One of the major hallmarks of the Great Depression was the deflationary spiral that took hold of the major industrial economies. Wages were cut, prices fell, wages were cut again. In many instances market prices for goods fell below the cost of production. It was a process that eventually broadly suppressed economic activity across the board. Several of the new deal programs were aimed at reversing this spiral by attempting to boost prices and wages. Some of those programs were declared unconstitutional by the SCOTUS.
The world has seen very little of deflation since WWII. The conventional economic wisdom has been that economic policy should aim for a sustained rate of mild and predictable inflation. This supports the assumption that sustained growth is essential to capitalist economies. The only significant instance of deflation was in Japan during their "lost decade" of the 1990s.
The financial crisis in Europe is now raising a fairly immediate prospect of a deflationary trend in the countries on the fringe of the Euro Zone.
Fears Rise in Europe Over Potential for Deflation
If the European Central Bank has one monetary dragon it considers essential to slay, it is inflation.
Keeping inflation under control is the central bank’s primary legal responsibility, and as Europe struggles to overcome economic problems caused by the sovereign debt crisis, inflation has remained the bank’s primary focus.
But some economists say it has become a driving obsession that has blinded the bank to a potentially bigger threat to Europe: deflation.
Prices fell in Ireland in April, while inflation was below 1 percent in five other euro zone countries. The problem also extends outside the euro zone.
These countries face a crisis over their public debt. It has risen to high levels as a percentage of GDP and they are under severe pressure from the bond markets and other members of the European Union to cut government expenditures and reduce the debt. The cuts in government expenditures and social benefit programs are likey to lead to contractions of stagnant economies and this in turn may bring on a deflationary spiral. That would make it even more difficult for them to repay the debt in deflated euros, reduce tax revenues, and block the changes of economic recovery.
It has been clear for several months that the economies on the periphery of the EU have been particularly hard hit by this major recession. What prospects do these developments have for the more prosperous European economies and the US? Paul Krugman has some interesting thoughts on the subject.
The Pain Caucus
What’s the greatest threat to our still-fragile economic recovery? Dangers abound, of course. But what I currently find most ominous is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.
When the financial crisis first struck, most of the world’s policy makers responded appropriately, cutting interest rates and allowing deficits to rise. And by doing the right thing, by applying the lessons learned from the 1930s, they managed to limit the damage: It was terrible, but it wasn’t a second Great Depression.
A similar argument is used to justify fiscal austerity. Both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea — not only does it deepen the slump, but it does little to improve the budget outlook, because much of what governments save by spending less they lose as a weaker economy depresses tax receipts. And the O.E.C.D. predicts that high unemployment will persist for years. Nonetheless, the organization demands both that governments cancel any further plans for economic stimulus and that they begin "fiscal consolidation" next year.
Economic policy makers have a basic toolbox at their disposal. The tools are classified as falling into monetary policy, a bit like using a file, and fiscal policy, more like using a blowtorch. Central banks are given a good bit of independence in managing monetary policy while fiscal policy is more directly under government control.
Some of the choices that managers of monetary policy have at their disposal are:
Raise or lower interest rates
Expand or contract the money supply
Manipulate the international exchange rate of the currency.
Fiscal Policy can be impacted by:
Raising or lowering taxes
Increasing or decreasing government spending
Increasing or decreasing the public debt
Monetary policy in most industrialized economies has now run up against the zero bound constraint. Interest rates have been lowered to near zero. They can't get any lower. That means that they can no longer use interest rates as a means of stimulating the economy.
I did a diary recently looking at the constraints the US government is facing in dealing with the public debt.
Sovereign Debt And Economic Growth
The gist of it is that because governments continued to take on more debt during prosperous times it was already at a high level when the crash of 2008 came along. The response to that crisis has raised it to a level to be concerned about.
Now, as Krugman points out, the Serious People™
are demanding retrenchment. They want to reduce the debt and increase interest rates supposedly in fear of inflation.
The US economy continues to teeter on the brink of recovery. GDP has experienced slight growth. Unemployment remains high and shows no sign of significant decline. There is a large and growing pool of long term unemployed workers. Consumer spending remains stagnant. There are three basic approaches that could be taken in the face of this situation.
Take steps to further stimulate the economy in an effort to create job growth. The two readily available tools for doing this would be to increase government spending funded by tax increases since more debt is problematic and/or for the Federal Reserve to engage in "quantitative easing", i.e. print money.
Sit tight with things as they are and hope that the economy manages to heal itself. This seems to be more or less the present policy course being followed by the government.
Heed the cry of deficit hawks and inflation scare mongers and tighten the belt by cutting spending, reducing debt and raising interest rates.
It doesn't look likely that following the present straddle the fence policy will take the US into a great risk of a deflationary spiral, although miraculous healing doesn't seem very likely either. However embarking on a national program of austerity and economic flagellation like those being followed in Europe could very well take us down the road to deflation and back into the abyss of recession.