Krugman Now Warning About Deflation

Ever since the financial crisis really took hold of the economy back in September, 2008, Princeton economist Paul Krugman has been warning about the grim prospect of Japanese-style deflation — a grinding, slow-growth economic malaise that could go on for years.

This past week he expressed the same views again (here, here and here), following an article by John Makin appearing in the conservative American Enterpise Institute’s Outlook Series which makes much the same argument.

Krugman writes that “it’s a good bet that we’ll be seeing deflation by sometime next year.”  Makin believes it may be even sooner.  “By later this year,” he says, “persistent excess capacity will probably create actual deflation in the United States and Europe.”  

Deflation is already happening in other countries.  Prices have been falling every year in Japan since 2004, Ireland’s deflation rate is 2.7%, Spain is close to being deflationary at a year-over-year core inflation rate of 0.1%, and core inflation rates are dropping in both the United States and Europe.

But deflation means lower prices, so how could lower prices be bad, you may wonder?

Well, deflation is great for folks who have plenty of cash (the further prices drop, the more their money is worth), but the great risk is a deflationary spiral in which reduced economic activity leads to lower and lower production and wages, less lending, more layoffs, and a general stagnation.

If you’d like to learn more about deflation, Greensboro Public Library has a couple of titles which look particularly useful:  Conquer the Crash:  You Can Survive and Prosper in a Deflationary Depression by Robert R. Prechter, Jr.; and Deflation:  What Happens When Prices Fall by Chris Farrell.

We also have quite a few recent books on the economic crisis.  For a list of those, please see this post.

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One Response

  1. One thing I think we should be clear about (and Krugman isn’t) is the difference between monetary deflation — deflation of the circulating money supply — and price deflation — what most people see as “deflation”. Price deflation is actually a *lagging* indicator of monetary deflation. If there is monetary deflation — not enough money in the economy to buy goods at the prices at which it cost to manufacture or produce them — the first thing that happens is *output* deflation. Companies will not sell goods for less than it cost to make them (that’s called a loss, and companies are in the business to make profits, not losses), and will instead accept a lower volume — and fire the people who are no longer needed at the lower volume of business. So if the circulating money supply dips by 5%, what you might initially see is company sales go down by 5% and unemployment go up by 5%, *not* price declines. Eventually prices *will* decline as companies cut profits to the bone and the cost of commodities that are inputs to manufactured goods go down, but never as fast as the economy itself declines.

    So Krugman is raising the correct warnings here — I looked at the Fed’s flow of funds data from the 1st quarter, and they’re dire, more money is flowing into the Fed as reserves (“mattress money”, no longer available for the economy) than flowing out. He just confuses people by focusing on price deflation when he really should be focusing on monetary deflation. I just wish Bernanke could find the keys to his blasted helicopter…

    – Badtux the Economics Penguin

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