By Arnold Kling
The threat of deflation and/or a liquidity trap has been discussed in a number of places recently.
- Columnist Robert J. Samuelson writes,
Global demand remains weak; surplus capacity discourages new investment; gluts depress prices. Deflation could be dangerous: Lower prices could squeeze profits and depress stocks; and lower prices could prevent corporate debtors from repaying loans, leading to defaults and bank failures.
- Princeton Professor Paul Krugman explains the basic economic issues, using textbook diagrams or, if you prefer, a four-letter word. In the latter essay, he writes,
In the 30s and well into the 50s many economists…thought that it was quite possible that a central bank fighting a recession would drive interest rates close to zero, and that any further monetary expansion would simply be stuck away in mattresses or in bank vaults, doing nothing more for the economy.
- Reports from the latest Federal Reserve policy meeting suggest that there is a concern with deflation.
The dollar tumbled on foreign exchanges yesterday as the US Federal Reserve issued a surprise warning that the threat of deflation, or continuously falling prices, is stalking the world’s largest economy for the first time since the 1930s.
I recommend some additional background reading. First, there is this discussion paper written by Fed staff economists.
an analysis of Japan’s experience suggests that while deflationary episodes may be difficult to foresee, it should be possible to reduce the chances of their occurring through rapid and substantial policy stimulus. In particular, when inflation and interest rates have fallen close to zero, and the risk of deflation is high, such stimulus should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity…Too much stimulus can be taken back later through a corrective tightening of policies.
Second, there is this speech by Federal Reserve Governor Ben Bernanke.
as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
Bernanke points out that even if the interest rate on Federal Funds reaches a lower bound, the Fed can still lower interest rates in the economy by purchasing long-term bonds or other assets. I view Bernanke’s speech as denying that the U.S. can experience a liquidity trap, because in his view monetary expansion can continue to influence interest rates and spending even if the Fed Funds rate falls to zero.
For Discussion. Is the liquidity trap a mere theoretical curiosity or is it a valid concern for policymakers today?