|December 31, 2002/New York TIMES.
Crisis in Prices?
By PAUL KRUGMAN
Some 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
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?