Tuesday, August 24, 2010

Deflation? Inflation? What’s the Government to Do?

The great American poet Robert Frost posed a serious question when he wrote “Some say the world will end in fire, some say in ice...”

Today the question plaguing the economics community is whether (1) the U.S. economy will suffer deflation, a double dip recession, or worse, or (2) an accelerating inflation due to burgeoning deficits, banks withdrawing excess reserves from the Fed for lending, and corporations spending their large cash holdings all at the same time. Each outcome is trumpeted by distinguished economists in rival camps.

The first team cites falling interest rates on treasuries issued to finance trillion dollar deficits, noting that the “bond vigilantes” are nowhere in sight. Unemployment and underemployment totaled 18.3% of the work force in mid-August. More fiscal and/or monetary stimulus is needed to keep the economy from falling into a deeper hole.

The second team cites historical instances which show that when public debt passes 90% of GDP, or some other important statistical ratio, governments resort to inflation to eliminate unsustainable debt burdens and/or economies go into periods of decline.

We cannot conduct a controlled experiment dividing the economy into Solomonic halves. What we can do, in the future, is try to understand what happened and which of the two teams had the better argument. It could even be that both teams were off the mark.

One thing appears to be missing from the debate. The vast majority of professional economists and investors, save a few (although like Bobby Thomson’s winning home run in the 1951 playoff, twice as many claim to have seen the “shot heard round the world” as there were seats in the Polo Grounds), failed to anticipate the financial crisis and consequential Great Recession. Such an event was not supposed to happen. The outcome represented the tiny tail in the distribution of possibilities, ignorance of history, incomplete or inapplicable theoretical models, closing eyes to reality—whichever you want. The list of “mea culpas” is impressive.

What’s to stop the bond vigilantes from erupting overnight in volcanic fashion, transforming U.S. debt into a Greek-like crisis? Mao Zedong wrote a letter to his colleagues on January 5, 1930, stating that “A Single Spark Can Start a Prairie Fire.” The failure of Lehman Brothers was a spark that almost brought down the U.S. financial system. Can the “don’t worry about deficits” team prevent or stop a prairie fire?

Just asking.....

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