Prior to the past decade, the Federal Reserve and U.S. government controlled all the resources they needed to implement monetary and fiscal policies required to salvage the U.S. economy. At the same time, because the U.S. economy was so big and powerful, its recovery alone would create the momentum needed to enable our trading partners to recover as well.
But today, we live in a truly global economy, in which the U.S. must increasingly coordinate its monetary and fiscal strategies with those of our allies to prevent global economic catastrophes akin to the Great Depression.
The combination of three forces ? productivity growth, shrinking consumer demand due to demographic shifts, and protectionism ? could lead to a 1930s-style depression in the decade from 2010 to 2020. Fortunately, there may be ways we can prevent this from happening. In fact, an assessment of the 2001-2004 period indicates that new international mechanisms are in place to prevent such a “death spiral.”
To understand why this trend has gotten so little attention, it’s important to understand that each of us is a product of his or her own experience. Although some of our fathers and grandfathers remember the Great Depression, most of us have grown up in an economy that has been constantly fighting inflation. Some of us have seen it spiral upward to uncomfortable and unhealthy levels at times.
The good news is that during the 1980s and ‘90s, most industrialized countries, the U.S. included, brought inflation under control. And since the most recent economic slowdown ended here, we’ve maintained a very low rate of inflation, at less than 3
percent. We’ve also experienced some of the lowest interest rates in history, which have only recently begun to rise as the Fed moves to keep the economy from overheating.
But with inflation and interest rates so low, another specter has raised its head and caused some concern: What if inflation went to zero? What if prices stopped rising, and actually began falling? Wouldn’t it be smarter to defer purchases until items became cheaper? What would this do to the economy?
Take a look at what’s happened in Japan. For the past decade, there has been a general decline in consumer prices of about 1 percent a year across the board, and that has caused severe economic troubles, including slow growth, joblessness, and chronic financial problems in both the banking and corporate sectors. In Japan, deflation, not inflation, is the enemy.
The tricky balancing act for both the Fed and for those in charge of fiscal policy is to keep consumer demand and business capital spending growing, while at the same time keeping inflation from rising to unhealthy levels. Congress has charged the Fed with preserving the stability of the economy and of prices. In that role it must make sure that its adjustments never eliminate inflation altogether, and risk plunging the economy into a deflationary spiral like the one that led to the Great Depression.
It’s useful to point out that deflation doesn’t refer to just “any old drop in prices.” We’re all familiar with drastically falling prices in various sectors, despite the fact that the U.S. hasn’t experienced real deflation since the Great Depression. These occur because demand is weak, or productivity increases dramatically.
Computers are a perfect example. When they first came out, they cost tens of thousands of dollars. Today, you can get some of them for free. Similarly, gas prices may fall again. But that’s not deflation. Deflation only occurs when prices are falling across the board, enough to influence measures such as the Consumer Price Index.
Deflation occurs because of a collapse of aggregate demand. People stop spending, and producers find that the only way to attract a buyer ? of anything ? is to lower prices. This predictably results in a severe recession with rising unemployment and severe financial stress.
This drastic situation should be contrasted with a normal recession, such as the one that occurred in the U.S. after the tech bubble burst in 2000. In that type of recession, inflation is still in positive territory. The significance of this phenomenon is that interest rates remain in positive territory, too, so the economy as a whole keeps churning along and inevitably heads toward recovery, as we have seen in recent years.
When a recession occurs with the complication of true deflation, however, interest rates actually go to zero, and the value of everything falls. Everything except the dollar, that is, which quickly balloons in value so that it can buy more and more goods.
The ramifications of this situation, which hasn’t occurred here since the early 1930s, are widespread. In the Great Depression, deflation was running at 10 percent a year. That meant that if someone borrowed money at a zero percent interest rate, he was actually paying 10 percent, because the loan had to be repaid in dollars whose purchasing power was increasing at that rate.
The effect this has is devastating. People stop buying homes, companies cut off capital investment, and spending declines across the board. Since spending powers the economy, the economy dies a slow death.
Even worse is the fate of those who borrowed before deflation began, for they now have to pay back loans in dollars of ever-increasing value. This results in bank loan defaults, mortgage foreclosures, and a general economic collapse. As we saw, bank failures were common in the period between 1930 and 1933 as a result of this so-called economic “death spiral.”
That’s why we have fiscal and monetary powers in place to control the economy, to set the pace, and to see that neither this sort of runaway deflation nor abnormal inflation results from internal or external forces. It used to be the case that we could do this all on our own. Our country was big enough and autonomous enough to set its own economic policies, while more or less pulling the rest of the economic world along in our wake.
But, that’s no longer possible in today’s global economy. At this point, coordinated monetary and fiscal policies among the world’s developed nations have become essential. As Richard Duncan discussed in a recent article in Finance Asia, it appears that such coordination between the Federal Reserve and the Bank of Japan proved crucial in preventing the most recent recession from turning into a catastrophe.
Back in 2002, coming out of the recession, the U.S. administration was looking for ways to stimulate demand and jump-start the economy for a long-term recovery. With the Fed Funds rate at 1.75 percent in the middle of that year, there was precious little room to do it by lowering the rate further. And the lower the absolute rate is, the less effect lowering it would have anyway.
The U.S. had just stared deflation in the face for the first time in 70 years. The Fed Funds rate was the lowest it had been in four decades. If the budget deficit increased, policy makers foresaw rising mortgage rates, even as property prices would fall. Overall consumer demand would follow.
At the same time, the U.S. dollar had crashed after a period during the 1990s that saw a very robust dollar promoting strong economic trends, including rising stock and bond prices. Private foreign investment poured into the U.S. during those years, further increasing the value of the dollar, but at the same time pushing the U.S. current account deficit to 5 percent of Gross Domestic Product.
By 2002, the trend was in the process of reversing, with investment fleeing the United States, sending the dollar into decline.
Naturally, some of the foreign investment money freed in this move went to Japan, which saw the danger of a sharply rising yen on the horizon. That would have hurt Japanese exports.
In the meantime, the U.S. was facing a crisis in its balance of payments, including $500 billion in trade deficit, and several more billions in financial debt. If allowed to proceed unchecked, this trend would have caused interest rates to rise, the real estate market to collapse, and stopped in its tracks the building global consumer demand that was powering the economy. That would have caused a world-wide recession.
How do we get out of this jam? The tax cuts were an obvious part of the solution to the problem. Moreover, the government was holding a surplus of $127 billion as of 2001. The question was how to convert that cash into a spending bonus without upsetting the economic stability. The answer came from Ben Bernanke, a governor of the U.S. Federal Reserve, who went to Japan and laid out a strategy for helping both economies pull out of recession.
The idea was simple. The U.S. would grant tax cuts to households and businesses here, while the Bank of Japan would buy our debt with money it printed on the authority of the Ministry of Finance. For 15 months during 2003 and early 2004, Japan printed new paper money amounting to 35 trillion yen, the equivalent of $50 for every human being on Earth.
With this money, the Ministry of Finance bought 320 billion U.S. dollars, which it then used to buy up American debt in the form of government bonds and other instruments.
While the European Central Bank let the euro’s value rise sharply, Japan instead printed yen and used it to buy up U.S. dollars.
In short, the printing of paper money in Japan, with the cooperation of U.S. authorities, was allowed to finance the Bush tax cuts, jumpstart the American economy, and benefit both countries in one of the earliest examples of a new, globally-coordinated use of unorthodox monetary policy.
These tax cuts, as we’ve seen in the past few years, stimulated spending in the U.S., with predictably beneficial results over the entire economy. U.S. demand, in turn, resulted in expanded manufacturing in China and other Asian countries, stimulating tremendous growth there.
China was therefore able to turn around and pay Japan back for its trade deficit, further benefiting that economy. This cascade of cash fueled the lightning-quick reflation we’ve seen in Asia, including revitalizing Japan itself after years of failed attempts by the Bank of Japan to do the same.
By the end of the first quarter of 2004, the situation had stabilized, and Japan ended its intervention. The U.S. economy was growing strongly, and tax revenues were up enough to push the budget deficit down from an estimated $521 billion to a real figure of $413 billion.
This novel strategy ? whether it was clearly thought out beforehand or developed on the fly ?benefited not only the U.S. and Japan but stimulated the global economy as well, which grew faster in 2004 than any year in the previous three decades. The success of this approach suggests that this is just the beginning.
In light of the emerging trend of coordinated global economic policy, we offer the following four forecasts:
First, the stage is set for a changing economic policy at the Federal Reserve. As the U.S. becomes more and more a member of a true global community, it will reap unprecedented benefits from coordinating its monetary and fiscal policies with those of its trading partners in win-win scenarios that reflect the needs of each participant. Other nations will follow the lead of the U.S. and Japan in seeing that cooperation, as well as competition, leads to a healthier global economy that benefits all stakeholders.
Second, the realization of this trend should make the prospect of another Great Depression a thing of the past. As global options become more widely accepted as financial controls for nations, economies in industrialized societies will become more stable, and less able to be upset by transient events. This will lead to more widely distributed stable currencies with less overall fluctuation in value, such as we’re now seeing with the euro and the dollar. In general, global industrialized economies will experience a degree of stability that is unprecedented in history.
Third, this new-found stability will diminish the likelihood of “currency panics.” One of the factors that triggered our brush with possible deflation was not so much the ability, but the desire of investors to move money quickly from one economy to another to avoid a potential collapse. And while these trends won’t affect the ability to move money, they will affect the desire to dump one currency en masse for investments elsewhere. A slower, more stable movement of investments will create less violent fluctuations in any one economy, while benefiting all with steady, sustainable growth.
Fourth, with the addition of new strategies to the monetary toolkit, the Fed and the administration will be able to work together with other nations to keep inflation low, while keeping deflation at bay indefinitely. This will provide a kind of international economic insurance policy, resulting in slowly rising prices, but also in rising productivity, growth, and income for a sustainable economy worldwide.
References List : 1. Finance Asia, February 2005, “How Japan Financed Global Reflation,” by Richard Duncan. ⓒ Copyright 2005 by FinanceAsia. All rights reserved.
