The Deflation Abyss

Posted Feb. 19, 2009, at 6:16 p.m.

When President Obama warned of a possible “negative spiral” if the government failed to act, he was really talking about a “deflation spiral,” the disastrous plunge that gripped Japan’s economy in a decade-long depression starting in 1990. His chief economic adviser, Lawrence Summers, introduced the term. He said that rapid enactment of the stimulus plan was essential “to contain what is a very damaging and potentially deflationary spiral.”

What exactly is a deflation spiral? Are we close to it? What’s so bad about it? And how can we keep out of it? Economists and analysts have studied it for years, and now the new administration is urgently seeking to avoid it.

In simple terms, deflation is a persistent general decrease in prices. It increases the real value of money and reduces the value of homes, land, stock portfolios and other private assets. So payments for a mortgage or a car loan represent a gradually increasing amount of purchasing power. In the Great Depression, deflation averaged 10 percent a year. That meant that even a zero-percent loan had to be repaid with money worth 10 percent more each year.

Deflation is an upside-down conversion of inflation, which can seem benign when it is moderate. But galloping inflation can mean big trouble, as in the early 1980s, when interest rates soared to 20 percent and for a while made it prohibitively expensive to borrow money.

Deflation can be even worse, although it, too, can seem desirable at first. Many prices are dropping. Look at the sales of cars, clothing, jewelry, fur coats and houses — if you can get a loan. (But ask anyone who does the grocery shopping, and they’ll tell you that most food prices are still rising.)

Deflation’s dark side is already showing, however. Investors and consumers are hanging onto their money, since whatever they buy is steadily losing value. As a result, demand is dropping, automobile companies and industry generally are cutting production and laying off workers. Mounting unemployment brings a further decline in demand for goods and services.

Minutes of the Federal Reserve Board’s closed-door meeting in December suggest why it cut interest rates to nearly zero. The Fed governors expressed concern about a “prolonged recession,” while insisting that this “was not judged to be the most likely outcome.” But many economists could see that what they feared was runaway deflation and even a vicious cycle, in which a problem exacerbates its own cause. That would be a deflationary spiral, which figured in the Great Depression of the 1930s.

With interest rates near zero, the Fed can’t cut them further. As the present Fed Chairman Ben Bernanke worried in 2002, it has “run out of ammunition.” Among other measures, he suggested printing paper money to increase the number of dollars in circulation.

Some analysts say the downward spiral has already begun. This danger explains why the Obama team is pressing so urgently for stimulus, aid to banks, and regulatory reform. Let’s hope they are big enough.

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