Inflation-Deflation: Macroeconomist Smackdown

Last Updated May 11, 2009 6:46 PM EDT

Of all the different vital signs for the U.S. economy, the measure that's drawn the most attention has been the rising unemployment rate. Inflation hasn't been as newsy, because prices have been pretty tame. But the long-term picture for prices is still unclear, and there's a hot debate among economists about where prices are headed -- toward damaging inflation, or possibly worse, gradual deflation economy-wide.

If GDP growth is the heart rate of the U.S. economy, then the rate of inflation would be something closely related -- its blood pressure, perhaps. When the economy is booming, people and businesses compete for things by bidding prices higher, and when it's slow, there is less pressure on prices.

Where we are today, of course, is the low-pressure case. The most recent reading on big-picture inflation showed an overall decrease in prices of 0.1 percent for the month of March, and a decrease of 0.4 percent from a year ago, the first year-over-year price drop since 1955. (The decrease was the result of a big drop in the price of oil and gasoline, and food, but even after taking those out of the calculation, inflation was mild at 0.2 percent for March, the same reading as in January and February.)

Wages are pretty weak too: U.S. employment costs rose by just 0.2 percent in first quarter 2009, and just two percent year over year, the smallest such increase since they started measuring this particular statistic in 1982.

The combination of a deleveraging economy, citizens suddenly cutting back their spending and saving a lot, and flattish wages prompted economist Paul Krugman to sound an alarm about deflation.

Widespread deflation is nasty stuff, as it drives an economic race to the bottom: workers compete to get hired at lower wages; businesses have to cut prices; and all sorts of business decisions are postponed, because you'll be able to get whatever you're interested in at a lower price in a few months. Meanwhile, people and businesses that owe money have to pay it off with declining incomes.

Americans went through deflation from 1920 through 1922, and again in 1929 through 1933, when prices fell by 27 percent. Imagine having to pay off a mortgage and a couple of credit cards with on three-quarters of your current income, and then project that out to the entire economy.


Krugman's bottom line is that the low inflation is a signal that the US economy needs more stimulus, in a hurry.

Diametrically opposed to Krugman's op-ed, in a sort of Macro Smackdown, was a separate editorial the same day from Allan Meltzer, a noted historian of Federal Reserve policy. Meltzer fears for a return of the punishing inflation of the 1970s, which came about through repeated and excessive stimulus to the U.S. economy, and a lack of discipline at the Fed in terms of administering strong medicine -- i.e., higher interest rates -- when it was needed.

It's too early to tell who is right or wrong, although the debate is pretty entertaining, with Krugman correcting Meltzer's interpretation of the recent history in Japan, and lots of snarky reader comments.

But this is a very important issue -- with near term implications on our incomes, and long run effects on the prices of our homes and retirement savings. I don't believe deflation is a likely outcome: the enormous push coming from the financial bailouts and government spending is larger than any our economy has had to contend with before, and in my opinion inflation will have to result. What we can't know is how much. The question of the size of the stimulus is an interesting one, and a topic for a future post.
  • John Keefe

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