"When the accumulation of wealth is no longer of high social importance, there will be great changes in the code of morals.
We shall be able to rid ourselves of many of the pseudo-moral principles which have hag-ridden us for two hundred years, by which we have exalted some of the most distasteful of human qualities into the position of the highest virtues"

( JM Keynes, "Economic Possibilities for our Granchildren" 1930 )

Sunday, October 24, 2010

Who is Afraid from Deflation??

For many decades economists and policy makers have labeled inflation as the main threat to stability and growth. Accordingly, policies were designed and applied to fight that threat, even when the Big War meant sacrificing other policy goals such as employment. However, the last recession revived the threat of deflation (Generalized decline of prices), until such a point that the “D” word has replaced the “I” word as the main enemy for the economy.

How it comes that Deflation turned to be the new economic “Ghost”? Mainstream economists and media offer various explanations for sudden shift in their attention, some of them to be exposed hereinafter.

The First of all , almost everyone point to the “Japanese Ghost”, a living example of a country that fell into a low growth trap following the bust of an immense asset bubble ( AKA “Lost decades”). That trap was accompanied with a steady decline of prices products and assets as well. Japanese Govt. tried to fight the recession with the accepted medicines ( public debts, lower interest rates) with limited success. The Ghostbuster replies: “True, Japanese ghost hit assets owners quite a bit ( Nikkei is still 35% from its peak in 1990) but unemployment rarely passed the 6% ,a figure unemployed American can only dream about. Anyhow, despite the “calamities” Japan is still one of the most advanced countries in the world . From a methodological perspective, casualty does not mean causality, so the anemic growth can be attributed to other factors such as income distribution... or job security , just to name a few, while falling prices are in classical economics the result , not the cause of the real world. So where exactly is the Ghost?”

From Japan we turn into theoretical “Spiral Ghost”. That theory claims that falling prices induce people to postpone their purchases since the consumer expects to get a better deal later. Since consumption accounts for ap. 70% of the economy, lower consumption means lower sales, less production and more unemployment, pushing prices down in an endless spiral.The Ghostbuster replies :”Unfortunately that Ghost cannot live in the same room with basic economic theory. We were told from the first day in the University that when a price of a product falls, the quantity demanded for it increases (“The Demand Curve”), so deflation ironically should augment consumption, not depress it. The focus on “timing” of that argument is another evidence for shortsightedness and misunderstanding the importance of prices as a market mechanism to calibrate between needs and capabilities. If prices are too high,it´s about time to reduce prices ( and profits.... ) so we all can enjoy prosperity. Sorry I don´t see any ghost around”.

Others mention the “Real Interest” ghost. That argument is focused on investment and consumption and their relation to interest rates and it goes like this : If prices fall, than the real interest on debts goes up. Since nominal interest must be above zero, falling prices mean (G-d Forbid!), positive interest rates. Such rates would restrict consumption and investment, eventually deepening the recession. The ghostbuster, still unemployed and a bit frustrated replies “ The very same pundits have told us that the crisis was provoked by a low interest rates policy held for too long tha fed a consumption and financial orgy which ended in the actual disaster. Now the very same experts want to apply the same poison? And we will end in worst recession nightmare later on? Are these guys serious? In addition, who will invest when 30% of the production capacity is idle?. Next , please ….”

If the Ghosts named above are not so real what is the real motive behind the implacable fight against Deflation? Nobel Laurate P. Krugman was very precise when he explained his vision in favor of inflation ( = against deflation) in an article published two years ago in the NY Times titled “ The case for Inflation”

“It goes like this: even in the long run, it’s really, really hard to cut nominal wages. Yet when you have very low inflation, getting relative wages right would require that a significant number of workers take wage cuts. So having a somewhat higher inflation rate would lead to lower unemployment, not just temporarily, but on a sustained basis”. (NY Times, “The case for Inflation, February 2010)

We should thank Pr. Krugman for his honesty. What he says in simple words is that since accepted ( and contractual) employment conditions of working people are too difficult to overcome, the “solution” is to bypass that obstacle by eroding their purchasing power . Applying Krugman´s logic, if instead of inflation we get a small deflation, real wages will surge . So, if low inflation is the cure which reduces real wages ( his main concern!), than the Ghost is ...high wages! . Eureka! . As a side notePr. K “forgot” to tell us that lower wages imply by definition higher profits to corporations. Well, that is just a “detail”....

Our professor is not alone, as that sort of “analysis” follows a long academic tradition of associating economic crisis to “high wages” or “low productivity” to which the “cure” is self evident :Low wages encourage employers to hire personnel, and reduce unemployment rates. Such “theory” is another sad example of how the “micro” perspective depict a twisted macro picture of the whole economy.

Let me explain. Right ,from a perspective of a small company higher wages mean more costs and probably lower sales. However, a macro economist should ask not only how the stuff will be produced but who is going to buy it .... and if the mass consumer looses purchasing power due to depressed salaries and buy less, the real gain of the capitalist is a Pyrrhic victory..

So the real ghost that bothers policy makers is not Deflation per se but another “D” word, “D”istribution , the possibility that in some point working people can enjoy a bigger share of the global prosperity. Do workers earn “too much”? Well, even Professor Krugman knows that the wage share out of national income ( i.e. the part of the national wealth that goes to the working people) is in record low in historical terms. Conclusion: Working people do not earn too much, I would say that they even earn less than the necessary to absorb the products offered at current prices, and therefore Deflation might be a good step to recalibrate that anomaly.

As any observer knows, the game of Political Economy is also a zero sum game between Capital and Labor . That implies that any worsening of the Labor conditions implies an improvement for Capital.The evidences that the concern of policy makers in favor of Capital are so evident in their last policy debates and actions, that it cannot be avoided but we will leave that for the next post that will deal with the QE2 initiative.

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