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Deflation Treatment: Stabilize Symptoms, then Address the Cause

Deflation: The Failed Macroeconomic Paradigm Plumbs New Depths of Self-Parody

by William K. Black, New Economic Perspectives

Patient bleeding out? Don’t treat the bleed; keep the crash cart nearby

Imagine you were a doctor in the ER when a patient was brought in presenting symptoms indicating a likely internal bleed. Here are the two critical questions you face.

  1. Would you (a) find and stop the bleed or (b) wheel the patient off to a “recovery” room with instructions to alert the crash cart to be ready to try to revive the patient should he go into cardiac arrest due to the continued, untreated bleed?
  2. If you chose option (b) in response to the first question, would you tell them to (a) use the crash cart that is known to be most effective, or (b) use the experimental prototype crash cart that has never been used successfully to revive a patient suffering from a cardiac arrest triggered by an untreated bleed and that most physicians think employs a methodology that is inherently incapable of reviving such patients?

If you picked option (b) in response to both questions, congratulations! Your patient may have died and your career in medicine may be over but you have demonstrated that you are the very model of the modern chief economist of the IMF, OECD, and ECB. Your initial salary in those positions may not dwarf your income as an incompetent physician, but the financial industry loves to make wealthy the “useful idiots” of the IMF, OECD, and the ECB and similar entities as soon as they leave what is termed “public service” (rather than “servicing the banksters”).

The latest proof of this dynamic is the series of recent European warnings about the “danger of deflation.”

As Warren Mosler and my macroeconomic colleagues Randy Wray and Stephanie Kelton have been trying to explain for decades, deflation is the symptom. Lack of adequate demand is the cause. Symptoms are important in both medicine and economics. A cardiac arrest is likely to kill you. But it’s the untreated internal bleed in my metaphor that causes the cardiac arrest. When a patient presents with a likely internal bleed any competent ER physician would start parallel treatment. One track would be looking to confirm, locate, and fix the bleed (or rule it out) and the other track could include providing fluids and transfusions. No competent ER physician would fail to look for and treat the likely bleed and instead simply alert the crash cart to stand by to attempt to resuscitate the patient if he went into cardiac arrest.

Austerians routinely prescribe quack remedies that increase the rate at which the patient bleeds out. The metaphor, of course, is inexact. The consequences of recession are fatal to many people, but the economy does not “die.” It gets very sick for years and causes terrible, wasteful, and unnecessary damage to people. Recessions are more common, more severe, and longer-lasting because austerians inflict a series of quack remedies that we have known for 75 years harm the patient (the economy). They do not stop the bleed (the inadequate demand), they do not provide the necessary fluids and transfusions (they do not use fiscal policy to provide the additional demand), they countermand the ER’s standard treatment protocols, e.g., typing the patient’s blood and starting fluids (the austerians try to turn off the economy’s “automatic stabilizers”), and they bleed a patient already suffering from a bleed (they create a “moral panic” about debt and deficits and demand reduced government spending, i.e., “austerity”).

As crazed and destructive as the quacksterians are, the “wait for it” deflationauts bring a degree of nuttiness to the economic ER that causes one to be stunned and horrified. For the deflationaut economists to figure out (finally!) that deflation is deadly they have to understand something about inadequate demand. The WSJ article shows that their rationale for warning (but not acting!) against “the threat of deflation” is based on the effect of deflation on demand.

“[D]eflation can be difficult to escape because households and firms postpone purchases in the hope that goods and services will be cheaper in the future, thereby further weakening demand and pushing prices down.”

Note that this passage implicitly admits that “weak demand” “push[es] prices down.” Inadequate demand, therefore, is what causes deflation.

The deflationauts also admit that if demand falls materially there is a serious risk that the economy will fall into recession. As the economy falls into recession deflation is likely to become worse and the recession will likely become more severe and last longer. The deflationauts’ logic, therefore, depends on their recognition that inadequate demand drives recessions and is the problem that the government should help fix rather than worsen. Under their logic deflation is the result (the symptom, akin to cardiac arrest) of the underlying inadequate demand (the loss of fluids and blood). Under the deflationauts’ logic the vital need is to start the stimulus (the vital fluids) as soon as possible promptly and assure that the stimulus remains adequate during the treatment.

Sadly, deflationauts are not big on internal logic or logical consistency. They act like deflation is a severe malady (akin to a cardiac arrest) that appears mysteriously and is unrelated to the inadequate demand that they have allowed to persist, or even exacerbated through their austerity policies (the severe loss of blood and fluids caused by the untreated bleed). It is overly kind to the deflationauts to say that they have reversed the direction of causality – their statements, and the Wall Street Journal’s analyses, demonstrate that they do not understand the concepts of logic and causality. I have used an extended quotation to ensure that the reader can understand the context and “logic” of the deflationauts.

“Deflation isn’t an imminent threat, but ‘you have to be on continuous watch,’ OECD Chief Economist Pier Carlo Padoan said in an interview Thursday. ‘If there is no strong pickup in growth and price levels go down, you have to be more careful.’

The annual rate of inflation in the euro zone has dropped sharply in recent months, and prices are already falling in a few countries, while barely rising in others. With economic growth set to remain weak and unemployment high, economists expect inflation to remain low well into 2014.

While few expect prices to fall across the currency area as a whole, a prolonged period of low inflation increases the threat of deflation, a persistent and broad-based decline in prices of the kind that plagued Japan for decades.”

The WSJ and the deflationauts plainly think that the quoted passage above demonstrates their sophisticated economic understanding of microeconomics and their foresight in readying themselves now to deal with a future “threat of deflation.” The quoted passages, however, actually serve as a confession of economic illiteracy and malpractice.

What causes high unemployment, weak growth, and deflation?

Parsing the quoted sentences, we begin with the question of what the deflationauts thinks causes deflation. The WSJ article presents no explicit answer. We are told that “a prolonged period of low inflation increases the threat of deflation” – which suggests that they think that deflation causes deflation. When inflation get extremely low it, by definition, becomes approximately equal to zero. When inflation is near zero even a tiny fall in prices must produce negative inflation – which is the definition of “deflation.” And all of this is merely definitional and useless in determining causality. The passage I cited implies that deflation is caused by deflation though their own logic requires that the answer be that inadequate demand is the common cause of high unemployment, weak growth, and deflation.

There is an equally important and glaring analytical flaw that is revealed by the three paragraphs I quoted above. Here are the key facts that the paragraphs reveal. Remember, the deflationauts and the WSJ agree that these facts are obvious, particularly in the eurozone.

  1. Deflation is very dangerous – it can “plague” an economy “for decades”
  2. Inflation is very low and “has dropped sharply in recent months”
  3. Deflation has already struck “a few countries” and is inflation has already fallen so low in “others” that it is near zero
  4. Economic growth is, and is expected to remain, “weak,” and
  5. Unemployment is, and is expected to remain, “high”
  6. The risk of deflation is “increase[ing]”

To these facts that the quoted passage expressly presents we must add the implicit concessions  that deflation “plague[s]” an economy by further suppressing already inadequate demand and causing recurrent recessions that can occur for “decades.” They implicitly concede that the underlying problem is substantially inadequate demand.

The obvious policy question is what nations should do in response to these facts. We have to begin with the internal contradiction. The passage that I quoted contradicts itself in adjacent paragraphs. The first quoted paragraph asserts that “deflation isn’t an imminent threat” while the second paragraph states that “prices are already falling in a few countries, while barely rising in others.” Deflation is not an “imminent threat” – it’s already a reality “in a few countries” and other countries are on the brink where even a small slowing of their already weak recoveries could easily lead them to suffer deflation.

Waiting for deflation to start before using fiscal policy to supply the necessary demand?

There is a more basic insanity than the failure to understand causality and ignoring the fact that deflation has already begun, rather than being a potential “threat.” Why are the IMF, OECD, and the ECB waiting for deflation to strike before they act? The six express facts and the implicit facts listed above make clear that waiting until deflation is “imminent” is an unconscionable policy that constitutes economic malpractice and displays disgusting callousness. Let’s review the bidding:  unemployment is high, growth is weak, and inflation is either trivial (and “has dropped sharply”) or has already been replaced by deflation. That is a horrific situation. High unemployment causes completely gratuitous harm to the economy, the people who are unemployed, and their families. We would all be better off if the waste of unemployment were dramatically reduced. Weak growth is very bad. It too represents waste. Very low inflation is dangerous and deflation is awful. Each of these symptoms demonstrates that demand is seriously inadequate. The government should intervene immediately by using fiscal policy to fill the demand shortage. If the government acts promptly to provide the inadequate demand it will also dramatically reduce the risk of deflation (a lagniappe).

To return to the ER metaphor, the patient is suffering severely and his symptoms are likely produced by an internal bleed. The bleed poses a serious risk of a cardiac arrest if it is not stopped and the lost fluids and blood replaced through IVs and transfusions. It would be obvious malpractice and grotesquely inhumane not to treat the patient immediately and instead wait and hope that we could revive the untreated patient once he suffered a cardiac arrest. Doctors do not wait until they think a cardiac arrest is “imminent” to treat the bleed and its symptoms.

With those points in mind; we will return to the OECD’s admission of its bizarre position on deflation.

“Deflation isn’t an imminent threat, but ‘you have to be on continuous watch,’ OECD Chief Economist Pier Carlo Padoan said in an interview Thursday. ‘If there is no strong pickup in growth and price levels go down, you have to be more careful.’”

No, you don’t “have to be on continuous watch” because you don’t have to wait to act until the threat of deflation is “imminent.” High unemployment and weak growth, particularly when inflation is well below the Central Bank’s target, indicates that the government should immediately use fiscal policy to combat those severe ills, which would also virtually eliminate the additional risk of deflation. The OECD’s “continuous watch” approach would be equivalent to putting the untreated patient in the recovery room hooked up to a monitor and waiting for him to code before using the crash cart to try to revive him.

Similarly, the “if” that begins the second sentence is nonsensical. The OECD is saying that if the Eurozone austerity policies (bleeding a patient already suffering an internal bleed) continue to cripple growth and deflation spreads to additional Eurozone nations then (drumroll please): the OECD, IMF, and ECB will “have to be more careful.” My medical metaphor may have been too kind. It’s not clear that if the top economists at these institutions were doctors they would even respond to a patient’s obvious external bleed until his death was sufficiently imminent. High unemployment, weak growth, and trivial inflation provide a compelling need for immediate intervention through fiscal policy. The root of “careful” is “care.” The OECD talks about “care” but unintentionally demonstrates a shocking lack of care for the over ten million victims of severe unemployment and crippled economic growth.

The OECD’s top economist returned repeatedly to his implicit claim that it was essential for the Eurozone’s governments and institutions to wait until “deflation is here” and then act in time to prevent it from causing catastrophic additional damage.  .

“Mr. Padoan acknowledged that identifying the onset of deflation is difficult, because it involves a fall in prices and a change in behavior by consumers and businesses. As Japan found to its detriment, deflation can be difficult to escape….

‘Blowing the whistle to say deflation is here is a delicate call,’ Mr. Padoan said.”

The OECD’s position is significantly insane. What harm would we suffer if we did not wait until “deflation is here” and instead acted now? Why not use fiscal policy to end the inadequate demand that is causing over ten million people to be unemployed and crippling our growth rates? Those same policies would largely eliminate the risk of deflation spreading – a win-win-win. We don’t wait in the ER until a cardiac arrest “is here” before we treat patients with likely internal bleeding. We don’t let them suffer unnecessarily when the treatment would help reduce that suffering and virtually end the risk that the untreated bleed could cause a cardiac arrest.

What is really scary is that the OECD and its counterparts plainly think they’re being prudent and farsighted while they’re actually exhibiting economic malpractice and callousness.

The IMF is also incoherent about deflation

The IMF’s statement of its rationale for its policy views about deflation is even more disturbing than the OECD’s.

That threat [of deflation] has become real enough across developed economies to prompt a warning from International Monetary Fund Managing Director Christine Lagarde, who on Wednesday said it would be disastrous for the recovery and must be fought decisively.

An extended period of falling prices would be very damaging for the euro zone, as governments and households are already struggling to reduce their high levels of debt, Mr. Padoan said. When prices fall, the effective debt burden rises.

If the IMF believes that deflation would be “disastrous” and the “threat” of deflation “has become real,” then why isn’t it acting today to demand that the Eurozone and the U.S. immediately adopt fiscal policies that would reduce unemployment, increase growth, and dramatically reduce the risk of deflation? Note that OECD’s top economist’s concern is not the suffering of the unemployed or the lost growth; he’s worried that about “effective debt burden.”

QE: even if the IMF and the OECD act against deflation they’re pushing snake oil

Just when you believe that the IMF, OECD, and ECB cannot get any more destructive on the subject of deflation they explain that should they ever actually urge action they will not urge the counter-cyclical fiscal policies that economists know are effective and will instead urge quack cures that have no track record of success and may even prove harmful.

“The ECB has a number of options to support the recovery and avoid a brush with deflation, including charging banks for overnight deposits, as well as providing more cheap funding to lenders through fresh long-term refinancing operations.

Mr. Padoan said the most effective way of fending off deflation is quantitative easing….”

I do not believe that even Padoan really believes that “the most effective way of fending off deflation is quantitative easing.” When there is high unemployment, weak growth, and trivial inflation the literally textbook answer is to use of fiscal policy, which has repeatedly shown its effectiveness for 75 years. There is no good evidence (or theory) suggesting that QE is “the most effective way” to reduce unemployment, strengthen growth, and avoid deflation. There is no track record of QE being effective and many theorists believe it could be harmful in such conditions. In general, monetary policy, including QE, has demonstrated weak or no effectiveness against situations in which there is high unemployment, weak growth, and virtually no inflation (or deflation).

Padoan’s purported explanation of why QE would be effective is that adopting it would “send a clear message.” To whom; saying what? If fiscal policy is used – now – to reduce unemployment, increase growth, and dramatically reduce any risk of deflation then we will send substance, a policy that actually works, and we will “send a clear message” that the Eurozone institutions have decided to drop their austerian dogmas and end their economic malpractice.

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5 Responses to Deflation Treatment: Stabilize Symptoms, then Address the Cause

  1. DonHeath says:

    Fiscal stimulation is only effective when the currency is strong.  Otherwise it continues the bleed.  Hope and expectation are the drivers of stimulation and oddly, since 2006, the conversation from Washington is increased taxes, hardly hopeful.  Investment drives demand, not the other way around.  To start a business, someone must invest in the building and equipment, and then hire the people.  Keynes errorneously seemed to think that consumers somehow could prime the pump.

  2. DigDeep says:

    We’ve averaged ~$1T annual deficits for 5 years now. Central planning interventions, by the Fed & fed gov, distort investment and asset prices - and Mr. Black wants more of the same. The higher levels of interventions, the larger distortions and the uglier the exit to get off this merry-go-round of intervention.
     
    I’m surprised Mr Black thinks that a small group of technocrats can orchestrate interventions without negative consequences. He’s an expert on crony capitalism. It’s easy for me to connect the distorted dots and the lack of sustainable results from artificially pumping from the top down. Wonder why a man who has obvious skills for regulating fraud – doesn’t see the inadequacy of ANY technicrats to manipulate market forces without brusing distortions.

  3. JeffSeussalias says:

    @DonHeath 
    customers drive demand..Why would I “invest” in a product/process w/ no (potential) sales???

  4. JeffSeussalias says:

    @DigDeep
     
    Well you got one part right.. The “top down” stimulus works as good as “trickle down”..

  5. JeffSeussalias says:

    @DonHeath 
    OR as they ask you when you want to start a business “who is your market”??? Or” what do you predict sales to be”?
    how do you avoid the obvious???