Is the risk of deflation real?

Great Debates
1

Caveat: I am not an economist.

CNN/Money report regarding the Federal Reserve Board and the strategy of reducing the federal funds rate in order to “stimulate the economy”: http://money.cnn.com/2003/07/23/news/economy/fed_bernanke.reut/index.htm . There have been a host of similar reports and remarks over the past 6 months. Virtually all of the quoted real economists warn of the catastrophic ramifications of a deflationary spiral. I grok their explanations - modern Japan and Weimar Germany are proof enough.

What I’d like to throw on the table is my gut-sense that the stock market, upon which most pundits and politicians alike hang their eco-prognostication hats, has virtually nothing to do with formal economic theory. Marketeers resemble to me nothing so much as a flock of starlings wheeling randomly across the skies that changes directions because somebody up front saw something shiny.

With the collective tightening of consumers’ belts, and the ample evidence that it has been the consumer alone that has propped up the U.S. economy for the past 3 years, I submit that the combination of a decrease in consumer prices and the pride that our conspicuously consumptive society takes in bargain-hunting and “bang for your buck” (see: WalMart, Target, and every other place my wife and I shop) ** would actually increase consumer spending and provide an immediate kick** (in the short term, mind you, which is precisely what the supply siders in the White House have been groping for) to the economy.

I also believe there would be a subsequent renewal of confidence in financial markets based on increased consumer spending, which would be tantamount to showing the aforementioned flock of starlings a shiny silver dollar.

Are there any economists out there who have tried to account for mass psychology, or are they all married to their models?

2

Basically, the whole profession of “economist” is a sham. Look at the high-tech boom of 2 years ago. Everyone was talking about the “New Economy” where profit doesnt matter, only market capitalization, etc. Serious, educated people predicted that the Dow would soar forever as the internet changed everything. And other serious , educated people believed it all. This was MASSIVE stupidity, by tens of thousands of educated bankers and loan officers, corporate execs, etc. I can understand why the man in the street jumped on the bandwagon,–but the band was being led by “expert economists” who freely lent millions of dollars to pets.com and other stupid ideas.

And how about the daily news from the markets "The Yen rose yesterday after , say Hans Blix’s report to the UN was less critical than expected. OR -“the Dow rose dramatically yesterday on the news of the resignation of the Italian prime minister”

these fluctuations are PURELY psychological, and have no basis in reality, or scientific mathematical models.

So-dont believe a word of anything an “Economist” predicts.

3

Uh, first of all, economists did not start dot.coms, entrepeneurs did. Economists did not make loans, bankers and venture capitalists did. Economists did not come up with the idea of exploiting the internet, nerds did.

You’re overlooking the widely-reported view of the chief economist of the United States, Alan Greenspan, as delivered in a speech on December 5, 1996: “But how do we know when irrational exuberance has unduly escalated asset values. We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability… But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy.”

Translation: pumped-up stock prices were a threat to the economy.

4

I am not an economist, either, but my understanding is that in Weimar Germany, the main monetary problem was not the brief period of deflation – which lasted a couple of months, if I remember right – but the incredible inflation thereafter.

I’m trying to piece together the strings in the OP, but let me just respond to the last point. I think economists like Keynes placed great value on the demand side of the economic equasion - you might want to label it mass psychology - so that economic slumps were pretty much attributable to slumps in demand.

And I’m not so sure that I understand what you mean by “married to one’s model.” You seem to be putting forth your own model on how you think the economy is performing.

5

Well, I’ve got a degree or two in the field. Here’s what I’ll tell you: economics is the study of mass psychology. It’s the whole point. The model of the “rational consumer” is what professors tell undergrads in macro-econ 101, actual economists trying to make forecasts are ultimately trying to answer the question “how will consumers and producers behave in the future?” Psychology has always played a vital role in answering these questions, since consumers behave in ways that they believe are in their best interests, rather than ways that actually are, or in ways economists think people ought to behave. If you want cites, pick up any published peer-reviewed economic journal.

Now, you seem to be positing your own model. “Decreased prices for consumer goods will increase the quantity of goods demanded/consumed.” If you think you’ve come up with some great revelation here, you need to crack open a macroeconomics textbook. The first question we’ve got to ask ourselves though regards price elasticity of demand. How much more goods will we demand at lower price levels? Then there are plenty of other questions… for example, are the price levels well below break-even points, and only artificially at such levels so as to shed unwanted excess inventory? I’ll leave the rest to the much better economists on this board that actually work in the field.

Or are you more interested in the consequences of prolonged deflation?

chappachula, I presume when you say “everyone” you mean those guys you heard on TV? Or have you got a nice handful of academic journal citations you’d like to provide?

6

Desdinova - thanks for the macro clarification. For some reason always got the impression that econ theory was more statistical and less normative.

Also, “married to a model” not intended as a slight. Simply an acknowledgement that experts within a given academic field develop a certain amount of inertia, often inhibiting their theoritical flexibility. Not good, not bad, just a natural by-product of expertise. The best academics are those that acknowledge their biases.

Clarification of the question is warranted now that folks have weighed in:

Is it possible that economic policy-makers on a federal level are devoting too much attention to the supply side when evidence over the course of the economic downturn would indicate is that in actuality the demand side is suffering (i.e. bailing out failing corporations is a less effective near-term remedy than enhancing the buying power of the consumer)?

7

Certainly an impression you’d get from your standard factoid based economists you see on television (and the radio, newspapers, etc). The truth of the matter is it’s a huge field, and pinning 'em down to a single “econ theory” is sort of like saying “psychology theory says that…” Once it’s all said and done, though, econometrics is only trying to support or debunk normative theories. If it doesn’t somehow tell us something about how consumers and producers actually behave in the real world, it’s nothing more than mathematical gymnastics.

**

. Absolutely. And the whole purpose of peer review and new research and econometric testing and everything else is to find those biases and, well, things that just ain’t so. Unfortunately this is entirely outside of the realm of the guys that give snippets of discussion on talk shows. Which isn’t to say that they’re necessarily completely wrong, or unqualified (many are highly respected economists from ivy league institutions) but rather that it’s difficult to say anything of value in the field of economics in 15 seconds, the same as a psychologist can’t really sum up a diagnosis of a patient with “he’s nuts and he needs to stop living in the past.” What people want to hear, though, is “Bush’s tax cuts are a bad idea” or “the stock market will turn around in the next month” or “we need to jack up our tariffs 500% to protect ourselves from cheap foreign labor.”

I assure you that whatever biases you can think of, and for that matter your entire OP, has been discussed to death by economists in pretty much every major university in the nation and every relevant academic journal.

First, some things ought to be cleared up. You may want to rethink your definitions of “supply side” and “demand side” before you go much further. The impressions you may have gotten from the popular media as to what “supply side economics” is are probably contrary to how they’re used in the field. “Supply side” != “tax cuts”

That being said, my own opinion is that given consumer savings rates that are still extraordinarily low (I can’t find the specific cite right now, but I’m sure it comes from the Bureau of Economic Analysis) we’re actually not paying enough attention to the supply side. The basic argument is this: we’re in a world economy, right? It’s not as if we have to personally consume everything we produce. What’s stopping us from concentrating on producing stuff we’re good at producing and other countries want, and exporting it elsewhere? This does not, of course, necessarily mean that we need to bail out failing industries… nor does it mean that aggregate demand stimulants are necessarily a “bad thing.”

Now, if the goal is only short term benefit, with no regard for the long term consequences, massive tax cuts and increased domestic federal spending would probably be an excellent start.

8

Greenspan is the head of the Federal Reserve, and while yes he is trained in economics, the Chair of the Fed is a central banker first, not head economist. Different roles.

9

I believe you are probably thinking of something like the emerging field of “behavioural economics”, see this little page for a convienent set of articles: http://www.tricity.wsu.edu/~achaudh/econ485.html

So the answer is yes indeed, and there is even a specific field attempting to integrate new observations in social sciences into economic frameworks.

10

I’m not sure that this “clarification” clarifies anything. The thrust of government economic policy in the current recession has been low interest rates and tax cuts, both of which “enhance the buying power of consumers”. I’m not aware of any emphasis on “bailing out failing corporations”, other than perhaps the airlines. If somebody has been trying to bail out corporations, they haven’t been very successful, because there have been an awful lot of bankruptcies.

Personally, I thought you had a good subject for debate in the title of the thread: Is the risk of deflation real? (In my opinion, no, but there are worthy arguments on both sides.) Your posts, however, seem to address everything but that question.

11

What I’ve seen that relates to the OP - and maybe this will get a real debate on the actual subject started - is the contention that China is giving us huge competition on the manufacturing side, and India on the services side, so that you have a massive “wave of deflation” coming out of these two countries as a result of their rapid development.
The other contention I’ve seen is that the bubble resulted in massive overinvestment in capital equipment that needs to be worked off, and that this will hold prices down. I’m at work, so I can’t search for the relevant cites, but these are the things I remember seeing in different articles re the current situation from those who think deflation is a danger.
Stephen Roach of Morgan Stanley is the one who advanced the “China Theory”, IIRC.