch” – these cheap workers? Maybe it wasn’t free after all.

  48. gaius marius

    JDH — destroying the dollar to create an inflation may be possible, but i think we would discover that it is not the less painful method of correction.
    beyond mr. waldman’s valid points on specific ability — let’s imagine the fed was successful in engineering rising prices with radical quantitative easing. what it could not do in such a situation would be to compel lending, which is very risky for banks in a steeply rising inflation.
    given that, and given what would surely be very high initial unemployment as a precondition of heavy quantitative easing, wages would likely not rise with prices.
    i encourage a rethinking of the problem facing the united states along the lines of james livingston’s recent essay. this economy suffers from a long-term decline in real wages at a time when consumer growth has become increasingly essential to the economy. levering the consumer masked the effect for 20 years, but now the bill is coming due.
    if the fed were to engineer a further decline in real wages by pushing prices higher in a stagnant wage environment, i fail to see how the problem is rectified. indeed, it may be severely aggravated — to the point where the social fabric may not hold together. this must be a consideration.
    deflation, for all its difficulties, can be addressed with compulsory debt forgiveness and debt-to-equity swaps. that may be painful for capital, but results in a workable consumer economy with real purchasing power on the other side, does it not?

  49. David Pearson

    Steve Waldman,
    I think you raise a good point about policy. Its impossible to have an optimal money supply that would result in equilibrium aggregate demand when velocity fluctuates wildly.
    If anything, the Fed is crashing velocity by paying interest on reserves. Its virtually ensuring that banks do not lend out liquidity to the real economy where it can be spent on actual goods and services, deposited, and re-lent. In short, as JDH has written, the interest on reserves encourage cash hoarding by banks.
    The only way to reverse cash hoarding by banks, firms and individuals is to extract a penalty for the action. The way to do that is to actually target a “penalty rate” of inflation. Of course, the problem is that velocity, if it turns, can turn with a vengence. The situation could tip into a dollar crisis if the “penalty rate” is sufficient to cause a sudden drop in demand for all dollar assets.
    So what is to be done? As someone points out above, all this tells us is that monetary policy is a rather ineffective tool, contrary to countless promises made to us by Greenspan and Bernanke.

  50. Arturo

    The Fed can cheap up money to zero, but nobody I know will be borrowing a dime for business growth purposes when self-employed SS is going up without limit, Bush tax cuts are expiring, capital gains are going up, 401’s for savings will now be taxed. And when, in addition to Fed tax increases, States, schools and local govt. are raising income, sales and property tax, why would anyone risk any of his/her capital stash for a down payment on any business venture? If there’s little potential for after-tax profit the government’s infusion of reserves will stay in the vault, unborrowed.
    Deflation may be stopped for an instant by printing money and throwing it out of a helicopter but upon seeing this, current short term lenders of trillions to government will demand interest rates that will eat up the new money from heaven – print enough and the dollar will crash with anarchy to follow, I fear.

  51. David Johnston

    If deflation is so easy to prevent why can’t the Japanese prevent it? Why don’t they print Yen and start buying up everything?

  52. DDK

    I may have understood this wrong. But Professor Hamilton’s analysis seems to point to a disturbing possibility: we could end up with a deflation in housing, which is difficult to fix, and an inflation in everything else, which is easily achieved by throwing money everywhere (financial rescue, unlimited swap lines for dollars, loans to AIG, GM, etc, and more fiscal stimulus from Congress.)

  53. JDH

    Andrew Foland and a different Chris: I’m not claiming there’s any “free lunch” here. I’m claiming that because the Fed controls the number of dollar bills created, it controls the purchasing power of a dollar bill. That doesn’t make us any richer or poorer, it just sets the exchange rate between a dollar bill and other stuff. My position is that deflation (an increase in the purchasing power of a dollar bill) would cause additional harm in the current situation, and therefore the Fed should avoid deflation, which it can and will. However, DDK has it exactly right: avoiding overall deflation does not make all the problems go away. This was exactly the point I was trying to make.

    Anon and HBL: We are talking about MV = PY, where M is money supply, V is velocity, P is price level, and Y is real output. If V goes down by exactly the same amount that M goes up, then PY is unchanged. If you can increase M an arbitrarily large amount without changing P, then you are in precisely the hypothetical situation that I explore above. If P doesn’t change no matter how much M the Fed creates, then the Fed should buy, and buy, and buy, with no limit to the wonderful benefits that the government could obtain because, under your hypothetical, there would be no adverse consequences whatever. The conclusion that I think you should draw from following that reasoning through is that your premise that V will offset M no matter how big you make M is simply false– increase M enough, and P will go up. I guarantee it.

    Rumple Stiltskin says: “Whether you cause a bit of inflation in the short run due to the buying is of little relevance.” No, it is precisely the point that I am discussing. If the Fed can “cause a bit of inflation”, then the Fed can prevent deflation. That the Fed can prevent deflation was precisely and exactly the main point I have been making.

    David Johnson: I have asked your question as to why didn’t the Bank of Japan stop the deflation to many people. The best answer I could get is that the BOJ felt unable to purchase any assets other than their own government’s short-term treasury securities. That they should have purchased alternative assets to stop the deflation is the universal recommendation of everybody I know.

  54. jult52

    I have very real doubts that any sort of accurate index of money/credit growth exists right now. If the Fed can’t measure the issue, how can it manage it?
    Great thread.

  55. David Pearson

    I don’t understand why Japan is trotted out as an example of ineffective deflation fighting. I think its a function of the too-high expectations for monetary policy that JDH alludes to.
    Japan had relatively low unemployment in the past fifteen years. It experienced real economic growth and income growth. It never tipped into hyperinflation or experienced a currency crisis. Social cohesion remained high and the country’s political and social institutions are sill intact.
    By the measure of Depression-avoidance, Japanese reflation was a stunning success.

  56. Steve

    Your solution to the problem of deflation sounds to me like you just want to abstract away from it.
    Deflation cannot, will not and has not happen! Why? Because it can’t! We can print money!
    It’s worth remembering that the Bank of Japan printed money to fight deflation. It doubled the monetary base, bought foreign exchange corresponding to 5 percent of their GDP (in one year!), and even started printing money and buying stocks and government bonds.
    Deflation did not budge. There are solutions to deflation, that research has been trying to get at, but the solutions is not ridiculing the problem and pretend it does not exist. It’s a serious issue

  57. Keith

    Sorry Professor, I am not yet convinced that reflation is the cure for deflation.
    While it does address the shrinking money supply and increased preference for cash from the hoarding reflex, it does not address the psychological problems of the Deflationay environment: The lender’s aversion to credit risk, and the borrower’s disincentive to borrowing. You can dump all the money into the system you want, but oil and water still won’t mix.
    Particularly for borrowers, the perceived real interest rate on using credit, and the expectation of lower prices, once set in, is a huge disincentive to borrow and spend – and we already see how flooding the system with cash (what, like over a trillion in the past year?) does not adequately affect the lender’s perceived increase in credit risk.
    As much as I loathed the TARP when initially rolled out, I at least understood the idea of them trying to remove questionable assets off balance sheets. That would actually address the psychological credit risk issue (I don’t think equity injections do the same thing). I also think it will soon be too late to stop the consumer from a deflationary mindset. The housing market has already been working on him for over a year. The thought of lower prices and exorbitant real borrowing costs from deflation will not make people want to borrow and spend.

  58. Michael

    Sir –
    You couldn’t be more wrong. They can not force banks to lend and they certainly can not force consumers to borrow. The problem with your thesis, is that BOTH need to happen.
    In addition, one would need to see wages spike dramatically higher for any semblance of hyper-inflation to actually work. If anything, we are seeing the exact opposite of what you have said thus far. Lower employment numbers, lower wages, decreased value in assets and destruction of credit.
    We are no doubt seeing an increase in the monetary base, but we are also seeing hoarding and mis-trust essentially freezing those monies. This is a zero-sum game until the incentives to take on more debt are greater than saving and getting out of debt.
    I really think the consumer is finally tapping out. The confidence in the system has actually turned worse and it will require an adjustment period to change for the better. They could inspire more debt with ridiculously low interest rates again… but there are very few who can actually take advantage with the strict lending rules coming online.

  59. Dame Salt

    Why not write a more detailed post RE why our situation differs from Japan’s? Your readers are obviously very interested in this question.

  60. don

    Several people have suggested (was mine the first?) that the difference between deflation and unwanted inflation may be a path too narrow to tread. I still ask why you (JDH) suggest watching the value of the dollar when inflating. I agree completely, so my question is merely whether our reasons agree.
    A difference I see between Japan’s situation and our own is the extent of external debt. I wonder how far we can go in pursuing a policy of Fed purchases of private debt to inflate the economy. It seems to me Japan was in much better shape to follow this advice. For us, it may lead to serious questions about Treasury default. The credit-default spread on U.S. Treasury bills increased substantially when the gov’t made explicit the FM-FM debt guaranty. And I think we have a lot further to go yet before the threat of credit crisis is behind us.

  61. Rumple Stilskin

    I think you have blinded yourself by not recognizing that there is a big difference between elegant, but speculative, economic theories and reality. I am sure you are happy with your ‘proof’. I prefer what the facts prove. I think evidence trumps theory every day of the week.
    As a consequence, I give up. Something about a horse and water. You are clever enough to work out that what you are saying is nonsense, hence I will just leave you to it.

  62. Carlo Ponti

    Regarding Japan’s deflation, it seems that most everyone overlooks a basic point. Namely, the existence until the 1990s of a price differential between Japan and the rest of the world that was sustained by trade barriers (explicit or de facto). In other words, consumer prices were higher in Japan than elsewhere. Higher prices were part of the social compact between the gov’t, corporate sector and public. High domestic prices subsidized Japanese corporations’ pursuit of market share overseas. In return, consumers benefited from lifetime employment and a seniority-based compensation regime that paid workers generously in their prime earning years. The government did its part by erecting trade barriers, mainly in the form of byzantine regulations. In this sense, Japan had a structural predisposition to consumer price deflation that does not exist in the US today. You could say it was a deflationary accident waiting to happen. Once Japan fell upon hard times in the ’90s and opened its domestic market in response to foreign pressure, demand for relatively cheap imports increased and domestic prices naturally fell-i.e., converged with international prices. Voila, dreaded deflation.

  63. JJ

    I haven’t joined in yet, but I do have a couple of late comments..
    First off, as mentioned above, some of you have stooped to what is essentially name calling. I see no “attitude problem” in the professor’s posting.
    I have only a BA, not a PhD, in economics, so I am not an expert, however, I get the feeling some of you are commenting w/o having read Prof. Bernake’s famous “helicopter” speech. It solves some of the exact problems mentioned above.
    In brief, some of you seem to defend your “pushing on a string” views by treating monetary policy in a hypothetical vacuum, as if the FRB would be working against the Treasury. Perhaps you’re right if that ever happenned, but in such an extreme situation, the federal budget would be used in concert with the FRB, allowing unlimited monetization of deficit spending.
    This solves the problem of being unable to force people to lend or spend. In reality, even if it has to pay unemployed brain surgeons to lay bricks, the govt. can “self create” as much demand as necessary to end deflation.
    As for the consequences of these actions, I agree that the FRB is unable to thread the needle so perfectly to prevent inflation (horrible misallocation of resources) down the road. As the 2002-2006 period shows, the FRB has to keep money too loose too long because of uncertainty of the fragility of the recovery, a la 1938.
    In fact, isn’t that the lesson of our current problem? Greenspan, post 9/11, propped up employment by using the area most affected by interest rates: construction. It worked, but eventually created a huge misallocation of capital into real estate, and finance (mortgages).
    The effects of preventing deflation, however, does not dispute the prof.’s original posting: that deflation can be prevented, short of an asteroid strike.
    Re: Japan, I am no expert, but let me point out that by the time Japan belatedly took action, it was facing a demographic problem. It now has too few young people to purchase the existing supply of real estate. A problem the US and europe avoid through immigration. IOW, there is no problem with the current Japanese economy that millions of immigrant laborers wouldn’t solve.

  64. Don smith

    There are too many houses, too many cars, trucks and RV; too many nail salons, too many mini-malls, too many resturants, too many retail stores like the big boxes – and the small boxes; too many of this and that.
    So . . . could someone explain to me how higher prices for goods and services would keep all these stores open . . . at a time when joblessness is rising, debt is increasing, etc. Is it as simply as: one buys today because it will cost more tomorrow? Isn’t that the reason why many won’t buy at all?

  65. Gepay

    There is a war between deflation and inflation When oil prices were rising, inflation was a problem all over the world and spilled over into food and other commodities. Then Lehman collapsed. Since then it appears the commodities rise was just the latest bubble. Now it appears that deflation is the problem with the original thesis of Jim H saying Helicopter Ben will fix it. But alot of the commenters here are correct. The problem is that the American consumer is tapped out as far as debt goes. Wages have not been rising. All the actual increasess in productivity have not been shared with the working or midddle class people. The only thing that got cheaper were mostly electronics made in China. All these trillions that Ben and Paul are pumping in are only going to FIRE that doesn’tcreate real wealth. It’s real job is supposed to be allocating the surplus wealth to the people who will create real wealth. Instead what it has been doing is skimming larger and larger amounts of money out of the hands of people who work and create wealth. Giving more money to them is not going to fix the problem. The Federal government has been financing two wars and a bloated military industrial intelligence complex that also creates no real wealth. We all saw how little the 160 billion Keynesnian rebate to the consumers did this spring. All it did was transfer the figures of a contracting eoconomy to the 3rd quarter. The deleveraging of risky speculation is causing 10s of trillions to to disappear as opposed to the trillions being injected into the very same institutions that caused the problem. This will only (eventually) weaken the dollar. some good could be done if this money was actually going to people who would actually create real wealth for everybody instead of just saving the asses of the clever idiots who created this problem.

  66. Michael

    JJ/JDH –
    Let me ask you a few questions;
    1. How does the USA service its national debt? What is the coupon and how would we continue to service debt if we turn on the printing press?
    2. Will the bond market support a hyper-inflationary scenario? Or will they essentially “slap” the people trying to pull such a stunt?
    3. What happens to the bad debt that has clogged the system to this point? We don’t have the cajones to print 54 trillion dollars or whatever the ridiculous numbers in the “shadow system” are, or do we?
    Another point is that the entire mess was created in a fraudulent environment. There are several investigations under way as we speak. Wait until the perp walks begin in earnest. The American people are a tad slow, but when they realize that this entire bailout was fraudulent… you can bet that the pitchforks will come out.
    Americans don’t have the patience for a Weinmar Germany/Zimbabwe scenario. It will get WAY ugly before that happens…

  67. alejo

    why could / did the Bank of Japan not create inflation following the methods you describe? it was and is a fiat regime. why is the situation in the United States different?

  68. KnotRP

    I recall pointing out to you on the “Where’s the Risk” post many moons ago that this was going to happen.
    The borrowing class is already busted. You think busting the saver class too, will cure the over indebtedness by making *everyone* broke?
    You were as wrong then as you are now.
    What the world lacks right now is a productive investment opportunity in which to deploy dollars,
    whether saved the hard way or printed the easy way.
    If you insist upon printing new dollars, you will only put the dollar into the ICU, in the bed next to the one the economy is currently in.
    But one thing is clear – this country lacks people who understand complex systems, and we’re the worse off for it. “It’s all contained”…yeah, right.

  69. Michael Krause

    What was our national public debt load in relation to GDP in the depressionary years of 1929-32?
    The way I see it, the US government can not afford a deflationary shock at any cost. Collapsing tax revenues will force us into a debt printing spiral that will force interest rates very high and the currency very weak.
    Unlike Japan’s 1990-present spiral, I doubt we have the safety buffer of high personal savings to fall back on. What do you think?
    The way I see it, if you step back from analysis of money and bond flows and look at it from a simple bookkeeping perspective, we have no way out that is not inflationary (likely via a devalued currency).
    If tax revenues cut in half from a deflationary spiral, we would easily be forced to increase our national debt by 2T+/year just to break even and keep existing services going. If we responded by cutting government jobs and entitlements severely (to balance our budget), you would see even exaggerated monetary velocity, decreased tax revenues, and lower aggregrate demand. A self-reinforcing spiral, if you will.
    I believe this recent economic boom (2002-2007) was entirely borrowed from the future, and now we are in the mire.
    I believe inflation will manifest itself in the form of our dollar exchange rate – we are inevitably heading to an era of decreased purchasing power in real terms, until of course we get some fiscal and broad policy that is intelligently designed at the government level to steer us in a better direction.

  70. groucho

    “I believe inflation will manifest itself in the form of our dollar exchange rate ”
    Does not appear to be the case.
    1) Us wants to maintain dollar hegemony(free rider)2) EU( old and new) will devalue faster than US 3) Asia and ME won’t revalue till the current crisis is over.
    The best the US can do is a moderate deflation with a streamlined default program that removes excessive debt burdens from consumers.
    Inflation policies won’t work unless cash is directly distributed to consumers on a regular ongoing basis; which of course means A WELFARE STATE….a pointless and futile endeavor.

  71. Michael Krause

    I don’t think it matters what the US wants, and as shown, how can we even militarily maintain hegemony considering our recent track record? Our viability as the world’s reserve currency will quickly dwindle if we don’t get our house in order. And I’m not advocating the euro specifically – I am just saying the future of the dollar does not spell out well unless our politicians suddenly turn brilliant.
    Bottom Line: We didn’t have the debt load in addition to medicare and social security entitlements to worry about during the depression. Thus its reasonable to say same bout of deflation would kill the currency, and end in country based hyperinflation/etc.
    This changes the whole government policy dynamic. Since earnings and thus real economic activity have been a product of leverage, the trip of deleveraging would be quite scary.
    Pick my argument apart. I want to be wrong.

  72. DickF

    Help me out here. There have been a number of posts saying that you have recommended inflation to get us our of the current economic decline but I did not read that in your post. I only read that you were repeating positions taken by Bernanke.
    Do you believe that we need inflation to begin recovery?

  73. JDH

    DickF: I am not advocating inflation, I am advocating preventing deflation. I am frankly amazed at how many commenters above seem to think that the purchasing power of a dollar could not have any relation whatsover to the number of dollars created.

    My position is simply that the Fed can, should, and will prevent deflation. Because the Fed controls the number of dollars it creates, it can control the purchasing power of a dollar. Specifically, there is a quantity of dollars that the Fed could create that is sufficiently large so as to prevent the purchasing value of a dollar from rising.

  74. Steve

    so the Bank of Japan should have tripled instead of doubled its money supply? Or quadrubled? What was the right level? And they should have bought 20 percent of GDP in foreign exchange instead of 5%? And somehow this would have exactly offset deflation, but gosh, not causes inflation. Obvious?
    Once again, it seems that you are abstracting from the problem, by asserting that it does not exists, instead of sayng precisely how it would be solved. Research in this area also suggest that if the equilibrium level of interest rate has to be negative, you can’t have stable inflation [see e.g. Krugman on the “law of the excluded middle” who explains this in a simple transparent way]. You either have to have deflation or inflation.
    I’m shocked by the level of ignorange this post and your repsonses manifest, given your position in the profession and your pathbreaking work in econometrics.

  75. groucho

    “the purchasing power of a dollar could not have any relation whatsover to the number of dollars created.”
    The “who, what, where and when” of dollar creation and distribution is far more important than the amt of dollars created.
    The BW2 system(which will now end)spread huge amts of dollars all over the world but taxed the US with interest payments on non-productive, non-liquidating long term “investments”.
    With the global economic collapse well under way and carry trades ending, the US is way too far behind the curve to prevent deflation.
    The silver lining to this sorry episode will be a new international exchange system. At last financial mercantilism will be put to rest.

  76. JDH

    Steve: Of course BOJ should have done more! Surely you’re not taking the position that they should not have?

    As for how to implement in practice, I’ve suggested direct, nonsterilized purchases of assets until you get the exchange rate depreciating. If we start seeing inflation rates below 2%, you do more and more. If you’re right that I never get ahead of deflation with this strategy, then I’ve succeeded in retiring the U.S. debt and eliminating the need for taxes altogether. Is that so bad an outcome?

    As for Krugman’s point, yes, it may be hard to target 0% inflation, and yes, part of Japan’s problem was they acted as though they thought 1% inflation was too much. But I don’t advocate a 1% inflation target. I advocate aggressive moves to prevent deflation. I claim there should be no dispute that this is completely feasible, and no doubt that Bernanke will implement it if needed.

  77. Michael Krause

    Any comments on debt obligations in 1929-1932 as percentage of GDP? Do you consider my thesis that a deflationary move of great depression proportions would be much more disastrous today (to the currency) than in 1929-1932 just due to national debt load and entitlement obligations, when considering sharply declining tax revenues?

  78. JDH

    Michael Krause: I certainly agree that deflation would be a very poor policy choice at the moment, aggravated as you observe by debt loads. Indeed, the decline in the relative price of housing (which I am distinguishing from the pure deflation discussed here) in conjection with the rapid expansion of mortgage debt is the number 1 reason that the problems are already so severe.

  79. Michael

    Please address the problem of forcing lenders to lend and forcing consumers to borrow… you haven’t to this point.
    The govt. buying assets is zero-sum game; plain and simple. There is no incentive to produce. Come on professor… hyper-inflation is a ridiculous solution and perpetuates boom and bust cycles. We need to reset the system.

  80. JDH

    Michael: I did not respond because I did not understand how your point related to anything I said. I say that the Fed can, should, and will prevent deflation. I do not say that it can, should or will force borrowers to borrow or force lenders to lend.

  81. Gepay

    People who use words like “direct nonsterilized purchases of assets until you get exchange rate depreciation” act on the assummption that Helicopter Ben and Hank “buddy,can you spare a few trillion dollars” know what they are doing. Now these kinds of words have very specific meanings until you get to assets and therein the devil is in the details. When you consider, In July 2007 US Treasury Secretary Henry Paulson postulated
    This is far and away the strongest global economy I’ve seen in my business lifetime.
    Or “I don’t see (subprime mortgage market troubles) imposing a serious problem. I think it’s going to be largely contained,” he added.
    Or I remain confident in our economy’s long-term prospects,
    Ben Bernanke
    Federal Reserve Bank Chairman – Testimony to Congress in early March 2008
    “Sometimes I wonder whether the world is being run by smart people who are putting us on or by imbeciles who really mean it.” – Mark Twain
    So which is it? Imbeciles or liars directing the rescue efforts?
    Whatever, it doesn’t give me much confidence. I learn towards liars for Hank – the richest man in the Bush cabinet who was the head of Goldman Sachs when the Ponzi scheme was in its prime. As for Ben I agree with the blogger who said “the economy is a train that’s run off a cliff and these fools think if they pump in enough money it will fly”
    Have you noticed how AIG was rescued because it was too big to fail and how Lehman wasn’t because it was a rival to GoldmanSachs?
    Are the rescue efforts increasing or decreasing the size of JP Morgan Chase and Cititbank and…so as to have financial institutions that are small enough to fail if they make idiotic decisions.
    What we need is to have discussions on how to create a rational financial system rather than how to save this one.

  82. Steve

    I did not articulate my point well enough.
    My point is that your post reads as if there is no such thing as a “deflation risk”.
    To me this is like saying that there is never an “inflation risk”. And then go on by claiming that there can be no such thing as an inflation risk, because surely you could just increase the interest rate by 100% or cut the money supply in half.
    Well, sure, you can always eliminate inflation by some action. The issue is how to do it and what kind of distortions it costs.
    Similarly the issue with deflation is just how it can be eliminated and at what cost.
    Surely it is more difficult as a practical matter to eliminate deflation when you can no longer cut the interest rate if its already at zero. So what to do? That’s the question.
    Buying foreign exchange just won’t cut it for the US. Why? Because the rest of the world is now suffering from the same problem. So now the US is going to buy up Tokyo and Japan New York?
    The deflation risk becomes more serios, the more smart people like yourself ignore it, or just come up only with hypothetical solutions that involves helicopters or stuff that can never be implemented at a policy level.
    It seems to me that the Bank of Japan could have eliminated deflation. But only if they would have firmly committed to realetively high inflation. And then, perhaps, started printing money and buying stuff.
    The problem with arguments such as yours is that it left BoJ off the hook. You seem to say, surely deflation is never a problem because you can just buy stuff. But as I read the literature it seems that buying stuff at zero interest rates does not work unless it simulatenously changes how people think about the future money supply (i.e. future inflation). This was Krugmans original point. So BoJ used your advive and bought bunch of stuff, but did not do the serious thing which was to set real goals for high inflation. So all the purchases had no effect, or at least not enough to curb deflation.
    For the US to print money and buy Tokyo will have no effect at zero interest rate if everybody things the Fed will sell Tokyo againt tomorrow (or when things have improved).

  83. JDH

    Gepay: I’ve known Ben Bernanke quite well for many years, and can tell you he’s smarter than I am. I agree that he may have expected too much of monetary policy. But one thing monetary policy definitely can do is prevent deflation, and I am confident that Bernanke will prevent deflation.

  84. Michael

    “But one thing monetary policy definitely can do is prevent deflation, and I am confident that Bernanke will prevent deflation.”
    Why? There is no happy medium here professor. The numbers are simply too large to quell into some sort of “stabilized state”. The academic approach to this mess has failed miserably thus far. Reality is that fighting deflation with printed dollars is a sure fire way to bankrupt the United States.
    We need people, entities and others to buy our debt. Otherwise we end up like Weinmar Germany or Zimbabwe. If these entities know the Printing press is running full speed, why on earth would they continue to buy our debt? The bond market will not tolerate printing.
    Do you want Weinmar Germany or Zimbabwe?
    Do you want a bankrupt United States that defaults on its debt?
    Those are your choices if we decide to print.
    Not only can we survive deflation… But I don’t think Bernanke and Paulson can do anything to reverse the deflation taking place right now.
    One other thing;
    Why are you so out of phase from Roubini and Mish? They’ve been singing “Deflation” for the better part of year. If Bernanke is just realizing that we are head long into a deflationary scenario, its way to late for monetary policy to work.

  85. JDH

    Steve: OK, I see how you might have read me that way, particularly the first two sentences. The main point I was trying to make was that the Fed can, should, and will prevent deflation.

    I certainly wasn’t letting BOJ off the hook. On the contrary, my view has always been that their errors were unforgivable.

    As to your last point, that buying up Tokyo doesn’t change prices given expectations, I understand that a number of academic papers have claimed this, but I don’t see the real-world problem. If that were true, then we get to own Tokyo, for nothing! If we ever truly faced that “problem”, I say, take all you can grab.

  86. JDH

    Michael: I repeat for you the question I posed to many others above. Are you claiming that if the Fed creates $100,000,000,000 in new reserves, we will have ferocious deflation, whereas if the Fed creates $100,000,000,001 we are back in Weimar Germany?

    If that’s what Mish and Roubini believe, then I’m proud to be marching to a different drummer.

  87. Gepay

    To JDH
    Is this more than a rhetorical question?, the head of what used the be the premier investment bank on Wall Street would have a moral and ethical compass closer to Ghandi or a shark?
    Then Bernanke is one of the clever ones also who thinks that he can carefully guide the US economy between those two Greek hazards now disguised as inflation and deflation. Now many people think that deflation wins hand down (like the Ellliot Wave people who have a better prediction quotient than andybody other than Roubini) while others (the gold bugs – eliminate the Federal Reverve – etc) think that with the trillions being given to the bailout will lead to the decimation of the dollar. I agree with the physicist above who says there are bound to be effects from creating trillions out of thin air to stop deflation even if one is successful. Bernanke has studied the Great Depression and thinks he knows the answer – I would imagine that is why he was picked to run the Fed because the people that really run things thought this present scenario was likely) just as the conspiracy theorists think Greenspan was chosen for his religious beliefs in the superiority of the free market ie this global meltdown was planned. About Bernanke, he will not be successful because he is operating from the past and not the present. The unintended consequences are always the ones that get you. In a chaotic (in the mathematical sense) of the global economy there is no way anybody can know how the present is different from a past only studied. It is not just housing which is deflating. I think we will have deflation and if the present course is continued by the Fed and the Treasury and the Congress then we will wreck the dollar along with it. There are even worse scenarios possible. As has been said, “Cheer up things could be worse! So he cheered up, and sure enough, things got worse.

  88. beezer

    Think Joe Pesci here. “OK, OK. I got it OK. There’s all this money sitting in bank vaults and nobody is lending it right? OK OK, I got it OK. So we take all the money and put it in the Bank of Pesci. OK OK. And we lend it out to stuff we want to make. OK? Like railroads and train engines. And windmills and turbines, all that stuff. And clean water, y’know? OK. What else?
    How about some super planes and some submarines. And what about cars. Y’know. The little ones with batteries and plug ins. How about diesel engines and biodiesel? How’s that? OK Anything else? I dunno. That would keep me busy for a while. How’s that? OK?”
    It’s not the money, it’s the spending. So let’s spend. If the private market won’t do it, let the Bank of Pesci do it. Or the Bank of Beezer. I’ll volunteer.

  89. steve

    I think my bottomline from reading this post and your subsequent reactions is that you were posing Paul Krugman and others as strawmen, by claiming that he and “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.”
    Paul, or anyone else in the profession these days for that matter as far as I can tell, never really said this. He said in his work that what matters was creating expectation about higher future money supply by creating expectations about higher future inflation. Paul argues that money supply today does not matter in itself being a perfect substitute with gov. bonds (two nominal claims on the government with zero interest!).
    You reductum ad absurdum argument, to buy up all the private assets in the world, etc., is just one example of an extreeme action taken that would surely increase expectations about the future money supply, using a basic arbitrage arguments for the government (although your argument does not work for buying government bonds). As I read the literature this arbitrage argument has already been formalized in some papers on the liquidity trap.
    So, again, to me this post just seems complete beside the point (although very well written an evidently it stimulated good discussion!). The whole post seems to be aimed at minimizing a problem that could become extreemely serious by pretending it does not exist and claiming that people that worry about it imagine that the government cannot in principle increase inflation. That’s just simply incorrect.

  90. FTX

    Prof H,
    Others have said it in different ways, but I’ll say it anyway…
    I think the problem many if us have with your post is that while we don’t dispute what you are saying is possible on a theoretical basis, we have doubts that the Fed could pursue such a course in the real world. So this would be my one question to you: are you satisfied in your own mind that if you (or the Fed) followed such anti-deflationary policies in current markets that you could predict the reactions of all market participants, and that such reactions will in no way undermine what you are trying to achieve?
    In the first half of 2007 the 10-year cost to hedge $10 million of US Treasuries against default was a mere $1,000 p.a. This week that insurance cost rose to $40,000 p.a., the level that Mexico and Thailand sovereign debt was trading before the credit crunch. CDS spreads on Treasuries have risen 40% since TARP passed.
    Fear is growing over the soundness of US government debt, and this is likely to increase pressure on long-term rates. So if the Fed goes into the market and starts buying Treasuries (e.g, to cap rates further along the curve as outlined by Chairman Bernanke in his 2002 ‘Deflation: Making Sure “It” Doesn’t Happen Here’ speech), what will be the reaction of investors who are being asked to fund hundreds of billions in US debt?
    I’m in no way convinced there is some marginal room for monetization here. For a nation with a huge trade and budget deficit, the moment that the Fed starts to print could be a tipping point – an instantaneous reaction from markets that at a stroke defeats your objective, because you would have to back down. In my view, there is no way in your inferior position that you could bluff markets out by simply monetizing more.
    I’m merely a market participant, not an economist. It’s you guys who are running the monetary show and you’re the macro experts, so if you can explain to a philistine like me why my take on this is misguided then I’d be grateful. You’ve educated me on a great deal of subjects, but in this case I feel I’m being asked to accept something purely based on academic theory rather than real-world analysis.

  91. Michael

    JDH says; “I repeat for you the question I posed to many others above. Are you claiming that if the Fed creates $100,000,000,000 in new reserves, we will have ferocious deflation, whereas if the Fed creates $100,000,000,001 we are back in Weimar Germany?”
    I understand your point, but this is a silly way to put it. You and I both know the numbers involved to retire the bad debt and/or buy enough assets to offset the CURRENT destruction of money/credit/debt are well over the amounts they have “printed” thus far. It will take a lot more than a paltry 700 Billion to stop deflation. (I can’t believe I said Paltry and 700 billion in a sentence)
    What I’m saying is these decisions don’t happen in a vacuum. You have a public that is on edge and paying attention. They have lost 20 to 70% of their 401K and pension funds are blowing up.
    Even if they don’t know the entire story, there is plenty of anger against the first bailout. You think the government buying up MORE bad businesses, good/bad assets, good/bad mortgages, other countries debt and so on isn’t going to spark public outrage?
    FTX – Bingo. Like I’ve said, admittedly less eloquent, the second the printing press is fired up. China and the rest of the world dump treasuries, in earnest. They may begin to dump anyway, see:
    We don’t have a positive savings rate and the MAJORITY of our people are debt slaves as it stands now. If the government owns the lion share of assets (they already own a good portion eg. Fran & Fred) the people have no incentive to produce.
    We still live in a quasi-democratic country, are you suggesting that we should just flat-out go Communist?

  92. Anonymous

    I don’t get it.
    How could FED keep printing. I think Michael’s points are quite valid.
    US is part of the world and this dynamic system is not something that FED could do anything it wants and hope to get desired results.

  93. Anonymous

    by the way, yeah maybe Ben is smarter but I don’t think anyone in this world has really understand how the dynamic works.
    What if China start dumping its treasury holding as it anticipate high inflation (or potential default)
    What if US$ loss its position in FX?

  94. Fullcarry

    Prof. Hamilton,
    I am pretty much on your side. I am truly confused by some of the commentators on your post. An indebted country can’t afford deflation and doesn’t have to because most of its debt is denominated in a currency it controls. This is not Iceland.
    But nevertheless there is a subtlety that many of us that theoretically agree with you feel like you are missing.
    The real world isn’t linear. There are singularities that could overwhelm you.
    In a Fisherian way I would say that monetary velocity isn’t stable. If confidence goes monetary velocity can explode. Or as Austrians would say demand for dollars can collapse once the end game becomes obvious.
    No doubt the US has no choice but to keep inflating. I have no doubt that the FED can do that as you suggest. I have argued the same myself many times. But…. and there is a but. Money demand isn’t necessarily stable. It is conceivable that at some incremental level the camel’s back breaks and the Dollar loses most of its hegemonic bid. What then?

  95. Fullcarry

    I fear that accelerating inflation is baked in no matter what the FED does.
    I would go a step further from the Prof and say that even with FED inaction dollar inflation is destined to accelerate. Once the delveraging process runs its course there will be no natural bid for the dollar.

  96. Jim Kapsalis

    It is good to read your lucid comments on the general view that the Federal Reserve can, should, and will prevent deflation of general prices.
    But as you hint, and history confirms, asset price deflation may be a little harder to avoid.
    Do you see the transfer of risk from the private sector to the Federal Reserve balance sheet as the main viable policy option to tackle asset price deflation? If yes, how much do you think the Federal Reserve can absorb, before sovereign risk and real interest rates go up?

  97. JDH

    Jim Kapsalis: In general, I’m not sure it’s feasible or desirable to try to increase the relative price of housing at the moment.

    I think the Fed can and should use asset prices as one signal of where the economy stands at any given time. For example, the booming real estate prices should have been one indicator to the Fed that they had overdone the stimulus in 2004-2005. Falling stock prices can be an early warning sign that real activity may be about to contract.

    It’s fully appropriate for the Fed to use asset prices as a signal that either confirms or refutes some ideas they’re forming as to what’s going on. But I am skeptical about defining the prices themselves as a target for policy.

  98. DickF

    Thanks you for your response. I did read you correctly.
    Many here do not seem to understand that deflation and inflation are both bad for the economy. One of the most serious problems we have today is that with a floating currency we can have both the effects of inflation and deflation manifest at the same time. Our producers face huge problems and as those in business know massive amounts of human capital are expended just of trying to find out how destructive monetary policy will be and how they can hedge against it.

  99. DickF

    Greg Mankiw, like most, has bought into the myths created by government historians concerning the Great Depression. He writes, Next came a series of bank panics. From 1930 to 1933, more than 9,000 banks were shuttered, imposing losses on depositors and shareholders of about $2.5 billion. As a share of the economy, that would be the equivalent of $340 billion today.
    While his numbers are correct the implication is wrong. The 1920s, with such things as the Florida land bubble and the explosion in auto production, actually created a glut of small micro-banks that should have failed. But even more, of the 9,000 banks that failed, over 40%, 3,853, failed in the first six months of 1933 and the reason they failed was government bungling.
    Congress had been attacking the banks as causing the economic problems from the beginning of the economic decline. For example Senator Carter Glass waged a vendetta against Charles Mitchell of the National City Bank for 3 years, because in 1929 Mitchell stated that his bank had an obligation greater than the Federal Reserve to avert a crisis in the money markets. The Democrats took over the Senate and in 1932 Sen. Glass exercised his power to destroy. The National City Bank was perfectly sound but Glass brought Mitchell before the Senate committee investigating the economic decline, and over a period of three days so destroyed the reputation of Mitchell that he was forced to resign, all because Mitchell had the nerve to question a government institution.
    The Reconstruction Finance Corporation was making loans to distressed banks to keep them operating. On August 22, 1932 the Democrat House forced the RFC to release the names of any new loans they made. All but the most troubled banks stopped coming to the RFC. Then on January 6, 1933 the names of ALL distressed banks that had received loans from the RFC were released to the public creating a hit list for bank runs. (Does Chuck Schumer and Indymac ring a bell?)
    This was followed by the worst blow of all, state bank holidays. The beginning was in Detroit. The auto boom in the 1920 created huge demand for real estate and the banks in Detroit over-extended credit. The excessive real estate loans reduced their liquidity and depleted their available funds and the banks found themselves in trouble. On February 14, 1933 the governor of Michigan reacted by declaring a bank holiday, all banks in Michigan were closed and were only allowed to issue 5% of deposits to a depositor. The situation in Michigan quickly spread to adjoining states out of fear of the same thing happening in their states. Because of this, between February 14 and March 4, 46 of the 48 states declared similar bank holidays. The result was that in that 14 day period there was a total bank panic. Depositors withdrew the maximum so that banks with only 7% reserves saw over 5%, over 70% of those reserves disappear within a few days. Not only did depositors withdraw the maximum they no longer deposited money into the banks where it would be out of their reach. The runs and reduction in deposits, totally caused by the actions of state governments, resulted in massive bank failures, even banks that were actually sound before the crisis.
    In the Panic of 1907 there was a similar situation, but here the heads of the banks who knew banking, not government bureaucrats, handled the situation. They totally closed the banks to the issuance of cash, but they allowed checks to be written on accounts to pay bills. The banks remained 100% functional and the liquidity crisis was averted.
    We have a similar situation with banks in our current crisis. The whole nation saw Fannie Mae and Freddie Mac nationalized and stockholders lose everything. The Congress passed the massive bailout, totalling over $1 trillion, saying that they would in essence nationalize, to some extent, private banks. The day following the bank bailout vote banking stocks fell 25% to 35% as panicked stockholders scrambled to divest themselves before the lost everything.
    The run on the banks in 1933 was due to massive stupidity by governments as was the market crash of 2008, but you will not see this analysis by major economists or news outlets. They all know that they could be treated as Charles Mitchell was treated; therefore, they run in fear of a government that can and will destroy their lives if it so desires. This leads economists to create and invent reasons that allow government officials to feign innocence. Those who distort history are also destined to repeat it.

  100. groucho

    “Those who distort history are also destined to repeat it.”
    Amen, brother!
    The irony of the current crisis…..Bernanke one of the key architects of the “making sure deflation doesn’t happen here” policies which then blew up the system and now a repeat of the same policies endorsed by JDH!
    And, Hanky Panky one of the key architects of the sub-prime mortgage fiasco running the bailout show.
    You gotta love this crazy world…….

  101. myself

    I can’t believe this utter Keynesian nonsense. What is the difference between Hamilton and a lunatic? Nonethey are one and the same (P.S.: If money creation were a panacea to all economic problems, Argentina, Zimbabwe and Weimarian Germany would have been success stories, wouldn’t you agree, you theoretical morons?)

  102. Michael Krause

    I’m going to divert from monetary policy and more towards fiscal … but the big picture is just as important. Monetary policy does not function in a vacuum.
    Expansionary monetary policy comes with great responsibility, often one that is not sustainably executed over long periods of time. The benefit of all of this are investment/research booms that would not otherwise happen, and actually progress society. (ie the Internet bubble – despite being a bubble, actually contributed plenty to all of our lives. Biotech, etc the same) Without capital available for investment (not so easily available in a gold standard system), its much harder for this sort of thing to happen.
    We clearly need to get a handle on our ‘unproductive’ exports of dollars (excessive defense and oil spending), excessive entitlements, and divert the remaining capital we have left to investment that actually gives back. Free trade is growth encouraging and benefits optimization of competitive advantage, but the foreign accumulation of reserves that does not circulate back to us is not sustainable nor politically desirable. I believe that plenty of what we ‘invest’ abroad in the form of defense spending does not come back and stimulate our economy. Same goes for oil consumption, etc. The beauty of all of this is that we still have time to get a handle on it.
    ie, if you spend $100M to build some weapons, you’ve payed the contractors (which will then recirculate it into the economy), but you’ve accumulated something that facilitates destruction, pilfering of resources, and once exploded, don’t exactly perform as an ‘investment’. They don’t produce a yield after this point.
    The only way forward is massive infrastructure investment along with aggressive non-oil based energy investment, and destruction of absolutely non-essential military spending (Iraq, Afghanistan, anything a ‘war on terror’) and a move towards means based (and even CDC age-expectation indexed) entitlement distribution. Plenty of social security and medicare entitleees can privately afford their own survival. Imagine the ‘tax cut’ benefit of $10/barrel oil (due to decreased demand due to alternatives filling the supply gap) and the upside potential for higher disposable income, increasing flexibility to pay off unmanageable debts going forward.

  103. Anonymous

    I read that the Swedes had a smaller but similar situation in the early 90s and successfully (but painfully) bit the bullet and got out of it. Japan had an even closer but localized situation and just sort of muddled through. The US appears to be using crisis techniques more to the Japanese model. In the comments I see no notes on how some other country successfully maneuvered itw way out of a deflationary period. It appears we are in a temporty lull until the next incident happens that once again triggers the panic that is everywhere just below the surface. when you say they are trying to avoid deflation, you mean they are trying to stabilize prices. Keeping them from dropping. Even if prices are stabilized, the main problem of the US is that with the manufacturing base moved to China and the US consumer tapped out. how are US consumers supposed to buy the surplus production coming from Asia. I get calls from the Philipines now instead of US telemarketers. Computing software jobs are being moved to India. We can already see how Paulson is going o run the bailouts. Warren Buffett made a deal with Goldman Sachs. The US treasury made a deal afterwards basically getting a deal worth 50% less than Buffett. A gift billions to GS from the Federal Treasury. And these are the guys who are going to finesse money creation to avoid unhealthy inflation in order to stop deflation.

  104. James Morley

    I agree with the premise that the Fed can and should prevent deflation. However, I worry about whether they actually will. Specifically, I think there is a “political economy” aspect to monetary policy, which has only been implicit in most of the discussion here, but that could put a constraint on Ben Bernanke’s ability to run the printing presses when needed.

    The political economy story has to do with the fact that large unanticipated changes in inflation/deflation produce large redistributional effects between borrowers and lenders. For example, if everyone expects deflation, but the Fed greatly expands the money supply, as proposed here, borrowers will be “bailed out” at the expense of lenders. And even with a Democratic supermajority, I’m not sure the “lenders” constituency will be completely ignored in the political realm. For example, I’m pretty sure the lending classes usually have a higher voter turnout rate and donate more to political campaigns than the borrowing classes (this is just a speculation on my part based on some demographic assumptions about the two groups). Also, the proposed mechanism of reflating the economy by buying private assets may not be politically acceptable to the borrowing classes, even if the resulting reflation is ultimately in their interests.

    At the very least, I think this political economy story can partly explain the reluctance of the Bank of Japan to address deflation in the 1990s. Even a temporary inflation of 5-10% would have had a big impact on the real-values of the “post-office” savings accounts of pensioners and I wonder if that would have been politically acceptable. Instead of creating big redistributional effects, the path of least resistance for a central banker is to do nothing and hope some other event comes along to help reflate the economy (e.g., WWII after the Great Depression), thus absolving the central banker of any direct responsibility for the inevitable redistribution from lenders to borrowers.

    Of course, the analogy between the US now and Japan in the 1990s is imperfect. Presumably, the lending classes in the US can and mostly do have better diversified portfolios than Japanese pensioners, with most portfolios including some hedges against unanticipated inflation. Also, I don’t think the Democrats or Ben Bernanke are particularly beholden to the lending classes compared to past governments and central bankers, given that many lenders can’t actually vote due to the fact that they are foreign central banks, sovereign wealth funds, and individuals from the rest of the world.

    However, the point is that once deflation expectations become entrenched, reversing them will inevitably produce some big winners and losers. And, while I’m sure Ben Bernanke *can* reverse deflationary expectations, I’m not sure he can prevent the deflationary expectations taking hold in the first place. That involves a psychological game of chicken with the general public over his willingness (and ability) to reflate, about which, if some of the posts above are any indication, there may be some skepticism amongst the general public.

    Also, on the “hedging against inflation” issue, I presume that the recent dismal stock market performance reflects some members of the lending classes “cashing out” of financial markets in a modern version of stuffing money in mattresses. A large surprise inflation will knock the real value of their wealth down to even lower levels. So I don’t know how well-hedged the lending classes actually are for a hypothetical return of 5% inflation or higher. At the very least, there will be some big losers from the reflation and they may some of the most politically sympathetic members of the lending classes (e.g., pensioners).

    Finally, while I believe that Bernanke has the will and knowledge to prevent deflation, I note that his term expires in Jan. 2010. He may be replaced by someone who is more prone to repeat the mistakes of the past, rather than make new mistakes. While 2010 might sound like a long way off, I suspect that we will still be discussing the very real possibility of deflation at that point. I.e., it will take some time for core inflation to fall towards zero, which I think is close to a necessary (but not sufficient) condition for the Fed to start buying all those private assets in a non-sterilized way.

    I realize that a reversal of deflationary expectations would inevitably happen at some point in the future, so the redistributional costs associated with it will have to be born by someone and they are likely to be larger the more entrenched the deflationary expectations become. So, from a normative point of view, I fully agree with the idea that sooner is better than later for reflation. And of course the Fed should anticipate the fall in inflation and act before it happens, thus minimizing redistributional effects. However, I just don’t see it is a 100% given that the Fed will do what is necessary *in time* to prevent deflation and the political economy of monetary policy is a major reason for my doubts. I’m pretty sure that liquidity traps aren’t mechanical constraints on the effectiveness of monetary policy, but they do occur and they reflect strong political constraints on monetary policy when there is deflation. Perhaps Ben Bernanke can act in the way proposed here to prevent deflation, but if he doesn’t move quickly and deflation takes hold in a year or two, the liquidity trap scenario of the Great Depression and Japan in the 1990s may return, not for mechanical reasons, but for political reasons. This is just a theory though and I may be giving too much weight to the “political economy” issue, given that it is far from my area of expertise. Hopefully, academic knowledge about what to do is a sufficient, not just necessary, condition for preventing deflation and liquidity traps. And hopefully we don’t have to wait a decade or longer for some cataclysmic event to pull us out of a deflationary state. But, despite my hopes that Ben Bernanke might pull this off, I don’t think there is anything inevitable about the fact that he will.

  105. Jan

    Would one of you regular churchgoers please explain once more why inflation is an absolute sin.
    In these times, one virtue of inflation is financial order. Transfer of wealth from the world’s lenders to its borrowers would cause less savings, more consumption, and hence, fewer bubbles and bursts.
    A second virtue is intergenerational justice. By paying miserly taxes and receiving bountiful public goods for the past twenty-five years, today’s American lenders were consuming what their grandchildren will produce. Inflation would force them to pay back a little of what they owe.

  106. gepay

    Doug Noland’s Credit Bubble Bulletin – “Federal Reserve Credit expanded another $63.2bn to a record $1,803bn”
    but that this latest whopping glop of credit from the Fed has reached “a historic 6-wk increase of $915bn.” Yow!
    The Mogambo Guru
    Almost a trillion dollars of new credit in 6 weeks! Gaaaahhhh! My hands now mysteriously clenched into Mogambo Fists Of Outrage (MFOO), I am forced to clutch a pencil between my teeth and try to laboriously calculate that if $1,803 billion in Federal Reserve credit is up $915 billion in 6 weeks, then the percentage change is, ummm, wait a minute, ummm, carry the one, ummmm, well, the percentage change is, ummm, well, who the hell cares what the damned stupid exact percentage is when you can just freaking LOOK at the problem to see that TFC has about doubled? Yow! A 100% gain! In 6 weeks!
    My brain is staggered! In 6 lousy weeks, all of the total credit in the banking system created by the Fed since 1913 was almost instantly (poof!) doubled! Gaaaahhhh! We’re freaking doomed!
    And don’t get me started on foreclosures, falling earnings, falling employment, insane levels of money and credit creation, or the horrors of inflation
    Credit card companies are saying that Americans are now using their credit cards to eat at McDonalds – “the second largest “merchant-vendor” for credit card use is now McDonalds.”
    . The Treasury needs to sell debt to raise money for the new initiatives and also cope with a weaker economy, two factors analysts say may push the countrys budget deficit to more than $1 trillion for the current fiscal year.
    This has to have affects on the creditworthiness of the dollar.
    More deflation in housing prices is coming and needed just to get housing prices in line with what most people are getting paid.
    The US and global financial system is hopelessly broken and out of order. while in the US, the money that couldn’t be paid back was lent to homeowners in Europe it appears it was also lent to Eastern Europe (Latin America in Spain) who will be unable to pay it back. Money lent that is not paid back goes to oney heaven and eventually has to be written off. The world has also lent to the US who will be unable to pay it back except in increasingly worthless dollars. There will be global deflation but dollar inflation especially if oil can be bought and sold in currencies other than dollars. Iran recently made a barter deal oil for Thai rice.
    It is a kind of truism the our current problems usually stem from our efforts to solve our previous problem.
    I just don’t think that Helicopter Ben and bankster Hank are going to be able to put HUmpty dumpty back together again without creating an even bigger mess.

  107. Arturo

    Be careful what you advocate… what’s an economist’s inflation theory (monetary equivalent of perpetual motion) worth in trade for food in the barter economy that results from the US printing the dollar into worthlessness as an antidote to deflation? From hyper-inflation, it’s not that far to food riots then to offing the farmers (kulaks) and collectivizing the land the Government had to “buy” … (which yoeman would voluntarily sell valuable land for worthless Government money?)

  108. Rumple Stiltskin

    I have a prediction.
    Apparently the recent surge in the value of the dollar has been a purely monetary phenomenon. Various parties in the US including financial institutions have had to sell up and bring their money back and this effect has overwhelmed the disinvestment effect from the rest of the world which has been repatriating what they had invested in the US. Once those parties in the US which have been forced to repatriate investments from the rest of the world have finish their forced repatriations the disinvestment by the rest of the world in the US will dominate.
    The US currency will then collapse. This is the biggest risk at the moment.

  109. DickF

    Let me correct an unintended impression I left in my post above. Senator Carter Glass was just one of many Senators who was attacking the banking industry in the 1930. Senator Glass engaged in a feud with Mitchell and was involved in calling Mitchell as a witness but was not at the Mitchell hearings. The other Senators were totally capable of destroying Mitchell’s reputation. For the record Mitchell was never found guilty of any crime and the National City Bank weathered the Depression just fine with never a loss.

  110. MarkS

    JDH said: My position is simply that the Fed can, should, and will prevent deflation. Because the Fed controls the number of dollars it creates, it can control the purchasing power of a dollar. Specifically, there is a quantity of dollars that the Fed could create that is sufficiently large so as to prevent the purchasing value of a dollar from rising.

    The rub here is WHAT PRICES is the FED using to guage deflation, and at what time… Is it food? energy? real estate? derivatives? equities? 10 year average prices? June 2008 prices? PPI? CPI? PPP? … I’m getting vertigo from the permutations!

    Lets get real here… most people in the world have little or no access to banking credit. The run-up in commodity inflation from banking deregulation has caused political and economic instability to the G10, but most importantly, severe hardship on the world’s poor.

    I’m not hearing any discussion about what criteria the FED would use to assess deflation. Perhaps its instructive to note that the FED issued many statements during Greenspan’s tenure, that it was incapable of assessing or addressing capital market inflation. What makes it capable of assessing or controlling deflation?

    The FED and other central banks abdicated their responsibility to effectively control money and credit expansion from 1992 until 2008. The vacuum from deleveraging and asset destruction is simply too big for “the system” to control. The best that can be hoped for, is that institutions be maintained although their functionality will be severely impared.

  111. groucho

    “The best that can be hoped for, is that institutions be maintained although their functionality will be severely impared.”
    “best” or “worse”? Bailing out the banksters after all the destruction they have created? How about “creative destruction” and outing the scribblers that wrote the playbook that was put into action and created the mess that we are ALL in?
    Citizens/consumers are re-balancing their own balance sheet through the default process. This should be encouraged with cash outlays for those who have lost their credit subsidy 🙂

  112. K. Durham

    I’m not an economist but here’s my two cents on how to solve our economic woes.
    If the Fed directly refinanced 30-yr fixed mortgages at 2% – 3$ APR, homeowners headed into foreclosure might be saved. They would save hundreds of dollars on their monthly payments. Homeowners who refinanced at this rate but were not going into foreclosure would have extra disposable income.
    That’s how we essentailly give Americans a monthly “raise”.
    Now, job stability and creation…
    The Fed loans funds to small businesses at the same rates. Their costs of doing business goes down. Less layoffs and possibly more small business startups occur.
    The Fed prints a ton of money. Hey, at least the taxpayers get something out of it and it stimulates the economy. It is better than financing all the golden parachutes and irresponsible decisions of big business.

  113. gepay

    I repeat a quotation
    “Sometimes I wonder whether the world is being run by smart people who are putting us on or by imbeciles who really mean it.” – Mark Twain
    “A particularly important protective factor in the current environment is the strength of our financial system.” Ben Bernanke Nov 2002
    later in this speech on deflation he says, “the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending–namely, recession, rising unemployment, and financial stress.
    However, a deflationary recession may differ in one respect from “normal” recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero.
    If he had said this as a prediction for sometime in the next 10 years, it would have been a pretty good prediction
    I don’t know about you but this sounds like today
    “massive financial problems, including defaults, bankruptcies, and bank failures, were endemic in America’s worst encounter with deflation, in the years 1930-33”
    “…some observers have concluded that when the central bank’s policy rate falls to zero–its practical minimum–monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.
    “…Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
    he further talks of buying assets but in the end, “If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.”
    do any of yu out there have an historical example of this so we can judge any side effects? I can’t think of any.
    Here is what Bernanke says about Japan and deflation:
    “First, as you know, Japan’s economy faces some significant barriers to growth besides deflation, including massive financial problems in the banking and corporate sectors and a large overhang of government debt. Plausibly, private-sector financial problems have muted the effects of the monetary policies that have been tried in Japan, even as the heavy overhang of government debt has made Japanese policymakers more reluctant to use aggressive fiscal policies (for evidence see, for example, Posen, 1998). Fortunately, the U.S. economy does not share these problems, at least not to anything like the same degree, suggesting that anti-deflationary monetary and fiscal policies would be more potent here than they have been in Japan.”
    I thought he was describing the present US condition pretty well except the US has a hollowed out manufacturing base and a citizenry deep in debt instead of savings like Japan.
    Here I put Bernanke into the idiots that really believe
    “Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy’s underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures.”
    so we have the clever bankster Paulson putting us on while he funnels hundreds of billions to his Wall Street cohorts and a true believer idiot piloting us out of the present mess.
    Obama’s main financial advisor, Rubin, is another denizen from Goldman Sachs. So there isn’t much hope.
    “What happens when you replace a sociopathic lunatic with an eloquent, sane man who espouses the exact same policies?”

  114. Rumple Stiltskin

    If your rhetoric is convoluted, clever and eloquent enough you can convince, even yourself, that night is day. Japan is far away and the 1930s are also far away (in time) so you can believe anything about what their problems were. For the rest of us living in this time and place some explanations are just not credible.

  115. DDK

    Professor James Morley,
    You raised a very interesting point about the political economy. It’s instructive to compare the political economy between Japan and US.
    In the case of Japan, the majority of Japanese are savers. High inflation would be extremely unpopular. The Japanese government did run up a large amount of debt. But it’s funded by domestic saving, which earned near zero interest. Deflation is bad, but really not as disastrous as the depression of the 30s.
    In the case of US, most American consumers are deep in debt. The same is true for US government. Many American companies are highly leveraged. A deflation would truly be disastrous. On the other hand, inflation would ease the debt burden, and the losers will be the foreign central banks and foreign private investors.
    By such an analysis on political economy, one would argue that inflation is the logical way out of this mess.
    Would you agree?

  116. gepay

    If deflation is stoppable, then Bernanke is probably a good one to stop it. Can he do it without disastrous inflation or wrecking the dollar is the question There is a global recession which is deflationary. There is the deleveraging of the derivitives turned into Ponzi scheme which is deflationary. There is the global lack of trust of American finanacial institutions as the fallout from the subprime debacle. I still have not found a good source for saying what was the final outcome of the Lehman bonds credit default swaps. The bonds were said to be in the amounts of $360-440 billion = others said they were $160 billion and the CDS were 440 billion whatever the number the auctions said they were on worth less then 10 cents on the dollar so
    someone(s) lost from S140 to close to 400 billion. Where can I find how much the CDS issuers actually paid out or conversely how much the bond holders actually were repaid?

  117. don

    Many have commented on the possibility of the dollar “collapsing.” But against what? The dollar is still overvalued relative to the euro (though not by much). Large drops against the yen and yuan would be truly disastrous for Japan and China. The U.S. economy, in constrast, would get a good boost. Europe would be in sad shape trying by itself to make up deficient global demand.
    As noted in this post in the past, the current fed policies are not money expanding – they are changes in the composition, not the amount, of fed assets.

  118. James Morley

    DDK writes:
    “By such an analysis on political economy, one would argue that inflation is the logical way out of this mess.
    Would you agree?”

    I would agree that inflating away debt is more politically feasible for the US than it was for Japan. However, I don’t agree that it is the logical way to proceed with monetary policy. Monetary policy should stay out of the business of redistribution as much as possible by doing whatever it can to maintain a predictable, low inflation environment. Making decisions about redistribution is the role of elected officials conducting fiscal policy. Indeed, avoiding direct redistribution is one reason why the Fed should stick to buying government debt, rather than private assets, when expanding money supply.

    If the US finds itself in a deflationary situation in a year or two, I think the best option would be to follow the prescriptions Professor Hamilton suggests (starting with paying down national debt), but making it completely clear to the public that the “program” of monetary expansion is completely contingent on their expectations of measured inflation remaining below, say, 2%. The Fed would need to make it clear that they would stop the debt purchase program the instant that a publicly reported measure of inflation expectations exceeded a publicly-stated comfort zone. Basically, I’m proposing an inflation target rule like the Bank of England has, rather than a specific Taylor rule that focuses on the overnight rate as the only policy instrument. Focusing on a given instrument is useful in normal times to make policy transparent, but I think buying government debt with printed money would be a very transparent way to temporarily conduct monetary policy with the aim to achieve a target inflation rate of 2%.

    The point is that I agree with Professor Hamilton that the Fed can and should buy government debt to achieve a positive measured rate of inflation. My only point about political economy was that doing so will create winners and losers, especially if the debt purchase program is only put in place after deflationary expectations become entrenched. And the losers may not be as politically unsympathetic as initial impressions suggest (think of pensioners rather than Wall Street CEOs). Meanwhile, if the plan to buy government debt takes place in a deflationary environment, I think it would need to be done with the approval of the Treasury and the political process more generally, given that redistribution should be the purview of fiscal policy, not monetary policy. Maybe Ben Bernanke can shift the policy target pre-emptively, which would be the best approach to minimizing the redistributional effects of the debt purchase program. But I think there are serious political constraints that would prevent a quick move by the Fed to do this. Once the Fed Funds rate hits zero, we’re going to hear a lot of political discussions about what the Fed can and should do. And my guess is that Ben Bernanke will have to listen closely to those discussions.

  119. golflouis

    Interesting post,…,the power of the interest rate instrument in a economic crisis environment remains rather elusive,moreover when it is a credit crisis environment like now; the banks may very well sit on their new credits afraid to create more dubious debt in their asset base,since most customers balance sheet is already loaded.
    The Feds remain privately owned entities,and printing new notes means diluting their capital,hence giving back money to the people,it seems to me that would be the very last resort they would use if ever.The only fix will come from a change in the mutual “fear factor” amongst the players in mainstream economy; this psychological glut is hampering the free financial flow necessary to produce any balanced inflationary pressure,essential to any growth.
    The political officers will have to use subtile but resolute conviction, supported by firmer guide lines,to produce any change in the credit players psyche.

  120. golflouis

    In conclusion, the economy may deflate for a while, until the political elite, driven by inspiration and example would create a new fiat and “toxic free” economical environment.

  121. DDK

    Professor Morley,
    But, monetary policy is probably no long relevant. Alan Greenspan has admitted as much that he and the FED had no clue about this crisis. It was sad to look at Bernanke helplessly sitting besides Paulson during Congressional hearings for the 700 billion dollar rescue package. The FED has lost its authority and prestige. Its standard tool, interest rate setting, is used up. The 700 billion dollar package is managed by the Treasury, not by the FED. And, its hard to imagine such a battered FED could still stand up against political pressure from Congress or the next administration.
    Also, what we are seeing is exactly a wealth redistribution process. The mess is not due to some natural or man-made disasters producing physical damages. It is due to misallocation of capitals, and to fix it, wealth redistribution has already started, from tax payers to financial institutions.
    Regarding deflation, Professor Hamilton argued convincingly that the FED can prevent it, should prevent it, and will prevent it. Others asked: why did the Japanese get trapped in it? You provided an insightful explanation: its not that the Japanese cant reflate; its that they didnt want to do it, due to political economy.
    As someone mentioned, a few years down the road, we would probably admire the Japanese for managing their deflation so well. Yes, their economic growth was anemic for more than ten years. Their stock market was pathetic. But their deflation was not a disaster with high unemployment and the collapse of their financial system. The Japanese got lousy return on their saving accounts, to fund the rescue efforts, but in a deflation environment, that was not really so bad. Their living standard probably improved due to falling prices. For an average Japanese guy with a job, it may even feel better than worrying about inflation eating up his savings.
    Can anyone imagine what a deflation would be like in America? The prospect of deflation got Greenspan and Bernanke so worried in 2000, when only the tech bubble went bust (but the federal budget was still in surplus). How could the FED let it happen now, after all the home equity withdrawals, an unpopular war without proper funding, and a big deficit in the federal budget? It just cant happen, due to the political economy.
    But, US is not Japan. US does not have access to a pool of domestic savings. US reflation must be funded by either foreigners buying up treasury or by printing money. Once FED starts printing, foreigners will rush to exit treasuries and there will be another round of global financial crisis. But fortunately, Japanese, Chinese, and other Asians are the big holders of treasuries. So, as far as political economy is concerned, its still better than deflation. This process will be about fiscal and foreign policies. And again, the FED is irrelevant.
    Now, I am not an economist by training. So maybe there is a third, fourth scenario. Id appreciate it if Professor Morley and Professor Hamilton could provide their insights on a better scenario.

  122. KnotRP

    The implicit question: Would the “printing cure” restore the economic patient to full health? Critical, but stable? Gun shots can cure cancer too, if we want to reduce the inflation proposal to ridiculousness, but the real question remains unaddressed — did the cure result in a positive net outcome?
    Let us FURTHER grant, for the moment, that one can switch from “big debts, sound currency” to “big debts, dubious curreny” in some sort of linear and controllable (stoppable?) manner that somehow arrives at “smaller debts, workable currency”.
    Global wage arbitrage is keeping a lid on US wages.
    Indian engineers can still be purchased at a 4:1 ratio to US domiciled engineers (whether US citizens, or immigrants…important to point out it’s not about worker nationality, but rather employment overhead in speciific economic regions).
    Let’s say we print, and eventually put a nominal floor in asset prices. The wage:home-price ratio remains unfixed, despite holding home prices high.
    The above 4:1 ratio means we are a long long way from a wage increase, printing or not….now what?

  123. KnotRP

    It seems the argument is that assets will stop dropping, if the currency is devalued “enough”.
    I would argue that US asset prices cannot stop dropping until global wage pressures equalize, thus putting a floor in the consumers ability to retire debt, rather than speculate & default in cycles.

  124. groucho

    “Once FED starts printing, foreigners will rush to exit treasuries and there will be another round of global financial crisis”
    That’s the FEAR that keeps FED/Treasury in check.
    Look how Hanky Panky guaranteed GSE debt when it appeared they might default.
    To a foreigner with a claim against the US any perceived excessive dilution will cause them to throw in the towel and head for the exits.
    For the record “printing” by the FED does NOT remove the debt from the US books. While ridding the debt of interest payments it still counts as debt and HAS to be taken into account for sovereign credit rating(think japan…now think japan without domestic savings…..VERY, VERY scary)
    The US is very limited in it’s printing potential……..unless your goal is to completely destroy the current international exchange architecture

  125. Marty

    Something qualitatively new seems to have happened with the cash money supply in the US in the month before the election. Here is a link that makes a graph of the BASE money supply (notes and coins only, held outside of the central bank and outside government, similar to M1) from the St. Louis Fed. For comparison, here is the same graph plotted along with “depository bank borrowing from the Fed” (BORROW) and “free and borrowed bank reserves of depository institutions” (FORBRES), showing that this huge spurt in cash occurred after the onset of huge bank borrowing and negative reserves (a fine concept…).

    Could people have actually withdrawn 0.31 trillion dollars in real cash (i.e., 16 billion $20 dollar bills) in a few weeks? Note that the only other blips that visibly rise above the normal monthly increase of .000003 trillion are Y2K and 9-11 (see graph in first link). Or could this 1.36x jump in cash include some of the first examples of true ‘helicopter’ money?

    Finally, is there similar data available online for the UK and EU?

  126. Dirk

    “In a general deflation, the purchasing power of a dollar bill goes higher and higher … But it is absolutely a problem that the Federal Reserve can fix. If you increase the quantity of dollar bills fast enough, you’re sure to create inflation, not deflation. And the Federal Reserve has unlimited power to increase the quantity of dollar bills.”

    I think at this point one should return to the General Theory and ask: “Why exactly do we need inflation?” The answer is that we need it so that entrepreneurs see the marginal efficiency of capital rising. The return to capital is higher when there is inflation. The entrepreneurs buy inputs first, and sell for an inflated price later. Profits have increased. This is why inflation is needed.

    Letting helicopters drop dollar bills (or having the government buy up all debt) will not cure this problem. Money is a way of social accounting. If you throw dollar bills at people randomly, the dollar will not be currency anymore. You have inflation, but a monopoly money that nobody will accept. Instead, we go back to barter (or use euros). Buying up all debt is also without consequences, since at a zero interest rate money and bonds are perfect substitutes. The household does not care whether she holds savings in money or bonds. Since money is more liquid, it is probably preferred.

    The solution of Keynes to change the expectations of entrepreneurs in a situation where the nominal interest rate is zero but entrepreneurs are still pessimistic, is expanding aggregated demand by government spending. Since the interest rate is zero, the government can load up with debt almost for free (at very low interest rates). Spending the money for infrastructure, education, digging holes, etc. will increase demand, so entrepreneurs start producing again.

    All this, according to the General Theory, should only be done in case of emergency (interest rate at zero), only when capitalism is about to fail. That is the perhaps main difference of what Keynes said and how Keynesians later interpreted the General Theory. (Among others, Paul Samuelson thought that keeping investment up would erase business cycles.)

  127. pl

    There are a lot of Mensans here, so i won’t even try to out-IQ the professor and the commenters, but a little common sense is called for.
    You can always use equations and data to fit your goal, but that’s counter productive if you don’t pass the smell test.
    The word here is “credit”, if you print money like a child, you’ll be treated as one. You will have no credit. The Chinese will dump their treasuries (which would be worth significantly less by the time you go to print).
    U.S. and the businesses within, in a sustainable economic environment, need the ability to roll debt forward. Or simply, ppl need financing (be it debt or equity). Credit, expectation, sentiment are a number of human factors that CAPM, Black Scholes can’t yet capture. That’s what you’re losing.
    I am quite sure you can prevent deflation by the method you put forth, but i am also quite sure by the time your policy is enacted, we will have NO capital market to tap (you won’t be able to tap surplus nations like countries in the Middle East & Asia). Our ability to overspend were entirely financed by the vendor/surplus countries. If vendor financing dissapears, that’s bad for the real economy. Think of buying a piece of heavy equipment (car) without a loan. It’s doable, just terrible, and you’re uncompetitive as a result.
    Unfortunately, that is exactly where we’re headed, to inflate our way out of this, just as one previous commenter said, no country has been able to pay back debt after some point.
    let’s hope we don’t go to your extreme yet and lose credibility once and for all. If you think behaving like ZWD is the solution, well, try to get a mortgage in Harare.

  128. MurrayR

    This money comes from a monetary “system” that is not really a system at all; it is a work of performace art — an improvisation of a monetary system. The system utilizes an artful combination of promises, accumulated goodwill, foreign borrowings and government IOUs to validate trillions of dollars worth of a paper currency that America prints for itself. As long as this improvisation delights the dollar-holders of the world, all is well. But at some point, they might tire of the performance, and a serious economic issue ensues.

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