The Fed is still talking about the risk of inflation…while the risk of deflation rises daily. Deflation happens when liquidity dries up. Suddenly, money disappears. Lenders don’t lend. Spenders don’t spend. The velocity of money declines as everyone holds on to what he’s got…fearful of losing it.
When this happens even the feds can’t do much about it. They have their printing presses…but they have no good way of getting the money into the hands of people who will move it around. The usual way is through the credit markets. The Federal Reserve pushes down short-term interest rates, for example, enabling lenders to offer money at lower rates.
But when a deflationary mentality takes hold of people, the last thing they want to do is to borrow money. They’re afraid that they might not be able to pay it back. Besides, in deflation, consumer prices fall. So the money they pay back will be more valuable than the money they borrowed. Their effective, or real, interest rate will be much higher than the nominal rate they are paying.
As prices fall, consumers become even more reluctant to spend. They begin to see that they’ll get a better deal if they wait. They turn Japanese.
That is the nightmare that haunted Ben Bernanke when he took over at the Fed. It is what prompted him to announce that “the Fed has a technology…called a printing press…” with which it can print up dollars at almost zero cost…and if need be, the Fed can drop dollars from helicopters in order to get the money into circulation.
Of course, this was a fanciful description of monetary policy. Let the Fed scatter dollar bills from helicopters and the US dollar would fall faster than the currency in Zimbabwe, where inflation is said to be running at 100,000% per year. Some things just have to run their course – like hyperinflation, for example. Once it begins it continues until the currency is completely destroyed. Deflation, too. Once begun, it is hard to stop…for the cure is often worse than the disease.
The Japanese economy was strong when prices began to fall in 1989. First stocks fell. Then property. Then consumer prices. All prices came down. And each falling price strengthened deflation’s grip on the Nippon economy. People hoarded money. You practically had to hold a gun to the consumer’s head to get him to spend. And business investment? Takeovers? Leveraged buyouts? All came to a stop.
But Japan could afford deflation. People had savings – lots of savings. And the economy always enjoyed a trade surplus. Nor was there any large subprime lending problem.
Can America afford a liquidity crunch…a credit contraction…a deflation? We don’t know…but if we were Ben Bernanke, we might want to make sure the printing presses and helicopters were in good running order.