Seven Myths. Nay: Seven Follies (II)

9 gennaio 2009 michele boldrin

Let's look at the second myth. The one that lead BB&Co to cut the Fed Fund Rate to zero last month. Even Bob Lucas, I am told, approved of it. I do not: it is either useless or, most likely, damaging because of the expectations formation process it motivates.

2. Deflation causes persistent depression. Inflation leads to growth.

This is nothing else but the eternal “Phillips curve” or “output-inflation” trade-off myth, dressed in slightly different clothes. Almost four decades after this nonsense was debunked, first theoretically and then by the harsh realities of the 1970s, it still rules the minds of politicians and central bankers alike. Because the old evidence of stagflation and all that should be well known to the readers, let's focus on more recent episodes. But do keep in mind: there was high growth in the 1950s and 1960s, when inflation was very low, there was little growth in the 1970s and until 1982, when inflation was high. After that inflation became lower and lower, and growth resumed. In fact, average growth has been higher between 1992 and today than it was between 1982 and 1992, while the opposite is true for the average rate of inflation. True, never during this period of time we faced a negative growth rate of the Consumer Price Index, still the years during which the inflation rate was below 2% (1986, 1998, 2002) since the stagflation of the 1970s, are NOT years of particularly bad GNP growth, quite the opposite. Historical data are even more interesting: during the 1950s and 1960s, there were many years of very low and even negative inflation and even during that period, low inflation and deflation were not associated with depression. Where does the myth come from, then, apart for the unique episode of the 1929-1939 Great Depression?

Preachers of the deflation scare often mention Japan 1992-2003 as if its lack of economic growth was due to the “deflation spiral”. There was no deflation spiral in Japan: assets were inflated during the 1980s, and their values dropped remarkably between 1989 (which is roughly when the Nikkei picked) and 1996 (when the real estate market first bottomed out). Through ups and downs they never recovered since, and the Nikkei index is now at about 23% of where it was at its historical peak! Now, that was asset deflation on a monumental scale, still the Japanese do not seem to be starving, are they? The very same thing happened in the USA (and around the whole world) in recent months. Hence, we all have already had our major and most needed deflation: asset deflation! Hopefully, the deflation scaremongers are not claiming we need to inflate our assets back to where they were a year or two ago. That would be disastrous: this is an impossible goal and much damage would lie in the collateral effects of trying and failing.

During the same period, in fact after 1992 mostly, Japan also suffered of a relative mild consumer prices deflation, which consisted of near zero inflation for a number of years, with small negative numbers (-1.0% was the biggest, in 2001) during the years 1999-2002. Overall, between 1992 and 2002 the Japanese GDP deflator went from 100.1 to 92.3 (the CPI deflation was half this), while real per capita income grew from 3,878 to 4,244 (that’s about 9.5%) during the same decade. Nothing to write home about, especially when compared to the previous Japanese performances, but not the end of the world either. Most of continental Europe did only marginally better during the same period of time! What’s more important, as we now understand, Japanese low growth rates were not due to deflation and lack of demand but, instead, to lack of incentives for internal investments. Such lack of incentives was due to a crippled banking system where banks were artificially kept alive by allowing them to hoard liquidity beyond any reasonable level. But about this later. The interesting thing is that Japan experienced deflation also in 2003 (-0.8%), 2004 (-.3%), 2005 (-.1%), 2006 (-.3%) and very low inflation in 2007 (.3%). During those years, though, the growth rate of GNP was, respectively, -.3%, +2.7%, +2.95, +2.6% and +2.2%. In other words, Japanese CPI-deflation has continued after 2003, while income started growing again at a pretty substantial rate.

In other words: not only the Japanese experience was not one of major generalized deflation following a big asset deflation twice the size the one we have currently experienced; not only deflation was not associated to a long or even serious depression in Japan but, in fact, after the banking system had been cleansed the recent years of relatively "high" deflation were years or relatively "high" economic growth, whereas during the years before the banking system had been cleansed there was just less growth, not more deflation! More importantly, the Japanese deflation was NOT a spiral and that the country did not collapse. The dramatically negative growth rates we are either observing or expecting in the next few quarters may be due to a variety of bad things (including bad policies) but there is no evidence whatsoever to think they are due to the incipient “deflation”. A very similar analysis of a very similar story could be repeated for the HK experience post-1998, but I will spare the reader a boring repetition.

Given that the statistical and historical evidence does not suggest a correlation (let alone a causation) between CPI-deflation and economic depression, let us consider the two theoretical arguments that “inflation advocates” advance to support their theory and their policy prescriptions. The first is: in a deflationary environment consumers expect durable goods’ prices to drop further in the future, depressing current demand and leading to an even larger decrease in prices, which reinforces the deflationary expectations producing a dramatic downward spiral. Theoretically, this is possible under special circumstances of the kind leading to the existence of multiple equilibria due to search externalities. There are reasons to believe that the substantial public fear created by repeated announcements of disaster to come if this or that bailout plan is not approved - look forward to an Obama's replica of Bush's infamous televised address of September 24th, to push through his version of a "stimulus" package - coupled with the sense of panic that the adoption of exceptional monetary policy measures obviously induces, have created a situation that may be conducive to such bad equilibria. Hence, I cannot exclude such possibility but treat it as (bad) “policy induced”: thinking that the policies that have created the crisis will also get us out of it, is wishful thinking.

Such thinking also omits the fact, obvious to anyone facing pay-cuts or at least freezes, that in a deflationary environment aggregate wages and nominal incomes drop too. In other words, either the deflation scaremongers are asking us to believe that prices will drop but wages will not, so that real income will magically increase (but then: alleluja, let’s deflation rule as we have finally found the solution to all our problems!), or the story of the spiral seems unlikely to materialize even in theory. If you postpone your purchasing waiting for lower prices, you will have to do it with a lower income than today. If, to compensate for the lower expected income, you save some portion of today’s income, then things are fine because today you have actually invested, which is (for the arguments given here) exactly what we need to do. This does not reduce aggregate demand today: it simply changes its composition. The deflation scaremongers, at this point, can only argue that households keep billions of hundred-dollar bills under their mattresses: they do not, but someone else does thanks to the policy BB&Co have enacted (more on this later). In summary: either BB&GWB’s repeated fearful announcements have lead us to an “expectations driven multiple equilibrium environment” (in which case they must reverse their policies and stop talking so much) or the ‘spiral’ argument is nonsense. If the impact that deflation had was to lead us to more saving and investment and somewhat less consumption (which, to a certain extent, it does have) then it would be good, not bad, news.

All these hard facts notwithstanding, it is reasonable to argue that the housing market, both in the USA and in the EU, is in a very low activity state because most potential buyers are waiting to see how far prices will drop, which puts further downward pressure on housing prices, thereby aggravating somewhat needlessly the frequency of defaults. Creating demand for houses, and for durable goods such as cars, would then appear desirable. Desirable it is, but trickier it is also if we want to do it without causing much collateral damages. The reason is the following, which (trust me) is what BB has in mind in his good and benevolent days. He would like to make households believe the following: tomorrow there will be rampant inflation but nominal incomes will not grow, so better start purchasing durable goods now while we can. Once he succeeds in making households believe the above, he wants to make sure to also do the following: do not inflate, instead, as soon as people start purchasing houses and durable goods again, magically lift rates without them (consumers) realizing you are doing so. This way, they will keep spending/producing but there will not be inflation ... Does this sound to you a lot like the circus trick BB and his predecessor tried to perform between 2001 and 2006, breaking all the plates and even a bit of the glasses still standing in the cupboard as a result? Well, indeed: it is the same trick, the results of which we are all currently enjoying. This time, though, BB&Co will perform it right.

The second argument is more cynic: it says that we need to inflate away the debts we are unable to pay back. This is half impossible and half insane, based, as it is, on the idea that the creditors are “someone else” (the Chinese?) and “we” are the debtors. If this were the case, defaulting our debt commitments, like Argentinians have repeatedly done, would be good for us and bad for them at least in the short run - i.e. until the next time we need to borrow: check how those smart Argentinian cheaters are doing in the international financial markets these days! In any case, that is not the case because, today, “them” is “us”!

Imagine, in fact, how a successful form of generalized inflation would work: prices will increase and housing prices will stop falling and maybe rise a bit. The latter must be truly “a bit” and certainly not as much as the CPI will be growing because, as argued above, a realignment of relative prices is needed, healthy and unavoidable. If not, then all the talk about a housing-price bubble would be nonsense, in which case we may as well all go home. Further, a rise in nominal incomes (including wages) of about the same percentage as the CPI wages would be needed for the operation to make sense: if nominal incomes do not grow while the CPI does, we are in even worse troubles because real incomes would be falling and this, after the drop in wealth we have already experienced, would reduce demand even further and, most certainly, increase the rate of default on outstanding loans ... I hope this point is clear, because it is key.

Assume, then, that this inflationary miracle happens: all prices and wages increase of, say, 10% a year for the next two years, housing prices stabilize or raise of, say, 2% and output does not fall. What will happen to financial markets and to banks in particular? Banks, per se, may not care: they are owed nominal loans and owe nominal quantities to depositors and investors, hence as long as those nominal dollars come in from the borrowers the nominal dollars can go out to the lenders/depositors. But, and hereby lies the trap, those lenders are us and we are not as dumb when we act like lenders as we (apparently) are when we act like borrowers. Reason is: interest rates can adjust for inflation, and can do it real quick. Let’s not forget that most of those loans are ARMs, i.e. Adjustable Rate Mortgages, and that Libor, Euribor and all the rest will not sit still out there, should inflation reappear. At which point, you understand, we are back to square one: a 10% inflation implies a 10% increase in nominal rates, which will match the 10% increase in nominal incomes and the real situation of homeowners who are now having troubles to pay their debt will remain exactly the same!

Well, probably not exactly the same because, as we have learned from experience, inflation leads to unexpected and damaging changes in relative prices that lead to economic disruption that leads to, probably, less real income than otherwise. Thank lord that financial markets do not seem (until now) to believe that “BB the defaulter” will succeed: nominal interest rates are going down even in the long portion of the term structure, signaling that banks are taking all the cash he is pumping in, to hoard it and not to spend it. Should they start spending it, interest rates will spike up in a matter of weeks, and the whole mess would be even worse than it now is.
In summary: we needed huge asset deflation, and we have already got it with the drop in the value of houses and stock. To this long-needed asset deflation there will follow a mild CPI-deflation due, among other things, to the fact that the components of cost due to those assets are now lower. Both evidence and theory suggest that such a mild deflation, per-se, does not cause a 'spiral' or a depression as it simply brings about a realignment in relative prices that seems highly needed. If a depression comes, experience shows, it is because the banking system and financial markets remain "clogged" and not operational. This is where the attention of policy makers should focus, not on deflation.

Further, should the "inflationary plan" that BB and associates are advocating succeed, we would be worse not better off than we are now, as we would just have stagflation instead of just a deep recession. Finally, there is the expectation-formation component of current monetary and fiscal policies, i.e. the fact that by looking at a government and a Federal Reserve that are scrambling to take extreme actions, private agents will (reasonably) interpret such actions as a sign that the "government knows something we do not know, and that something is really bad", hence sell those stocks and cut down investment plans because the end of the world is coming. It might, but if it should I will argue BB&Co have brought it upon us.

17 commenti (espandi tutti)

PREMESSA:

Abitando a Milano e conoscendo diversi giapponesi (e non avendoli visti morire di fame agli angoli delle strade ai tempi) mi aspettavo un'analisi della situazione attuale che partisse dallo studio di quella giapponese, sui quotidiani o in televisione.Invece tranne vaghi accenni non ho trovato nulla quindi volevo ringraziarti (anche per la mail di prima di Natale, sono io "il folle" che ti ha scritto chiedendoti della P2).

DOMANDA:

If a depression comes, experience shows, it is because the banking system and financial markets remain "clogged" and not operational

Questa tua affermazione ed in generale il post mi hanno spaventato molto. Non solo per la situazione che prospettano ma perchè tutti sembrerebbero convinti della bontà di questo Mith/Follie ...so the question is:

In your opinion are they really to blind to see or they see, but they prefer not to "touch" (or they know they cannot touch) the banking system and so they're searching for alternative strategies?

 


anche per la mail di prima di Natale, sono io "il folle" che ti ha scritto chiedendoti della P2

E non ti ho mai risposto! Non mi sembrava folle, anche se la tesi centrale era un po' ardita ... ora vi rispondo, privatamente ;-)

grazie.

Vengo all'altra domanda difficile che fai (hai un vizietto, tu!):

In your opinion are they really to blind to see or they see, but they prefer not to "touch" (or they know they cannot touch) the banking system and so they're searching for alternative strategies?

Mah, who knows? Siamo tutti prigionieri delle nostre teorie e dei fatti che ci sembra di vedere o di come li interpretiamo. Siamo inoltre prigionieri, e questo e' ancora piu' importante, dei vested interests che difendiamo ed a cui apparteniamo. Sul sistema bancario non ho dubbi: le banche centrali di quasi tutti i paesi sono "captive" delle loro banche nazionali. Su questo tema intendo ritornare in uno dei miti (il numero VI) quindi per ora passo :-)

In general, it is clear that:

- Central banks are captured by the financial/banking industry, hence they are too concerned with the failure of banks and less with the fact that allowing a "shakeout" of the banking system worldwide may, at the end, be beneficial. This, again, is the theme of myth VI.

- Governments are concerned with unemployment and so on, hence they try desperately to keep firms alive, even firms that should die (e.g. Detroit's Big3). My view is, in one line, the following: let bad firms die and spend the money you are spending in keeping them alive to provide unemployed workers with insurance and easing the process of finding new jobs. If public spending we need, I favor providing insurance over providing bailouts.

- Economists and experts in general are ... debating. Let's just leave it at that.

I am sorry I scared you, as I am actually trying to do the opposite. I am trying to say that there is a recession, but it is not the end of the world and deflation is neither. There are too many doctor dooms trying to get publicity by preaching fear and the obvious. We do not need that.

 

Central banks are captured by the financial/banking industry, hence they are too concerned with the failure of banks

In Ireland (substitute "central banks" with "banking regulators") they are starting to realize that, and to look into possible fixes.

Talking about bailing out the Detroit Big Three, today's NYT had a small article hidden in the Business Section that examines GM's situation. It turns out that the government's rescue package for GM has "a requirement that the automaker demonstrate a plan for achieving a positive net present value."

The author then makes some quick back of the envelope calculations that show that even under fairly rosy scenarios it is difficult to come up with a positive present value going forward. Hence, the article concludes,

even tough action [by GM: i.e., deep cost cuts, debt restructuring and union concessions] may not persuade the government that G.M. is sound enough to escape bankruptcy.

...Not as flashy as Paul Krugman's articles, but very illuminating!

If you postpone your purchasing waiting for lower prices, you will have to do it with a lower income than today.

I disagree with the reasoning inplicit in the above statement regarding expensive durable goods payed out of savings (cars, real estates). If prices are expected to drop, and one has savings available for purchasing, a deflationary environment would advise to postpone purchases, in my opinion.  Actually, what should really matter is the difference between how saved assets (are expected to) increase in value (according to how they are invested) and how desided durable goods (are expected to) increase in price, all nominally. If one assumes that the naive consumer expects his savings to be constant in nominal value (put under the mattress) then an inflationary environment advises to purchase durable goods out of savings while a deflationary environment advises to postpone.

There is one other argument used by (moderate) inflation advocates that is missing in your post, unless I missed it.  Especially in period of crisis, but actually always, there is need to adjust salaries up and down according to demand, productivity, competition, etc.  But while there is strong psychological resistance in accepting nominal salary cuts, constant salaries in presence of inflation (of order 3%) are considered psychologically more acceptable to impose.  Therefore inflation permits more psychologically acceptable real salaries reductions in response to changes in the economy.

If one assumes that the naive consumer expects his savings to be constant in nominal value (put under the mattress) then an inflationary environment advises to purchase durable goods out of savings while a deflationary environment advises to postpone.

Agree. Which is the case considered, in fact (I say "The deflation scaremongers, at this point, can only argue that households keep billions of hundred-dollar bills under their mattresses: they do not, but someone else does thanks to the policy BB&Co have enacted (more on this later). Etc ..."). I agree that that is the incentive, but unless people literally keep money under the mattress, which they do not, saving will turn into investment IF and WHEN the financial system functions, i.e. if and when banks lend. Should that be the case, you have the following: demand for consumption decreases and demand for productive investment increases, in a deflationary environment, leading to a change in relative prices. If the banks do not lend we have the problem. But the problem is the banks, not deflation, which is what I argue.

There is one other argument used by (moderate) inflation advocates that is missing in your post, unless I missed it.  Especially in period of crisis, but actually always, there is need to adjust salaries up and down according to demand, productivity, competition, etc.

Agree as well. I mentioned that too, but only in passing. Reason is that, right now, very few people if any argue the problem is that real wage are too high (but maybe it is, why not?) and should be reduced via inflation. I frankly doubt the problem to be too high real wages as, apparently, the whole mess originated with the fact that nominal wages were too low relative to the price of houses and the size of mortgages, so people stopped paying the mortgages. Put differently, measured in units of houses, real wages were too low. Now they have increased (prices of houses down, nominal incomes roughly constant). Hence, a general inflation in goods (not accompanied by inflation in nominal incomes) would reduce real wages when measured in goods other than houses. Is this what is needed? Maybe, but I cannot see the logic though.

In any case, the real problem is: assume you get inflation. How do you prevent nominal incomes from adjusting and nominal interest rates to do the same, leading to the inflationary spiral? That, to me, is the issue.  Thanks.

If I understand well the underlying hypotheses of the article are the following (in chronological order):
1)    deflation (whatever the cause) lowers consumption, which in turn gives rise to higher savings.
2)    the financial system works as it should.
3)    savings and investments go hand in hand (unless the consumer put his savings under his bed).

If all the above hypotheses are correct then the conclusion is that lower consumption expenditure is compensated by higher investment expenditure. Deflation is not an issue!

But since the financial system is in a shambles, we need to put the financial system back to work: “fix the financial system and that’s it”.

Hypothesis 1 (H1) is not controversial.
I agree that H2 is part of the problem but what to do about it is the most challenging task. 
However, I totally disagree with H3. It is a leap of faith to assume that higher savings automatically translate into higher investments. Firms do not invest simply because money is abundant on the capital markets (which is a necessary condition by the way) or cheap (which is the current situation). Firms plan their investments if they foresee new opportunities. I don’t see how firms can be optimistic in a deflationary environment and how banks should be enthusiast about lending when opportunities are scarce.

However, I totally disagree with H3. It is a leap of faith to assume that higher savings automatically translate into higher investments. Firms do not invest simply because money is abundant on the capital markets (which is a necessary condition by the way) or cheap (which is the current situation). Firms plan their investments if they foresee new opportunities. I don’t see how firms can be optimistic in a deflationary environment and how banks should be enthusiast about lending when opportunities are scarce.

Francesco, thanks. Your observation goes to the core of the problem, so let me anticipate some stuff I was planning to discuss in the future and try discussing the important issues you raise.

Your main point is correct, in the sense that firms' demand for investment may be particularly low due to expectations of a low demand for their goods. In fact, this is certainly the case in the construction sector and related sectors. It is also the case for various durable goods, cars in particular, which is why we have entered a recession. I would like to make clear that THIS fact I accept: we are in a recession for the reasons we all know. Recession means, among other things, that a number of firms will close or scale down and factors of production will have to find different activities to be invested in. I am not trying to deny this fact, I agree.

The issue is: does low inflation or deflation make the recession worse? That is less obvious. On the one hand, I agree, it may lower demand for consumption and increase savings, the effect of which I discuss below. You point to a second effect: firms may decide to postpone investments or cancel them altogether because deflation leads consumers to postpone demand that would be there otherwise. This I doubt, because deflation does not mean also lower selling prices but also lower costs of production. Hence we are back to the argument developed in the main text. As I said, theoretically there are circumstances in which this may happen ("bad expectational equilibrium") and if we are in one of those (rare) situations then fine, you are correct.

As I am suggesting, I also have that doubt and I believe there is an expectational problem. But, then, the problem becomes: how do we turn around those expectations? On the one hand, historical experience does not suggest this happens all that often nor it shows that, when it happens, it takes the form of a dramatic downward spiral. On the other hand, do we really believe that setting the fed funds rate to zero will reverse those expectations? For the reasons I said in the main text, I doubt this is the case. Again, if the issue is "expectations", then we should be focusing on the causes of these negative expectations, which current policy does not seem to be doing. Policy seems to focus only on deflation and seems also to be creating furthe panic of a "deflation spiral", which is insane. Because the prices of a large number of assets dropped and because the prices of many goods were too high (due to prices of assets that were too high) some prices will have to drop. Hence, lower inflation or mild deflation is unavoidable, and even healthy I would say. The problem, as I argue below, is to funnel savings/investments to the production of goods that people want to buy at profitable prices. If there is an expectational problem, it is there!

Now, let's get to the saving that deflation "creates" and see if this is damaging. Also here, I agree with you that the problem is: are financial markets, i.e. banks, working properly? The answer seems to be: no, they are not. But then, again, the problem is banks and financial markets hence, we should ask again, does the zero fed funds rate help to make banks work properly? Is deflation the reason banks are not working properly? Asset deflation certainly IS one reason, but that has already happened and there is nothing we can do with it: if it had not happened there would be no crisis to begin with ...

Back to saving. Saving by households must turn into investment or public demand for goods, unless either households keep their saving in form of fiat money stashed at home - of which there is no evidence so far (i.e. there is no evidence that the amount of outstanding cash is dropping and that people are withdrawing cash from banks to keep it home) - or banks stop lending and pile up excess reserves - which is instead what is happening. Short of this, there is no alternative.

Income that is not saved must either be left in the bank, as a deposit, or turned into some financial instrument. This either increases the demand for Treasury securities or that for private securities. In the first case households' saving is financing public expenditure, which is demand for goods and services. In the second case the households are providing firms directly with funds, which either leads to an increase in the stock prices (if households buy stocks directly, which does not seem to be a massive phenomenon these days) or makes it easier for firms to raise debt. Now, obviously, it is possible that firms do not use these resources and just pile up cash without spending it. But, again, I do not believe there is any evidence that this is the case. Will get back to this in future myths.

Further, and more important: the recession is due to the fact that lots of PREVIOUS investments have gone wrong, hence they were wasted. That's why we are all poorer than we (thought we) were and that's why there is a recession. Those wrong investments, are bygones, they are lost. In order to grow again we MUST invest in new activities, hopefully in activities that will produce goods people would like to buy at reasonable prices, not houses that nobody wants. Do we agree on this?

If we agree on these two points (i.e. (1) a piece of the old K is worthless, so productive capital is now K'<<K; and, (2) we need to build up new and better capital to produce new goods) then saving is useful and necessary because we need resources to finance these new and better investments. I agree that, for those investments to take place, new firms must be born or old firms must find products that people like. Nobody has the magic wand here, so nobody know WHICH goods will be worth producing. What is certain is that, IF someone finds those goods and believes it is the case to invest to produce them, this someone will need funds, i.e. savings. Further, whoever is trying to purchase these goods and carry out these investments will look at deflation with mixed feelings. On the one hand, it is true, it may lower the market price of the goods they are selling but, on the other, it makes the land they purchase and the equipment and materials they need cheaper. It is not obvious that, overall, the final effect will be negative: it depends upon which prices will drop more or grow less. Again, deflation per-se is not the problem for these people, the change in relative prices and the availability of savings that can be invested is. That's the way I see it.

Those wrong investments, are bygones, they are lost. In order to grow again we MUST invest in new activities, hopefully in activities that will produce goods people would like to buy at reasonable prices, not houses that nobody wants. Do we agree on this?

I definitively agree on those two points.

Further, whoever is trying to purchase these goods and carry out these investments will look at deflation with mixed feelings. On the one hand, it is true, it may lower the market price of the goods they are selling but, on the other, it makes the land they purchase and the equipment and materials they need cheaper. It is not obvious that, overall, the final effect will be negative: it depends upon which prices will drop more or grow less. Again, deflation per-se is not the problem for these people, the change in relative prices and the availability of savings that can be invested is. That's the way I see it.

I think that in a recession deflation and inflation have not the same consequences.
It seems that we agree on the psychological side of the story: with deflation consumers hold their fire, spend less and save more. This worsens the recession. Now  let us concentrate on firms. You say that under deflation firms face two opposing effects: a) lower output prices,  and b) lower input prices. I totally agree. On average, and without considering the varying degree of competition in those markets, there are winners and losers. But, I add, the overall cash flows stays the same  whether deflation or inflation (because of recession cash flow is of course lower than in a boom). So the average effect of deflation (or inflation) on firms’ expenditure should be neutral at best. But here is the catch, there are rigidities and anomalies in the system that make deflation a haunting presence during a recession. First anomaly: salaries and wage are less flexible than prices, so during a deflation output and input prices decline but not the price of the most important input of all, labour. Thus understood, cash flows during a deflation shrink most often than not (this does not happen with inflation). Second anomaly, both consumers and firms have debt, with a significant part that is fixed. Deflation makes debt more expensive if interest rates are fixed (e.g., 25% of mortgages and 100% of the US corporate bond index by the now defunct Lehman Bros), while it has a neutral effect at best for those debts with floating and adjustable interest rates. So deflation had another negative dimension. A dissenter would say that debtors’ losses are exactly compensated by creditors’ gains. But here we have another catch, while the total credit in the system matches the total amount of debts (for now I assume that the international investment position of the economy is zero) creditors are more concentrated or less dispersed than debtors, making the depressing effect on debt more widespread than the galvanizing effect on fewer creditors.

To sum up,
1) with deflation the screwed up psychology of  consumers depresses their consumption expenditure and gives an option value to their wait-and-see posture. But we have more savings and higher real wages, with less employment because of recession.
2) with deflation there are winners and losers among firms, the overall effect of deflation in term of cash flow is neutral at best. But deflation and wage rigidities make more likely a negative effect on cash flows, at least for a while. This is less likely in the US than in Europe, but still wage rigidities matter.
3) with deflation, debts with fixed interest rates (which is not a trifling amount) become more expensive, with a further depressing effect on top of the ongoing recession. Even if total liabilities equal total assets, debtors are more numerous than creditors (i.e., assets are more concentrated).

In the best case scenario deflation/inflation should not matter. In the worst case scenario, deflation depresses the recession even further. Why to risk then? 

And so far neither Phillips curves nor adaptive expectations have been taken into account. My feeling is that deflation is not the mirror image of inflation for psychological and balance sheet reasons. Deflation+recession hurts more than inflation+recession.

and one has savings available for purchasing

A big if, in these times and in the countries that are most affected by the financial crisis (USA / UK).

I have not read about it in a while but IIRC it goes like this: In a deflationary environment the entrepreneurs' debt burden is increased (in real terms) and they go broke, worsening the depression/deflation.

And in an inflationary environment, with fix rates, ... the lenders go broke!

Whereas, with adjustable rates, the situation is the same as now:

Assume, then, that this inflationary miracle happens: all prices and wages increase of, say, 10% a year for the next two years, housing prices stabilize or raise of, say, 2% and output does not fall. What will happen to financial markets and to banks in particular? Banks, per se, may not care: they are owed nominal loans and owe nominal quantities to depositors and investors, hence as long as those nominal dollars come in from the borrowers the nominal dollars can go out to the lenders/depositors. But, and hereby lies the trap, those lenders are us and we are not as dumb when we act like lenders as we (apparently) are when we act like borrowers. Reason is: interest rates can adjust for inflation, and can do it real quick. Let’s not forget that most of those loans are ARMs, i.e. Adjustable Rate Mortgages, and that Libor, Euribor and all the rest will not sit still out there, should inflation reappear. At which point, you understand, we are back to square one: a 10% inflation implies a 10% increase in nominal rates, which will match the 10% increase in nominal incomes and the real situation of homeowners who are now having troubles to pay their debt will remain exactly the same!

Actually, in a deflationary environment you can go to your lender and recontract the value of the loan, which is what lots of people in the US are doing ... Banks are getting the point (partially: Citibank, for example, is willing to re-contract on your mortgage's principal only after you skip a few payments! Talk about incentives! Who said that bankers know what they are doing and that's why the deserve the big salaries they earn?) and that's what you would expect. Note that, in the case of houses, the deflation has already happened and that's why, in fact, lots of people decided to default: they were upside down. The bubble we had before, that was "inflation", local, but inflation.

To put it differently: there is no monetary solution to real problems.

and that Libor, Euribor and all the rest will not sit still out there, should inflation reappear

ONLY IF governments will source the funds necessary for reflating the economy by issuing debt instruments. Should they decide that their interests are aligned to the debtors' (a category to which in the West they do belong, in part by owing trillions to people they don't even claim to represent, such as Asian sovereign and private investors), and starts printing money, then the real interest rates might well be driven into negative territory for an extended period of time. It happened already, when Nixon on August 15, 1971 shut the gold window "to defend the dollar agaist the speculators" (ha ha!) and those sneaky unpatriotic types who weren't buying American products -- also stung with an extra 10% tariff for good measure.

Of course, the foreign governments did not stay idle and started monetizing their debt as well, and we all got the wonderful seventies.

So, why couldn't it happen now?

Wondering what I mean when I say that the Federal Reserve System is de facto captured by the banking sector and by Wall Street, which it should instead oversee? I mean things like this.

We will now have as President of the most important Fed in the country the "architect" of a failure (how else to label the central bank's response to the financial crisis?) and as a Secretary of the Treasury his former boss that approved and implemented the failed strategy (while he was busy making "innocent mistakes" with the IRS).

You may also want to keep in mind that Dudley

resigned as chief U.S. economist at Goldman Sachs in October 2005. He remained with the New York-based firm, which he joined in 1986, as a consultant and co-chair of the group that oversees the firm’s retirement-fund assets.

Apparently he has been at the Fed only since January 2007, hence my early claim that he was sitting for a year and a half on a conflict of interest was incorrect  (the Bloomberg release was ambiguous, and I interpreted it wrong. Apologies. ) On the other hand, this suggests that a person that has been in the Fed system for only two years, with a whole career in the investment banking sector is now running the most important Fed. One should not be surprised, then, if his preferences, models of the world, value system and goals allign all quite well with those of the industry he should instead oversee. The world "capture", I should stress, does not mean "corruption", or "in the pocket": quite the opposite. It refers to the fact that through mechanisms such as these the regulator progressively sees the world more and more through the glasses of the regulated. Because regulatory activity is highly judgmental and requiring an enourmeous amount of independence, clear critical thinking and "orthogonality" of interests, capture is unambiguously bad. 

Wondering how he was picked to replace Geithner? Here you go:

Stephen Friedman, a former Goldman Sachs chairman who was also director of the National Economic Council from 2002 to 2004, headed the panel to find a successor to Geithner, 47.

Not good omens for the future, I guess. This is what happens when regulators are captured by the special interests they are supposed to regulate and independently monitor.

In case you were wondering what the bailout money going to banks was being used for, here's one of its main uses (other socially valuable uses include keeping the regular managerial salaries up, redoing the interior decoration, purchasing the assets of a few loosers who did not get bailed out, and so on ...).

Let's look at the silverlining: if they consume it, maybe it provide a "stimulus" ...

Even Paul gets it right, sometimes ...

Frankly: let's nationalize the banks. I am serious: given the circumstances and the choices the two administrations have made, let's nationalize them all and manage them for a year or two. Then we can sell them off, in tranches, to the best buyers. They will come, the buyers. Maybe from China or Dubai, or even Europe, but they will come.

Oh, you're saying the banks are a strategic asset? Like nuclear bombs you mean? I see ...

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