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Why deflation may help get us out of this crisis

Could it be that in this case a whiff of deflation may help us get out of the crisis?
/ Source: Business Week

Over the past 10 years we've been trained to treat deflation — an actual fall in prices, as shown in Wednesday's consumer price index release — as a horror to be avoided. Could it be that in this case a whiff of deflation may help us get out of the crisis?

We are in this mess, in part, because many workers have been hit by falling real wages since 2003. For example, the typical weekly earnings of a college graduate without an advanced degree, adjusted for inflation, dropped by 3.6 percent over the past five years, according to the Bureau of Labor Statistics. Another number: Sales occupations experienced a 4.6 percent decline in real pay. Those jobs, which are not subject to overseas competition, should mirror the vitality of the entire U.S. economy — but they didn't over the past five years.

Because pay was not keeping up with inflation, workers were forced to borrow and borrow some more. At the time, that didn't seem like a problem: Americans assumed the pay decline was only temporary because the economy seemed strong. But when real pay declined year after year after year, all of a sudden loans became an enormous burden.

But now the process is going in reverse. The latest CPI release, on Nov. 19, showed a 1 percent decline in prices in October, the largest one-month drop since at least 1947. To a large extent, this was driven by a decline in energy prices. However, core inflation — leaving out food and energy — was negative as well, as the price of clothing and motor vehicles fell. As a result, real wages jumped in October. Buying power increased, which benefits workers even as it hurts companies.

In the near future, we could see a string of very low consumer price increases or even declines, especially as home prices continue to fall. Shelter — owner-occupied housing, rental housing, and temporary housing, such as hotels — counts for fully one-third of the CPI. It takes time for the collapse in home prices to seep into the BLS measure of shelter prices, but as it does, consumer inflation will be dragged down with it. To put it another way, slowing inflation, or even deflation, may represent a normal response to excess supply in the housing, energy, and auto markets. With so many excess homes and cars out there, we would expect and hope that prices would fall to clear the markets.

As inflation falls, all of a sudden wages will go further. In 2007, wage and salary payments totalled some $6 trillion. If prices were to be 1 percent lower than expected, that would be equivalent to $60 billion in additional buying power. That could give a big shot to consumer spending.

So what's the problem with deflation? First, of course, businesses will eventually reduce wages. But that's not an easy process, and it takes time, so for now price deflation will increase borrowing power. Second, for companies with fixed-rate debt, price deflation makes the debt more onerous. That is, a fall in the price they can charge for their products lowers their revenues and makes it harder for them to make their loan payments. That's a real problem, but given that the focus of the financial crisis is in the housing sector, something that helps consumers may be beneficial on net.

Finally, deflation reduces the power of monetary policy to affect the economy. Even if the Fed cuts rates very low, companies may not be able to borrow if they expect the prices they charge to fall. With deflation, the "real interest rate" — the quoted interest rate minus the inflation rate — could stay high, no matter what the Fed does.

Under ordinary circumstances, this is a good reason to stay far away from deflation. However, the financial crisis has already reduced the ability of monetary policy to boost growth, which is why the Fed and Treasury have reacted with so many new programs. In today's world, a bit of deflation that boosts real wages may be the best way to get American households out of the hole.