The prospects for the current economic crisis leading to a prolonged deflation in prices
(Dated: December 26, 2008. This is the second part of the response to Professor Kenneth Rogoff's article "Inflation is the lesser evil" on Project Syndicate. The first part also appears below.)

On more than one occasion, I have found that Professor Kenneth Rogoff’s middle-of-the-road proposals to be fertile grounds for further investigation. However, with the latest article, “Inflation is the lesser evil”, I was quite stumped to see that Professor Rogoff was in effect advocating inflation rates of 5 – 6 %. Moreover, he was on CNBC expressing his support for a fiscal deficit that is at least half-a-trillion dollar! That is the reason for my previous skeptical comment (see below). However, true to form, I found that on investigating further, Professor Rogoff’s proposal was indeed chosen judiciously. The following comment is the result (I have also posted it in several other places on Project Syndicate, where appropriate):

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There are two economic situations where prolonged deflation could occur:

1. Globalization: In the last several centuries, there have been specific periods, each stretching up to several decades, when there were significantly increased flows of goods and services across national borders. During these times, the less developed countries had figured out how to produce goods that require older technologies efficiently. Hence, they could trade these goods at significantly lower prices. Also, improvements in transportation enabled the free trade of these goods. For example, the late 19th century was one such period. I quote from Professor Jeffry Frieden's Global Capitalism (p. 8), "From 1873 until 1896 prices dropped by 22 percent in the United Kingdom, 32 percent in the United States, more elsewhere. ... ... Prices and earnings declined but debt burden remained constant. Expectations of further price declines caused uncertainty and pessimism. More important, the price declines were not across the board. The prices of goods that entered readily into world trade fell particularly rapidly, such raw materials as wheat, cotton, and coal by 59, 58, and 57 percent respectively. But the prices of other goods and services fell more slowly or not at all. For example, American farm prices declined by more than a third, mining prices by nearly half, but construction costs stayed constant."

2. Depression: In a depression situation, due to severe mis-communication of price signals, the economy invariably goes into a chaotic condition. Firms lay off employees in large numbers expecting a severe downturn. The result is that consumers don't have the incomes necessary for purchasing goods. Inventories pile up and firms have to cut prices. However the more the firms cut prices the more is their losses, and they have to lay off more employees and reduce production. In the worst case, a quarter or a fifth of the working age population is unemployed. This cutting of production and prices, and laying-off of employees lead to a downward spiral of contraction, deflation and unemployment, where these three factors reinforce each other. Thus there is a prolonged period of spiraling downwards, in particular a deflation in prices, before some external event puts an end to it. This was the situation in the Great Depression of the 1930s. During its worst phase, the GDP contracted by a third.

It is clear that the current economic crisis of 2008 would not lead to unemployment above 20%, nor a contraction of a third of GDP. Moreover, due to massive accumulations of capital, like social security and pension funds, consumers could continue to maintain their usual level of spending on essential goods even if they lose their jobs. Thus the re-appearance of a dire economic situation like the Great Depression cannot be cited as a reason for prolonged deflation in contemporary times.

Next, during the current phase of economic globalization, the phenomenon of 'China price' has been hitting the global economy since the 90s. These deflationary forces have been successfully managed so that there would not be severe destabilization of the global economy. This is the great contribution of Alan Greenspan, that he allowed the stock market to boom right into 2000, even though he worried about a bubble in the stock markets as early as 1996. China's supply of manufactured goods at low prices helped to keep inflation low, and enabled America to continue to grow with unemployment rates well below that specified by the Non-Accelerating Inflation Rate of Unemployment (NAIRU). On the demand side, the wealth effect created by the stock market boom enabled consumers to keep spending so that the economy could keep growing, which in turn allowed an increasing trade deficit with China. Thus Greenspan's stewardship ensured that America and China developed a stake in each other's well-being. Moreover, the case for globalization producing a prolonged period of deflation this time around is not compelling at all, since the resulting deflationary forces have been successfully managed for the last 15 years or so.

So why are several famous economists still warning against the dangers of a recurrence of the Great Depression? Depending on their preferences, these economists are either advocating inflationary monetary expansion, or huge fiscal spending to the extend that the budget deficit next year could be a trillion dollars. These are in addition to the massive expansion of the Federal Reserve's balance sheet (from $900 billion to $2.3 trillion so far), the $700 billion TARP program, and the large scale off-balance sheet programs announced by the Fed and the government for rescuing financial corporations and buying all kinds of securities.

Well, it appears that a consensus has been developing among economists in the advanced industrial economies that by enacting massive fiscal spending programs, they could re-engineer entire economies of the West so as to shift their focus on manufacturing and construction, and possibly away from services. As Professor Paul Krugman put it in his recent New York Times column, Life Without Bubbles, "By selling more to other countries and spending more of our own income on U.S.-produced goods, we could get to full employment without a boom in either consumption or investment spending". Other famous economists like Professor Robert Shiller, Professor Nouriel Roubini, Professor Bradford DeLong and Professor Joseph Stiglitz have written articles expressing support for a massive fiscal spending program with the goal of maintaining full employment.

Well, there is some strength in this argument. Infrastructure is definitely crumbling in many parts of the United States. It would be appropriate to recall here that not long ago, a large bridge on an Interstate highway collapsed in Minnesota killing dozens of people. Schools, public libraries, courtrooms, police stations, airports, railway stations and other public buildings require upgrades urgently. Moreover, potholes have been springing on most public roads, and the local governments have only been doing patch-work on them for lack of funds. Similarly, the manufacturing industry has been languishing for several decades now. So there is definitely a case for upgrading infrastructure and reviving the manufacturing industry in the Western economies.

However, I should also point out that expending all the political capital that the left has won in the recent elections (for US President and US Congress) on a trillion dollar deficit spending program may not be the 'best bang for the buck' (to borrow Professor Stiglitz's lingo). At present, the most economic benefit that the United States can obtain is to recover its standing among the world nations by conducting its foreign policy with vastly improved diplomacy. In particular, spending the far less amount of $20 or $30 billion towards Millennial Development Goals and eradicating poverty would improve the goodwill for America around the world. As a result, America would obtain much better long-term economic benefits by spending just 2 or 3 percent of the trillion dollar deficit program.

(Dated: December 15, 2008. The following is the first part of the response to Professor Kenneth Rogoff's article, "Inflation is the lesser evil" on Project Syndicate)

Professor Kenneth Rogoff's previous article on Project Syndicate "Super-sizing the IMF is Wrong" seemed straight-forward to interpret. In contrast, the current article "Inflation is Now the Lesser Evil" is quite tricky, though it is difficult to say if this current article is as noteworthy a contribution as the previous one.

First of all, Professor Rogoff's argument that inflation is the lesser evil seems to be an exercise in real-politik. With the major oil-producing countries encountering a reverse-oil-shock, the advanced economies like US, Europe and Japan, seem to have successfully avoided the oil-shock of `73 and `79. This time it is the oil-producing countries that didn't quite have their act together. So, the oil-producing countries that were hostile to the US, like Iran and Venezuela, have been severely restricted. Among the emerging economies, China, India and Brazil have had to slow down their growth, in view of the worldwide economic crisis. Russia's attempt at flexing its muscles to lay claims to its former superpower status, by invading Georgia, have come a cropper because of its own sudden economic decline in the wake of the fall of oil prices from $147 a barrel of crude oil to $50. Japan has been mired in a state of anemic growth for many years now. Finally, though the European Union seems to be in a better position, at least on paper, to weather the economic crisis, its efforts to ward off the crisis have been undermined by regional political leaders, like Prime Minister Gordon Brown, who have been trying to obtain political mileage from this crisis.

In this scenario, where the rest of the world is not able to demonstrate sensible economic leadership, it appears that it would finally fall to the US to find a way through this crisis. When such a time comes, the rest of the world would forgive the US for having caused the crisis in the first place. This would restore the status-quo -- (i) China and Japan would continue to buy US securities and the stability of the dollar would be restored, (ii) highly intelligent people would keep immigrating to the United States to foster innovation and research, (iii) the rest of the world would see America as the leader in political and economic matters, etc. Thus inflating one's way out of one's debts does not appear to be a bad policy for the United States, since in due course of time, it would be able to compensate the rest of the world by providing leadership. This seems to be the line of reasoning followed by the advocates of inflation.

However, this exercise in real-politik is fraught with danger. One has to realize that inflating one's way out of one's debts could only be a stop-gap arrangement. Only long-tem economic growth would provide a sustainable solution for the current crisis. It is difficult to see how the United States alone can find the prospects for economic growth. Most of the economic value that has been lost in the stock markets and the financial markets have been concerned with innovation. What is going to replace innovation as a source of economic value? Would buying more time through inflationary policies help to find a replacement for innovation? The fact is that the kind of innovation that created economic value in recent decades has requires skills in math, science, technology and computer programming. The United States is lagging behind many countries on math and science scores at the high school level.

This is where taking to games of real-politik could back-fire. There is no free lunch. Tinkering with the global financial system to provide unilateral benefits to oneself could be seen as fraudulent behavior. One should keep in mind that the US occupation of Iraq was seen in many quarters in the rest of the world as flouting the rules and conventions of international relations. This led to a reduced standing for US foreign policy in international circles. With the new President-elect, there are renewed chances for mending these mis-steps and restoring the effectiveness of the foreign policy of the United States. Playing with inflation should not lead to another fiasco, this time on the economic front, just when the United States is trying to restore its credibility in the foreign policy front.

All in all, this does not look to be a crisis that can be solved through trillion dollar domestic spending, or through inflation, or through the attempts of the leftist economists to write their own history -- they have been claiming that the second phase of the financial crisis began with the fall of the Lehman Brothers in mid-September, and not with the mismanagement of Fannie Mae and Freddie Mac which led to their arbitrary takeover in early September. This is why I believe that Professor Rogoff's previous article, though simpler and more straight-forward, is the better contribution.