PHILADELPHIA REFLECTIONS
Musings of a Philadelphia Physician who has served the community for six decades

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Whither, Federal Reserve? (1) Before Our Crash
The Federal Reserve seems to be a big black box, containing magic. In fact, its high-wire acrobatics must not be allowed to fail. Nevertheless, it may be time to consider revising or replacing it.

Curing Deflation

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Some recessions and deflations have lasted a long time, in spite of every effort to reverse them. The cause and cure of deflation remains uncertain. {bottom quote}

It's uncomfortable to notice that Japan almost couldn't recover from its fifteen-year depression, or deflation, in spite of numerous suggestions from economists, and in spite of the Chinese boom, right next door . It's even more uncomfortable to reflect that -- just as America has -- Japan experienced first a wild stock market bubble, then an incredible real estate bubble, or asset inflation. Soon came their stock market crash, followed by the very stubborn deflation which they are only starting to cure. Sounds ominous for us, except maybe we still have a chance to head off deflation, avoid the quicksand. Since it has previously been unprofitable to heap blame on industrial overcapacity and various other economic instabilities, let's have a look at the central unchallengeable truth of economics. Let's look for flaws in the marketplace.

During a recession, prices return to pre-boom normal. But during a depression, prices go lower than that and keep going lower. Something causes the buyers to expect even lower prices, something persuades the seller to lower his price. In a recession, both buyer and seller remember prices before the boom, expecting present prices to return there. In a depression, everyone looks into the future and fears prices will go much lower than that. The signals of the marketplace persuade the seller to lower prices while he still has a chance to sell, while the buyer waits for still lower prices. Things are bad, going to get worse. So all we have to fear, is fear itself?

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Stock Market Bubble

Franklin Roosevelt showed that rhetoric might win elections, but couldn't reverse a deflation. It's been said that Roosevelt proved that only a world war would cure deflation, but that's wrong, too. World War II may well have reversed that particular deflation, but the huge war expenditures also demonstrated that the American economy had lots of money all during the depression and just wouldn't spend it. That's not invariably the case; England very nearly ran out of money and had to sell its empire, but we had wealth and were scared to spend. In spite of wealth, we had no money, showing there can be a real difference. That's a clue, but in fact no one is certain how to combat deflation. Deflations do eventually end, but what cures them is elusive.

Increase liquidity. Some historians believe the confiscation of Catholic Church property by Henry VIII released wealth into the economy of Great Britain which then released prosperity, although it is also argued that the Spanish gold captured by Sir Francis Drake performed that function for Elizabethan England. This analysis of Tudor success puts its focus on the long dark ages after the fall of the Roman Empire, where inadequate banking systems paralyzed the bottled-up economy of Europe, and today is perhaps only partially useful as an example.

Wipe Out Bad Debt. The apparent solution to Japan's fifteen years of deflation was inadvertent, and certainly surprising. The Japanese had seemingly tried everything, without effect. Interest rates had been driven to zero or even effectively below zero; huge government projects of bridges and tunnels to nowhere had not budged the economy. And then, private housing construction was stimulated by the government, with the result that increased supply made home prices affordable. Banks finally became willing to liquidate bad loans to meet the new demand, and the Japanese economy finally began to pick up. The paradox was that a deflation was corrected by lowering prices on the one commodity which had seemingly maintained its value. Japan had plenty of money, plenty of liquidity and savings, but they were locked in the banking system by the unwillingness of bankers to admit they had over-loaned during the earlier boom times. This certainly sounds like a very special case, but perhaps it illustrates a more fundamental truth which future historians can explain to us. There's a hint here, just a hint, that prices will move up and down in harmony until one major commodity gets stuck and remains high. And the whole economic system refuses to rise, until that one discordant factor -- falls.

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Japan was an extraordinary case: the Ginza kept humming along and there really were no visible signs of strain, and yet every macroeconomic measure was at a 1,000-year trough
Posted by: G4   |   Mar 16, 2007 10:24 PM

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