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Top Ten Myths about the Economic Downturn*

*You don’t know fear until you’ve faced number seven.

One of the curiosities about the current crisis is the sudden currency of economics opining, blogging, and just plain bloviating. Once the exclusive stomping ground of people you’d never invite out for a beer, economics is bringing the Bill O’Reilly out in all of us — including distinguished Berkeley professors of economics. If there’s one thing economics has consistently been short of, it’s shrill, so I guess we’re making up for lost time.

In the spirit of deshrilling the noise, I offer up my ever-humble debunks of the most popular myths about our beloved economic downturn. These fearsome fantasies certainly sell blog entries, but a big part of our economic downturn is lack of confidence. So deshrilling might be one of the tickets off this express train.

Today, we take on the gruesome spectre of deflation, so scary it’s got Nobel-prize winning economists waking up in sweats in the darkest hours of the night.

Myth: We are about to enter — if we haven’t already — a deflationary spiral.
Of all the bugaboos economists can conjure, there are two that cause grown, Harvard-educated PhDs to wet their pants. The first is hyperinflation, such as we see in Zimbabwe, and the second is its polar opposite, a “deflationary spiral.” So terrifying it is that highly distinguished economists such as Paul Krugman are conjuring the death-touch of deflation to justify any stimulus package at all. “Spend or die!,” quoth the Raven. Actually, here are his exact words: “we’re at major risk of falling into a deflationary trap.”

In fact, here’s some more nightmare before Christmas from Dr. Krugman:

But deflation is a huge risk — and getting out of a deflationary trap is very, very hard.

Now, Paul Krugman is a Nobel-winning economist and I’m a nothing-winning non-economist, so far be it from me to disagree with his highly educated and highly measured primal scream of “FIRE!” in an overcrowded theatre. But, really, a deflationary spiral is only possible if the powers that be purposely let it happen. Really. Trust me.

Paul Krugman and others are looking to the Great Depression for their model of a deflationary spiral. In that period, from 1929 to 1933, prices and wages steadily declined (in other words, the purchasing power of the dollar increased). What you could buy for a dollar in 1929 cost about seventy-three cents in 1933. (The Consumer Price Index in 1929 was 17.3 and in 1933 it was 12.6.) This represents a 37% increase in the purchasing power of a dollar and a 27% deflation of the currency.

That’s deflation and put that way it sounds okay. However, as in (almost) all deflations, it was accompanied by a rapid decrease in gross domestic product as the nation become in essence poorer (people who kept their money safe, however, did very well as the purchasing power of that money increased). Most economists agree that the Great Depression was as bad as it was primarily because of this deflationary spiral.

This is what happened. The deflation was triggered by a scarcity of money. Businesses stopped investing, banks stopped lending, and consumers stopped purchasing. As demand went down, businesses laid off employees and, as a result, consumer spending and business investment dropped even further. Thus, a deflationary spiral that couldn’t be broken as more and more people got poorer and poorer.

That’s the chucacabra Krugman and others are conjuring.

But they seem to forget that the “dollar” between 1929 and 1933 is not the same “dollar” we use in 2009. The difference is crucial. The dollar in 1933 was backed by a real asset, gold, and the value of the dollar rose and fell based on the value of the underlying asset. If the value of gold dropped, the government printed less money. Simple as that. It is perfectly normal for currencies based on an underlying asset such as gold or silver to rise and fall in value, that is, to go through inflationary and deflationary periods, as the underlying asset rises and falls in value. In fact, the gold-backed dollar went through four phases of deflation including two massive ones: 1839-1843 (the currency contracted 30%), 1873-1896 (the Great Deflation, which, paradoxically was the result of economic growth rather than contraction).

While stopping the deflationary spiral that caused the Great Depression flummoxed the Hoover administration, Roosevelt solved the problem in a matter of weeks — actually, days. Not only did he stop the deflationary spiral, he literally turned the economy from a deflationary economy to an inflationary one in a matter of a couple weeks.

How?

He created a different dollar, one that is more like the dollar we use. He abandoned the gold standard — in fact, he abandoned pretty much any asset backing of the dollar — and declared a dollar a dollar and that was that. Called fiat currency, freeing the dollar from any underlying asset meant that the government could print as many dollars as it wanted — it did not have to peg the amount of dollars in the economy to the value of gold, which is what caused the dollar shortage to begin with.

Roosevelt became president on March 4, 1933 and immediately changed the dollar to fiat currency — the dollar became a pure symbol. By April, the economy had reversed course and entered an inflationary cycle. In fact, in June, the annual adjusted rate of inflation hit an unheard of high of 40%. Thus ended the deflationary spiral no-one thought could be ended until the economy hit zero.

Now, pace Paul Krugman, but that didn’t seem hard, did it?

Keep in mind, that in the 140 year history of the United States before the Great Depression, there were a total of five deflationary periods including three massive ones. After FDR removed the currency from all tangible assets, in the almost eighty years since we have had exactly zero deflations of the currency. This is true of every economy using a similar currency.

Why?

There is one economist who understands deflationary spirals better than anyone else on the planet: “Helicopter” Ben Bernanke, who has written the most important economic studies of the Depression and, as luck would have it, is the Chairman of the Federal Reserve Bank.

Why do I call him “Helicopter”? He got the nickname when he was questioned about the danger of a deflationary spiral, at which he laughed and joked, “Listen, if we had a problem with deflation, all we’d have to do is drop money out of a helicopter and that would solve it.”

He is, of course, right. Deflation is caused by a shortage of money. In the case of the Depression, it was a physical shortage of money as the value of gold decreased (leading to fewer dollars being printed). In our current crisis, money is changing hands more slowly, i.e., people aren’t spending the money they have as quickly as they did before, the so-called “velocity” of money has decreased. Obama’s stimulus package intends to increase this velocity of money by having government spend it in such a way that it gets into the hands of other people who will spend it rapidly.

If that doesn’t work, yes, the Federal Reserve could print money and throw it out of helicopters. Not so crazy that. If the Fed were loony enough to make me chairman, in a deflationary spiral, I’d print money, stuff it into envelopes, and mail each and every person a thousand bucks every other week until prices start to come up. (By the way, if you want to lobby for my appointment as Fed chair, that’s my platform — a thousand freshly printed bucks in every mailbox every other week). Prices would probably start going up the day the first cash-stuffed envelopes arrived in the mail. Now the Fed would never do that, but they have other instruments that work in a similar fashion.

So, yes, we are seeing a classic economic contraction as people save rather than spend, businesses save rather than invest, prices are coming down to move excess inventory, people are being laid off, and, as a result, consumers are spending less overall. It looks and talks and walks and quacks like a deflation. But recessions always do. For all those who have lost faith in monetarist economics, putting more money in the economy is still the proven antidote to deflationary spirals of any magnitude.

That is why I say that a deflationary spiral is only possible if the powers that be actually want one to happen. But rest assured, Lex Luthor is not in charge of the Fed, so you can sleep at night. No deflationary Jack Kirby monsters are going to eat your business up before morning.

The point is this: if you’re making business decisions based on the fear of a long-term deflationary spiral (not a temporary decrease in prices to move excess inventory off the shelves), then you’re probably not making the right decision. You need to plan on another 12 to even 18 months of economic contraction and/or stagnant recovery. But deflation isn’t in the cards and never will be.

Unless Obama appoints Lex Luthor to the Fed.

*David makes a wonderful comment and I feel it deserves to be answered here in the body of the blog.

Is deflation “evil”? Not always, as the great deflation that ended the 19th century shows. Dramatic increases in productivity due to technological innovations and transportation networks produced a huge increase in output without a corresponding increase in money (because money was tied to gold reserves). So prices came down — a classic case of too little money in the economy. But because it was based on higher productivity, it did not produce widespread poverty, which is the usual case of a deflation.

Something similar has happened in the computer and electronics industry. Moore’s Law is essentially a deflationary law — and we’ve seen marked deflation in almost all areas of computing and home electronics in the past thirty years. These “deflations” did not produce poverty, but an increased standard of living. In this case, higher productivity and increased demand drive prices down. Increased demand, of course, should create higher prices, but when increased demand results in production innovation and economies of scale, then the price comes down. For instance, if we all started by solar power, the price would come down as innovators invest money in cheaper technologies and production facilities. Not to say the benefits of economies of production scale.

The deflation monster that economists and the politically-inclined are trying to scare us with is a different beast. It is a deflation caused not by increased productivity and growth of demand, but by decreased demand. In this case, the decrease in demand leads to inventory backups, clearance prices, decreased production, and layoffs, all of which translate into lower demand that leads to inventory backups, clearance prices, decreased production, layoffs, and eventually lower prices. That’s the deflationary spiral that happened at the start of the Great Depression and threatens the economy today (but doesn’t, really, because deflations are caused by a shortage of money, a problem that is easily rectified).

Readers of this blog know that I’m a big fan of certain deflations that are happening right now, like the deflation of home prices. Housing is still massively overpriced and can come down much further, at least to 2002 or 2001 levels to bring the median price of a house more in line with income (about 2.8 times). Since we’ve been measuring, this ratio (2.8) seems to be a natural equilibrium (except for the last ten years when the housing bubble inflated). In this case, rescuing banks and mortgage holders to maintain housing prices does help employment, but at the cost of “stealing,” as David says, from the rest of us in terms of inflation. In this case, real inflation in the sense of eroding the purchasing power of the dollar in one area of the economy (this is the same problem with health care). Of course, if you, like my wife and I, purchased a house “intelligently” at a reasonable price with an affordable, long-term mortgage — keeping housing prices high doesn’t hurt, but rather helps since your house still contains a huge amount of the value it gained during the bubble.

But both the bank and auto industry taxpayer “loans” are about rescuing the entire economy. Failure in these sectors could lead to dramatically higher employment. In the case of the financial industry, the bailouts are keeping credit prices low (if the banks fail, the “price” of money in the form of interest rates would go way, way up).

In the case of the auto industry, we’re stealing from the taxpayer in order to safeguard the taxpayers’ jobs, since a failure in the auto industry will wash throughout the entire economy. The problem with the auto bailouts, as I’ve said repeatedly, is that the bailouts are in part paying a “mismanagement premium.” That is, taxpayers are being asked to assume in part the cost of GM’s and Chevrolet’s mismanagement. But keep this in mind: if the companies did not need bailout money, then consumers would be paying much of this mismanagement premium (the costs of mismanagement are also partly assumed by equity holders and, in some cases, by debt-holders). You pay this premium in terms of higher price or lower quality relative to price . . . or both. Right? GM and Chevrolet have for years been passing on the costs of mismanagement to the poor folks who buy their cars. While that’s not obvious to consumers, a government loan that in large part is paying for mismanagement, is much more obvious and make people angry. However, if the auto bailouts involve serious management and governance shakeouts at the Detroit automakers, the end result, if the automakers survive, will be to reduce the mismanagement premium that you pay everytime you buy a Ford, a Cadillac, or a Dodge. This is a good result.

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One Response to “Top Ten Myths about the Economic Downturn*”

  1. David says:

    Thanks for the post.

    Why did you say that it would be “evil” (Lex Luthor) to allow deflation to occur? Isn’t it worse to prop up bad practices by the banks and auto companies by stealing the value of the dollar through inflation? Isn’t the purpose of a recession to allow bad debt to default instead of re-inflating it?

    You mentioned the Great Deflation of the latter 19th century when economic growth was increasing at the same time as deflation. Wouldn’t this be a good thing, effectively increasing the wealth of everyone?

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