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Letting it happen here

By Karl Smith

In 2001, Ben Bernanke earned the nickname Helicopter Ben, after a talk he gave at the National Economists Club. The title of the talk was “Deflation: Making Sure ‘It’ Doesn't Happen Here,” a reference to the spiral of disinflation, leading to economic stagnation, leading to outright deflation, that gripped Japan for over a decade after the collapse of its real estate and stock bubbles.

Bernanke, then a Federal Reserve governor – now its chairman – argued that this spiral of economic destruction could be prevented in the United States:

The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

Virtually all economists agree that disinflation and deflation are caused by a shortage of dollars in the economy. The majority agree that such deflation is accompanied by a rise in unemployment. If inflation is too many dollars chasing too few goods, then deflation is too few dollars chasing too few goods. As a side effect some of those goods are never caught. No one buys them, their producers lay off workers and unemployment rises.

But, Bernake said, we need not let it happen here. The problem is – we are.

The economy is contracting, inflation is falling, wages are stagnant and we are dangerously close to outright deflation. The spiral has come home to America.

Intimidated by inflation hawks, however, Ben Bernanke said, “I have rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy.”

That’s true Fed speak, so let me see if I can parse it out for you.

The economy is being dragged down by the spiral of ever lower inflation. As banks and businesses see inflation fall, it only increases their incentive to sit on the cash they have. As I mentioned before, if we reach outright deflation then they can earn a profit simply by stockpiling money in vault. Every year as prices fall the money locked in that vault would become more and more valuable.

However, money locked in a vault does nothing to support economic growth. It does not fund new investments, new workers or new products. Without that base of new investment or new spending, prices fall further, goods are discounted more deeply and the deflation spiral worsens.

We could power out of such a spiral by raising inflation expectations. The Fed could promise that any decline in prices today would be met by an equal rise in prices tomorrow. Any business considering sitting on its cash would know that know that this is a losing proposition. What it gains by taking advantage of disinflation today, it will lose when exposed to re-inflation tomorrow.

Making this plan work, however, requires that the Fed be willing to produce catch-up inflation -- a short period in which inflation would be higher than normal, so as to make up for the current period were inflation is lower than normal.

At a talk this weekend, Bernanke, however, "rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy."

That is, he has rejected the idea of catch up inflation. He has rejected using the Fed to power out of the spiral. He has decided to let it happen here.

We can only hope that time will bring back the Bernanke of yore.

Karl Smith is an assistant professor of economics and government at the University of North Carolina and a blogger at ModeledBehavior.com.

By Karl Smith  | November 8, 2010; 12:30 PM ET
 
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Comments

The liquidity trap, in Keynesian economics, is a situation where monetary policy is unable to stimulate an economy, either through lowering interest rates or increasing the money supply.

Posted by: marteen | November 8, 2010 12:37 PM | Report abuse

Someone needs to explain to Sarah Paling that taking a class in high school in home economic doesn’t really prepare one for discussing macroeconomics. Geithner’s plan is brilliant!!! Either way the US wins.
After failing to get accommodations from the Chinese, Geithner is putting the Chinese in a no win situation. He is forcing the hand of every country to compromise or else. After failing to make any real progress, Geithner has adopted a more Israeli style of hardline negotiating! Geithner has masterfully created a situation where he will win on the currency conversion front or inflation or both; regardless of how well or how poorly Geithner does at persuading the G-20 to support his plan.
Currency conversion is not complicated. A strong dollar raises the value of Chinese US holdings, while a weaker dollar decreases the value of those same holdings. The fear of the Chinese walking away from the dollar completely is crazy… they own too many. Overtime the Chinese will decrease their holdings, but this was inevitable with or without Q2. Chinese revenue from sales in the US is on the decline and that decline is not going to be reversed anytime soon. Lower sales in the US means the Chinese simply have few dollars to buy US debt.
LET ME REPEAT… fighting the Federal Reserve and the currency traders would require massive purchases of the same dollars that they fear will go down in value!
Don’t feel sorry for China… China was and still is Fannie Mae’s largest bondholders, so China effectively got almost a half-trillion dollar bailout when the Fed stepped in and rescued Fannie Mae bondholders! China has exploited US policy thru fear and intimidation for far too long!
If the Foreign Central Banks try to fight the US Fed it will require them to buy mountains of dollars. It is not hard to imagine how pissed-off the Russians and Venezuela are about this prospect given their very vocal campaign to reduce their dollar holdings.
It is true that Japan, other Asian economy and developing countries will need to take some protective measures to limit capital inflows, but that seems to be a small price to pay to keep the US from falling into a Japan deflation or worse.
The doomsday scenario that Geithner fears is one where the US employment stumbles further and where the developing nation’s recovery pushes commodity prices to extreme levels. It would be terribly destabilizing!
Screw Germany. The German unemployment rate is half the US because of very shrewd maneuvering and favorable trade agreements. Russia hates anything that helps the US!
Hats off to Geithner!!!

Posted by: radioceleb99 | November 8, 2010 3:27 PM | Report abuse

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