Deflation, Part 2

Reuters: UPDATE 1-IMF-high German deflation risk; Japan’s may worsen
You would think, given that inflation — and likewise deflation — is caused by the money supply not matching with an economy’s production, that it would be open to an easy solution. Apparently you would be wrong, or certainly someone would have considered it at this point. In theory, solving deflation should be as easy as expanding the money supply and continuing to do so until deflation is gone.

The difficulty, I think, lies in defining the money supply. I remember reading that to combat inflation in the 1970s the Fed tried to force the money supply to grow and contract at the same rate as GDP. The difficulty, as I recall, was that new financial instruments were constantly being created that functioned as money, making the control of the money supply impossible. You can’t really manage something you can’t define, or whose definition is constantly changing.

As a result the Fed went back to controlling short-term interest rates and Paul Volcker, in the 1982 recession that marks a turning point in this country’s economic history, raised interest rates so high that he crushed inflation and the expectation of inflation. People’s behavior was altered and we’ve been mostly prospering ever since.

Now, however, we may be facing a completely different problem that doesn’t lend itself to a solution as easy — however painful — as raising interest rates until inflation drops and peoples’ expectations change. Interest rates can only go so low, namely to zero, and from there other means will need to be used to expand the money supply.

It’s really beyond my scope of knowledge, but that won’t stop me from speculating about it, being a blogger and all. Besides, if I say something stupid — or already have — it will be corrected by my readers in the comments section.

My first thought in dealing with deflation, should it come to this country, is to literally print more money. As in with a printing press, as opposed to fiddling with interest rates or changing the reserve requirements of a bank. Maybe that’s an overly simple response, but it seems to make sense. Figuring out how much is needed should be no problem since they already capture statistics on the velocity of money and are able to calculate the overall money supply (M1, M2 and M3)

I’ll be blogging on this more, particularly with regard to Germany because they could be a leading indicator of what happens to us and because they are in a position such that they can’t control their own money supply because they adopted the euro.

Germany is at high risk of deflation and Japan, Hong Kong and Taiwan are vulnerable to an accelerating pace of price declines, the International Monetary Fund warned on Sunday in a blunt assessment.

The report found a low chance of deflation in the United States, but added that there are “considerable uncertainties” in that outlook.

“There has been a clear increase in the vulnerability to deflation for a number of industrial and emerging market economies,” the IMF said.

Low post-war inflation rates, the bursting of an equity price bubble, rising banking sector stresses in some economies and declining credit growth are to blame, the IMF concluded.

The study, put together by a special task force overseen by IMF chief economist Kenneth Rogoff, comes at a time of increased worries about deflation around the world.

The U.S. Federal Reserve has recently raised concerns about deflation in the United States and fears about deflation in Germany’s stagnant economy have been on the rise.

The IMF report warned that deflation, defined as a sustained decline in an aggregate measure of prices, is seldom benign and is difficult to anticipate.

There is a “considerable” probability Germany will face deflation over the next year if economic growth meets projections of 0.5 percent this year, the IMF said. If the economy contracts the risks are even higher.

And Germany, with a weak economy, rising unemployment and banking sector strains, has limited policy options to fight it, the fund added. However, there is room for the European Central Bank to ease monetary policy, the IMF said.

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