Inflation or Deflation?

Martin Feldstein

 CAMBRIDGE – The investors that I talk to these days are not sure whether to worry more about future inflation in the United States or about future deflation. The good news is that the answer – for at least the next few years – is that investors should worry about “neither.”

America’s high rate of unemployment and the low rates of capacity utilization imply that there is little upward pressure on wages and prices in the US. And the recent rise in the value of the dollar relative to the euro and the British pound helps by reducing import costs.

Those who emphasize the risk of inflation often point to America’s enormous budget deficit. The Congressional Budget Office projects that the country’s fiscal deficit will average 5% of GDP for the rest of the decade, driving government debt to 90% of GDP, from less than 60% of GDP in 2009. While those large fiscal deficits will be a major problem for the US economy if nothing is done to bring them down, they need not be inflationary.

Sustained budget deficits crowd out private investment, push up long-term real interest rates, and increase the burden on future taxpayers. But they do not cause inflation unless they lead to excess demand for goods and labor. The last time the US faced large budget deficits, in the early 1980’s, inflation declined sharply because of a tight monetary policy. Europe and Japan now have both large fiscal deficits and low inflation.

The inflation pessimists worry that the government will actually choose a policy of faster price growth to reduce the real value of the government debt. But such a strategy can work only in countries where the duration of the government’s debt is long and the interest rate on that debt is fixed. That is because an increase in the inflation rate causes interest rates on new debt to rise by an equal amount. The resulting higher interest payments add to the national debt, offsetting the erosion of the real value of the existing debt caused by the higher inflation.

In the current situation, the US cannot reduce the real value of its government debt significantly by indulging in a bout of inflation, because the average maturity on existing debt is very short – only about four years. And the projected fiscal deficits imply that the additional debt that will be issued during the next decade will be as large as the total stock of debt today. So raising inflation is no cure for the government’s current debt or future deficits.

Those who worry about deflation note that the US consumer price index has not increased at all in the past three months. Why won’t that continue and feed on itself – as it has in Japan – as consumers delay spending in anticipation of even lower prices in the future? And doesn’t Japan’s persistent deflation since the early 1990’s also show that, once it begins, deflation cannot be reversed by a policy of easy money or fiscal deficits?

But the recent weakness in US prices is very different from the situation that prevails in Japan. Zero inflation for the past three months has been a one-time event driven by the fall in energy prices. The other broad components of the consumer price index have increased in recent months, and the consumer price index is up about two percentage points over the past 12 months.

Moreover, surveys of consumer expectations show that US households expect prices to rise at more than 2% in both the coming year and the more distant future. That expected inflation rate is consistent with the difference in interest rates between ordinary US government bonds and Treasury Inflation Protected Securities. With such expectations, consumers have no reason to put off purchases.

A second reason for relatively low inflation in recent years has been a temporary fall in the cost of production. As firms shed workers during the economic downturn, output fell more slowly. The resulting rise in output per worker, together with slow wage growth, reduced unit labor costs. That process is now coming to an end as employment rises.

So the good news is that the possibility of significant inflation or deflation during the next few years is low on the list of economic risks faced by the US economy and by financial investors.

But, while inflation is very likely to remain low for the next few years, I am puzzled that bond prices show that investors apparently expect inflation to remain low for ten years and beyond, and that they also do not require higher interest rates as compensation for the risk that the fiscal deficit will cause real interest rates to rise in the future.

Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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Resetting economy, society and the world

Review by Abby Wong

 The Great Reset: How New Ways of Living and Working Drive Post-Crash Prosperity

Author: Richard Florida
Publisher: Harper Collins

AN economic downturn is always unwelcome. But amidst even the worst depression, there is always a silver lining. This hope is firmly held by Richard Florida, a renowned American economist and urban theorist who has authored three international bestsellers on social trends of the 21st century, The Rise of the Creative Class, The Flight of the Creative Class and Who’s Your City?

In his latest book, The Great Reset, Florida sets his foot into economics, calling the current financial woes the necessary adjustments that will eventually give rise to new epochs of inventiveness, ingenuity, economic growth, and prosperity. But Florida is not being imprudent. Lest he upsets millions of people affected by the current downturn, he backs this idea with facts drawn from both history and rigorous research.

With flair of a storyteller, Florida recounts causes of the Long Depression of 1870s and the Great Depression of 1930s, and analyses the ensuing social and economical effects – the rise of innovation, changes in infrastructure, geographical resettlement and alteration of ways of living and working. Florida calls these adjustments resets and thinks the next Great Reset will take place soon or even now, if not already.

But what has worked in the past will not work quite as well in this era. No longer is our economy driven by manufacturing and factories like it was in the 20th century. Connected by a web of countries across the world and confronted by a mélange of problems never before seen as imminent, today’s economy can only be propelled by ideas and creativity.

Furthermore, with the busting of consumerism, restarting economic growth this time requires more than boosting spending but a new socio-economic framework that is in line with frugality, flexibility, conservation and environmentalism.

With his trademark blend of wit, verve and analysis, Florida presents an optimistic future and a society that he envisions as vibrant, mobile, prosperous and creative. To achieve this vision, he calls for abolishment of certain long-held beliefs, realignment of our way of life and redesign of governments’ policies.

So, will the current crash usher in a new age of thrift, caution and frugality? Will car-ditching be the next badge of honour, replacing car-loving? Will troubled, if not deserted, industrialised cities be revitalised? With mortgage lending became overblown and began to undermine the economy, will house ownership be replaced by renting? Finally, will education, infrastructure, employment, and the role of government be improved, adjusted and attuned?

Yes to all that, according to Florida, as he puts forth his reasons and suggestions. For instance, to breathe life back into abandoned industrial cities, he suggests a high-speed rail system that is faster than a speeding bullet, knitting active and dormant cities together to form mega-regions.

On jobs, which are fast disappearing as a result of the crash, Florida advocates creative job creation by knowledge professionals, rather than depending on big conglomerates that hire and fire and then close down when crisis takes place. On housing and cars, bigger is no longer better, while renting will be the new normal, more for mobility reason than for cautious introspection.

Though some changes may have already taken place, the real challenge, according to Florida, lies in the efficient and productive use of capital, which has become dangerously scarce after the financial crisis. Only by making intelligent investments in new infrastructure that goes beyond the current energy and environmental constraints, can we build a new creative economy and society that is vibrant and prosperous.

The Great Reset is a fantastic book that I think should be read especially by all policy makers seeking an inkling as to what will and should happen in the aftermath of this disastrous financial meltdown. Although much of the context is drawn from the United States, it is very much written for the emerging economic and social landscapes of the world.

Indeed, I closed this immensely stimulating book with a sigh and reflected on what seems to be a poverty of natural resources we are facing and wondered for how long the earth can endure human destruction before arriving at the much better world that Florida envisions.

Not too long, I hope.

G20 walks tightrope between growth, deficits

(Agencies)
Updated: 2010-06-28 08:04, China Daily

TORONTO – World leaders agreed on Sunday to take separate paths toward shared goals of lasting growth and safer banks as two years of global crisis give way to a fragile economic recovery.

The leaders of the Group of 20 pose for a family photo at the G20 Summit in Toronto June 27, 2010. [Agencies]

Balance was the buzz word. The Group of 20 pledged to halve budget deficits by 2013 without stunting growth, and clamp down on risky bank behavior without choking off lending.

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But they left room for countries to move at their own pace and adopt "differentiated and tailored" policies that match national economic or political priorities, a sharp reversal from the unity of the previous three crisis-era G20 summits.

"The G20's highest priority is to safeguard and strengthen the recovery and lay the foundation for strong, sustainable and balanced growth, and strengthen our financial systems against risks," the group said in a statement released at the end of meetings here.

The G20 allowed each country space to decide how to proceed with controversial provisions such as taxing banks to recoup bailout costs and implementing tougher bank capital rules.

The G20, which includes emerging economic powers as well as the developed economies, which is where the economic trouble started, united last year to throw trillions of dollars into the battle against recession.

But that unity has begun to fray as countries emerge from crisis at different speeds and with different policy needs. Emerging Asian economies such as China have come roaring back while the US recovery remains tepid and Europe lags behind.

"Now that the worst of the crisis is past, the dewy-eyed vision of G20 countries pulling together to solve global economic problems is steadily giving way to a more pragmatic approach of merging competing perspectives and agendas to fashion imperfect compromises and make incremental progress," said Eswar Prasad, a senior fellow at the Brookings Institution and a former International Monetary Fund official.

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