Will the Fed's Fear of Deflation Lead to Rampant Inflation?

The financial pages these days it is easy to see that deflation is the major worry among the world's central bankers including the U.S. Federal Reserve.  The word "deflation" also turns up in articles and interviews with financial advisers.  The price of gold is down and few financial advisers are providing advice or strategies for dealing with inflation.

While there is no question that much of the world economy, including to some extent the U.S. economy and to a much greater extent the European economies, is suffering to some degree from deflation, there is an inflation time bomb lurking just over the horizon.

While I generally don't pay much attention to the doom and gloom concerns of Glenn Beck, I did find myself in full agreement with him this past Tuesday when, on the Sean Hannity show he made reference to the trillions of dollars worth of reserves the U.S. Federal Reserve and other Central Banks have been pumping into the world's banking system since the start of today's ongoing recession.

These trillions of dollars of reserves are new money created by central banks out of thin air and deposited into the world's banks.  While digitally created deposits, this money is basically no different than the massive amounts of paper money printed by the post World War I government in Germany.  The excessive printing of money by the German government resulted in  hyperinflation which led to the rise of Hitler and his Nazi party.

One other difference between the digital funds the world's central banks have deposited into banks and the paper money printed by the post World War I German Weimar Republic is that the digital funds are not circulating but are sitting on bank balance sheets as excess reserves.  So far banks have been hanging on to these funds and not loaning them out due to fear of another financial crises in which they might need these excess reserves to remain solvent.

While central banks intent at the start of the 2007-08 financial crisis was to shore up bank reserves with the injections, subsequent central bank efforts have been an attempt to increase the amount of money in circulation by providing banks with more money to lend.  However, banks have continued to remain cautious and have kept most of this new money as reserves.

The ongoing recession that has resulted from the financial crisis at the start of President Obama's term has been due to people being a fearful as the banks about a future crisis.  Just as the banks have kept the injected funds in reserve, people have been cautious about spending and have used much of their money to pay down debt and build up savings.  This has slowed the circulation of money which has led to fewer sales of goods and services.  This slow down in economic activity has led to layoffs and a reluctance to expand and hire more workers by employers.

This slowdown in the rate of spending by consumers has led to deflation which has prolonged the 2007-08 recession. Deflation is basically a reduction in the amount of money in the economy due to people hanging on to it rather than spending it.  They standard Keynesian policy response is to try to ignite some  inflation (the opposite of deflation).

According to a report on CNBC at the start of the financial crisis, the total amount of new money the world's central banks injected into banks as reserves exceeded the total amount of money in circulation in the world economy at that time.  Since then more money has been created and injected into bank reserves.

What central banks have been trying to do is get banks to move some of this money into the economies of their nations by loaning it out.  This injection of new money into circulation would result in some inflation which would off set or cancel out the deflation and get the world's economy moving and growing again.

However, the real problem is lack of confidence by consumers and business in the Obama Administration's tax and regulatory policies and fear that these will lead to another economic downturn.  In such a climate most people are being cautious and accumulating cash by cutting spending.

Creating money and putting it into the economy via the banking system is a traditional monetary tool for stimulating an ailing economy.  Central banks can also do the reverse and pull reserves out of the banking system which results in banks having less money to loan which forces economic growth to slow when the central bankers feel inflation is accelerating at to rapid a pace.  However, using monetary policy to stimulate or slow down an economy is not an exact science and considerable economic damage is frequently the result of these efforts.

The problem today is that if peoples confidence returns and banks respond by increasing lending there is the possibility that we will go from today's current deflation to rapidly increasing inflation.  If central banks stay focused on deflation and hesitate to act quickly, rampant inflation could result.  On the other hand, if central banks hit the monetary breaks too soon and too hard, the economy could fall back into a recession. 

Deflation and Wage Stickiness

In a recent article on HubPages, I described what deflation is and the two types of deflation which are generally referred to as good deflation and bad deflation. While I go into more detail in the HubPages article, basically the term good deflation refers to falling prices resulting from increases in worker productivity while so called bad deflation is the result of falling aggregate demand.

A major obstacle to combating a major deflation resulting from a fall in aggregate demand is the so called stickiness of wages. Minimum wage laws, union contracts, government mandates and regulations, etc. all combine to prevent wages from falling.

Unlike other prices which fall when aggregate demand declines, wages tend to remain the same. Of course, while individual wages tend to remain unchanged, employers’ wage costs do adjust as workers are laid off and employers are freed from having to pay those laid off employees.

While no one, including me, likes the idea of having their wages fall, market forces will force a new equilibrium some way and the most common way is layoffs (I didn’t like that either when it happened to me during the major downturn in the late 1980s).

Here is a simple example showing how reducing wages or laying workers off each achieve the same result.. A company employs ten people, with each one earning $10 per hour. The total hourly wage bill for the company is $100 (ten employees times $10 pay per hour = $100 per hour wage bill). Now, if business is such that the employer can only afford a total wage bill of $90 per hour they have two choices.

The first choice is to reduce everyone’s pay by $1 which makes the wage $9 per hour. Since $9 per hour times ten people equals $90 the employees’ wages have been reduced to what the employer can afford to pay. This is the free market response and is one of the assumptions behind Say’s Law (which states supply creates its own demand and was named after the nineteenth century French economist Jean Baptiste Say).

The second choice is the Keynesian solution (after the mid-twentieth century British economist John Maynard Keynes) which is to keep the wages at $10 per hour but lay off one worker thereby leaving nine workers each earning $10 which results in the same $90 per hour wage bill that the employer can afford to pay.

While the initial result for the employer is the same under each option, namely that the total wages paid fall to what employer can afford to pay, the second choice, keeping individual wages unchanged causes a couple of problems.

First of all, unemployed people lose their wages and are now forced to cut back even more on their consumption which further reduces aggregate demand. At the same time, workers who are still employed remain fearful of losing their jobs so they also choose to hold money rather than spending it which reduces aggregate demand some more.

Unemployed workers frequently cannot afford to make the payments on their mortgages, car loans, etc. and the defaults on these loans, coupled with the decline in values of the assets securing these loans cause problems for banks as the value of their assets decline leading them to pull back on making more loans.

Second, even though the laying off of workers reduces payrolls to the amount that employers can afford in the new declining business environment, keeping wages at current levels makes it too costly for employers to rehire the laid off workers or for new businesses to hire new workers.

This fear or reluctance on the part of employers towards expanding and hiring new workers becomes a vicious circle in which aggregate demand falls because unemployed workers can’t afford to buy things which, in turn, causes employers to decide not to expand and increase output by hiring more workers.

The solution to this problem is to try to reverse the decline in aggregate demand with so called stimulus spending in which the government pumps millions of dollars into the economy in an attempt to artificially stimulate aggregate demand. This was the policy, that was prescribed by John Maynard Keynes during the Great Depression of the 1930s and followed, without success, by President Franklin D. Roosevelt and his New Deal Administration.

Instead, the solution, which President Ronald Reagan employed in fighting the stagflation of the 1970s and early 1980s, is to concentrate on calming fears and enacting policies designed to stimulate aggregate supply. This policy has been successful in the past while the Keynesian policies have never worked.

Links to My Other Articles on This Topic:

The Real Cost of Paying Employees

Deflation - What It is and Why We are Worried About It

Combating Deflation - Option I The Keynesian Prescription