Crisis in Prices?
By PAUL KRUGMAN - NYT, December 31, 2002Some fuzzy math: In the first 30 days of December 2000, according to Nexis, only six articles in major news sources contained both the word "deflation" and the phrase "United States"; none of those articles suggested that deflation in this country was a real possibility. In the same period last year there were 292 hits; this past month there were 566.
Will deflation be even more on our minds a year from now? About five years ago economists realized that monsters from the 1930's were once again walking the earth: Japan, the world's second-largest economy, was trapped in a cycle of falling prices and rising unemployment. But not many people in the U.S. cared about the woes of a faraway country. Like big-time corporate malfeasance, deflation didn't seem like something America had to worry about.
But like corporate malfeasance, deflation has turned out to be something that can happen here. It's by no means a foregone conclusion: Federal Reserve officials assure us that they can and will steer us away from a Japanese-style black hole. But we're close enough to such a black hole that it's already warping our economic space.
Here's how it can happen: First, for whatever reason, the economy becomes depressed. The central bank responds by cutting interest rates — but it turns out that even cutting rates all the way to zero isn't enough to restore more or less full employment.
At that point the economy crosses the black hole's event horizon: the point of no return, beyond which deflation feeds on itself. Prices fall in the face of excess capacity; businesses and individuals become reluctant to borrow, because falling prices raise the real burden of repayment; with spending sluggish, the economy becomes increasingly depressed, and prices fall all the faster.
We know from Japan's experience that the descent into such a black hole is a gradual process. Although most economists now date the beginning of Japan's malaise to 1991, the Japanese economy actually grew, albeit slowly, until 1998 — and it wasn't until 1998 that Japanese officials appreciated the severity of the problem.
So we shouldn't take too much comfort from our own sort-of recovery in 2002. Yes, the U.S. economy grew, but too slowly to employ an expanding and increasingly productive labor force. The output gap, the difference between what the economy could produce and what it actually produces, continued to widen. And so the threat of deflation is worse now than it was a year ago.
In fact, by some measures deflation is already here. Prices paid by consumers are still rising, but those received by many businesses aren't: the government's index of the prices received by nonfinancial corporations has been falling since the third quarter of 2001.
As a result, we've moved closer to the event horizon. The Fed funds rate is only 1.25 percent, yet nothing suggests that the economy is about to close the output gap. The back of my envelope says that G.D.P. would have to grow at least 4.5 percent over the next year to bring an end to deflationary pressure. That's well outside the range of consensus forecasts.
And the pull of the black hole is increasing. Consider: A Fed funds rate of 3 percent was low enough to get the economy moving in the early 1990's, so why isn't a rate of 1.25 percent low enough now? In part because back then business prices were rising, while now they are falling, discouraging borrowing even at very low rates. What if a year from now the Fed funds rate is zero, but prices are falling even faster?
O.K., let's take a deep breath. Nothing I've said is news to Fed officials — a group that now includes my Princeton colleague Ben Bernanke. Also, the black hole metaphor can be pushed too far; as Mr. Bernanke points out, the Fed has other weapons in its arsenal besides low interest rates. The policies he describes haven't been tested, but in theory they should work. Those policies would be more likely to succeed, of course, if the Bush administration would stop playing politics with fiscal policy and . . . oh, never mind. Anyway, the Fed will do its best.
But two years ago deflation in America seemed a prospect literally not worth writing about. Will it be all over the newspapers a year from now?