Deflation, Savings, and Where We Go Next

The Japanese media has recently been obsessed with defure, or deflation.  The September annualized rate of deflation for Japan was 2.24%, compared to September annualized deflation rates of 0.18% in the U.S. and 0.80% in China.  Canada, the U.K., Australia, and the European Union had very low rates of annualized inflation in September.  Why does the media panic about anomalous low-single-digit deflation while ignoring the well-documented effects of seventy-five years of chronic inflation?  The rationale for the panic is that deflation can lead to a liquidity crisis (government stimulus is rendered impotent) and/or a deflationary spiral (hyperdeflation); yet, blind to the lessons of history, inflation is considered a necessary evil, and the possibility of an inflationary spiral is underserved. 

First, an explanation of the relevant terms.  Originally, inflation meant an increase in the money supply, and deflation meant a decrease in the money supply.  However, modern understandings of the terms are more nuanced; now inflation and deflation are related more to purchasing power and price levels.  Because when there is more of something it becomes less valuable, inflation is now understood as a devaluation of currency.  Deflation is when a currency becomes more valuable.  Usually during economic booms, there is a robust rate of inflation as people move their collective wealth from cash-based resources into assets; there is more cash around, so people treat it with less respect and tend to spend frivolously.  During recessions, people tend to value security over potential profits, and attach more value to cash-in-hand; a dollar is worth more as a result.  Deflationary periods indicate increasing aversion to risk among the population, but not necessarily recession: in the late nineteenth century the U.S. experienced both persistent deflation in the absence of a central bank and high rates of economic growth.

Some regard the Great Depression as an example of a deflationary spiral, but the concept is largely confined to theory and controversial: there has never been an instance of hyperdeflation in recorded history.  From 1929 to 1933, prices in Great Britain fell 33%, but this was in linear - not hyperbolic - fashion.  On the other hand, there have been many documented instances of hyperinflation, especially in the twentieth century in countries with central banks and often associated with war and/or ethnic cleansing.  In the years during and immediately after World War II, Greece, Hungary, and China experienced rapid devaluation of their currencies.  In July 1946, prices doubled every fifteen hours in Hungary.  Other examples of devastating hyperinflation include that of the Weimar Reichsmark in 1923, leading to the rise of Hitler, Yugoslavian hyperinflation in 1994, and the 2008 hyperinflation in Zimbabwe.

There are actually many arguments in favor of a liberal, sometimes deflationary currency: one is that deflation makes necessities more affordable, thereby reducing poverty along with the length and severity of a particular recession.  Often, as in the Japanese case, an active central bank policy is the only thing preventing natural deflation.  Let us not forget that currencies deflate all the time - relative to other currencies.  Why are they not allowed to deflate relative to soy beans or new cars?  In Japan, after World War II, the exchange rate was fixed by the occupying authority at 370 yen to the dollar as a way to foster the development of a cheap Japanese manufacturing exports industry.  When Nixon ended the gold standard in 1971, thereby ending the era of fixed exchange rates, the yen took off, reaching a high of 80 per dollar in 1995 before the Japanese central bank began purchasing dollars en masse to save Toyota et al.  During this period of Japanese yen deflation against the U.S. dollar, Japan experienced one of the more rapid rates of economic growth in world history and developed a quintessential middle-class economy.  A similar devaluation recently occurred with the British Pound; at the same time London usurped New York as the world's principle banking center. 

The most obvious argument in favor of allowing small rates of deflation in a spirit of cautious optimism is that deflation is the currency market's attempt to correct for chronic undervaluation.  A culturally-appropriate Japanese metaphor for this would be building a dam against the flow of a very powerful river.  It had been the policy of the Japanese government for nearly fifteen years of stagnation to purposely devalue the yen to make Japanese exports more attractive to foreign consumers by buying U.S. dollars.  When Yukio Hatoyama's Democratic Party of Japan took power this past year, Japanese currency policy changed: the dollar dam fell into disrepair and the river's water began gradually leaking through.  As such, the Democratic Party of Japan seems to believe the maintenance of the dam - i.e. persistent purchase of U.S. dollars to artificially devalue the yen - is more costly than letting the dam be overrun by the force of the river and adjusting to the effects of a flooded valley.

It is often suggested that deflation encourages savings over investment or consumption.  This is because as the value of currency rises, or, as people notice the value of currency rising, they forego unnecessary purchases like new automobiles and that extra Christmas present, and instead save, that is, do not invest and do not consume.  This analysis makes sense logically at first glance, however, the impact of deflation largely depends on the decisions of hyper-rational, economically competent individuals relative to an awareness of persistent deflation.  If individuals were rational in an aggregate sense, they might hold on to their money, but most people are too excited about ten-dollar DVDs and supermarket sales to wait for prices to get even lower, nevermind notice low, single-digit deflation.  Plus, if there is 0.18% deflation now in the U.S., is that really enough to reverse 75 years of persistent inflation? Most people would notice little change in prices at the supermarket.  This kind of analysis is why economists are often the butt of academic jokes.

Were we to think about currency like any other commodity, getting into currency makes sense during periods of deflation.  Foregoing unnecessary expenses, making deposits to savings or CD accounts, being more wary about stock investments, and thinking twice before purchasing property are encouraged by a deflationary economy.  Those are terrible things, right?  Don't Americans need to be out buying Cabbage Patch Kids, self-help books, and unaffordable mortgages?  Aren't we supposed to solve the credit crisis with more spending? (On the contrary, economist Irving Fisher believed that deflationary spirals could occur when there was excess debt.)  Or does it make sense to weather the effects of the economic pendulum's swinging back to a rational equilibrium?       

For many years in the U.S., saving money has been the ultimate sucker's bet.  (In the past, saving was often the only recourse for low-income-earners, but for several years now, there have been companies like E*TRADE and Charles Schwab, whereby investing small amounts of money is possible.)  If you deposited 30,000 1964 dollars into a typical compound-interest-yielding bank account in 1964 (just under 3% compounded annually), you would have over 100,000 2008 dollars today; but in real terms, you would have actually lost over 100,000 2008 dollars to inflation.  If, on the other hand, you put your 30,000 1964 dollars into a piece of property on the outskirts of a major city or along the new interstate highway system in 1964, you would have profited by over 800,000 2008 dollars.  No wonder Americans don't save!  We're finally starting to get it.  Saving is totally illogical in a chronically inflationary economy.  The wealthy, more than anybody, know this, and put their money in assets, like real estate or businesses, immune to chronic currency inflation.  Like the lottery, inflation is essentially a stupid-tax, and, if you've had a large bank account not tagged to inflation all these years, the joke's on you. 

Nevertheless, all these years of inflation came back to bite us when too many people putting their money in assets resulted in an asset bubble that exploded dramatically over a year ago, because we had nothing to fall back on and instead had to refinance the macroeconomy.  It seems a significant savings parachute would be prudent to protect us from aggregate mistakes in the future.  Ironically, a deflationary economy renders central bank monetary policy impotent, which may suggest a conflict of interest. (However, the Federal Reserve and Congress hedged against this by spreading the stimulus through several years.)  Whether one believes in the efficacy of a central bank-led, top-down monetary policy or not, perhaps allowing the deflationary river to break through the dollar dam and adjusting to it is best for now.  Everything in moderation prevails: When the credit crisis hit over a year ago, Americans had a near zero saving rate.  Now, they are starting to save a little, and saving a little is good for the macroeconomy; we have something to use on a rainy day as well as money to start new businesses, invest, or treat ourselves to something nice once in a while.  For now, with the stock market rising at a moderate rate, and unemployment still a major problem, a modest, deflation-based reallocation of resources could be good for us.

This is not to say that we should allow deflation to continue unchecked.  It will eventually be necessary in the future to return to growth and restore some elements of consumption, but this will not be through some top-down tinkering or massive government-led job giveaways, but through bottom-up regrouping and restoration of creative enterprise.  Nevertheless, let's examine the problems of the current economic crisis, what we've done, and where we are now, and see if we can ascertain the most effective policy solution.

First the problem: too much across-the-board debt and financing of purchases with nothing.  With the sub-prime crisis, banks were lending money to people they had no business lending to and then collecting assets when those people defaulted.  When the assets then declined massively in value, the banking crisis occurred.  Lehman Brothers was the first casualty, then others, across the board with few exceptions.  When finance started feeling it, lending/investment stopped, the markets crashed, people were fired, and individual consumers who had based mortgages and other purchases on the assumption that they would not be fired found themselves unable to pay back the huge amounts of debt they had taken on.  Since nobody had any savings, there was nothing to fall back on. 

Next: what we've done: in September 2008, when the economy appeared in hindsight to have already reached a crisis point, both John McCain and Barack Obama had incentives to support corporate bailouts, despite a decisive opposition among the public.  The decisions of each candidate can be modeled as a typical prisoner's dilemma.  If either candidate did not support stimulus, it would allow the other candidate to take on the role of hero and win the election no matter what the result.  For instance, Barack Obama chooses not to support the stimulus; John McCain does; the stimulus does not pass; the economy is still bad and McCain gets to say "I told you so."  the stimulus passes, and McCain gets to say he saved America with a big, public celebration.  The effects of the stimulus are so far beyond Election Day that whether it works or not is irrelevant to getting elected.  Hence, both candidates and both political parties supported an overwhelmingly unpopular stimulus package.  Massive amounts of dollars were printed and distributed to banks with the provision that they submit themselves to government inspection, and, in many cases, direct ownership.  Even banks that reportedly did not have financial problems were forced to take stimulus money.  The rationale for the stimulus was that trickle-down economics would eventually help everybody by lowering the unemployment rate.  The opposite has happened and the dollar has started deflating, despite the unprecedented inflation in the classical sense, which means we're either still waiting for the trickle-down and/or inflation to happen, or that, despite the massive stimulus, it simply wasn't enough.  The Fed had to walk a fine tightrope of expertise to save the economy, and it seems like, either it's still walking, or it fell off, and we didn't notice. 

Where we are now: the stock market and banks are doing all right, and why wouldn't they be?  They were saved by taxpayers.  The people on the other hand are still dealing with unemployment above ten percent.  Nevertheless, we've started to correct for some of the irresponsible behaviors that exposed us when shit hit the fan last year: saving has gone up ever-so-slightly and new restrictions have been set for the banking sector, probably to little effect and mostly as lip-service to the zero-sum worldview majority, the Federal government is deeply in debt, fighting two wars, and considering passing an expensive healthcare overhaul.  The stimulus is spread out over several years, we have several more years committed in Iraq and are escalating hostilities via the Afghan surge, and our financial and military overextension is apparent to would-be-troublemakers.  Basically, the U.S. government has made it as difficult as possible to make it to the black within the next ten years.  Even if we cut here and there, we've already committed to several expensive causes that we can't just get rid of overnight without dire consequences.  Despite all of its difficulty, the next task for the Democrat-controlled Congress is a Bill Clinton-esque move to the right of the Republicans: it must find ways to reduce government spending while simultaneously paying for our current commitments, which also include entitlements for retiring baby boomers.

Where we go next: raising taxes is unpopular, however, it must be done in some way given the fact that we've already committed to so many things.  Nevertheless, here is where we can really kill an entire flock of birds with one stone: we need to gradually implement a self-sustaining, simple, fair consumption tax system, like a value added tax, to increase government revenues, reduce government loss and expenditures (IRS budget, tax-dodgers, offshore accounts, business expenses, slush funds, etc.) that follow from the professional manipulation of our current, Byzantine system, end coerced taxation via the income tax, and encourage savings and investment over consumption. 

Of course, it would be easier if lawmakers did not make unnecessary financial commitments, and American citizens held them to higher standards of accountability instead of voting for whichever candidate gives them the most free stuff.  This can be accomplished by supplementing a new consumption-heavy tax code with a moderately-structured balanced budget amendment.  During times of economic growth, the tax system should take in more than it pays out, to be saved and then used in times of economic stress.  In no way does this mean that something like healthcare overhaul cannot or should not be passed; rather, Congress will have to weigh the costs and benefits of invading a third world country posing no threat to the United States against those of providing healthcare for the poorest American citizens.   

For now, the government should not legislate any additional bailouts in order to stimulate the economy, because the solutions to the problems that got us to our current situation have nearly broken the camel's back, as well as disproportionately benefitting the wealthiest Americans.  In the medium-term, however, our economic problems can be corrected by gradually shifting taxation from income to consumption.  At present, with a deflationary economy, is the time to implement a consumption tax, say at a rate of 2% a year, because widespread price-increases will not be felt by consumers.  In ten years, we will have raised enough government revenue to pay all of our debts, provide services for a disproportionate number of elderly, and we can effectively neuter the income tax, thereby giving people control over more of their own money.  A consumption tax with a balanced-budget amendment will solve our current economic problems in the medium term while encouraging making and keeping money - not borrowing and spending it - both for American citizens and lawmakers.