There’s been a lot of chatter in the financial news this
past week concerning deflation, with one blogger for the Motley Fool [http://caps.fool.com/blogs/viewpost.aspx?bpid=111216&t=01001019292467236494]
even proclaiming, “Clearly deflation is here.” But is it?

Are we there yet?

Deflation is defined as falling prices over a lengthy and sustained
period of time, often combined with a decrease in the money supply. Therefore,
an unusual one-time tick lower of the monthly Consumer Price Index [http://www.bls.gov/news.release/cpi.nr0.htm]
does not qualify. Granted the core CPI measure also fell slightly, which is
even less common because it doesn’t register the volatile effects of energy and
food prices.

Instead, the October decrease in CPI is the unwinding of the
run-up in prices during the first half of the year, the one that culminated
with gasoline at $4.50 per gallon and crude oil at $147.27 per barrel. Keep in
mind that, although retail prices fell 1.0% in October, they nevertheless
remain 3.7% higher than they were in October 2007, almost double the Federal
Reserve’s unofficial “soft” inflationary target of ~2%.

Analysis of the cycle

The disastrous deflationary spiral known as the Great
Depression actually began in August 1929 when the U.S. slipped into recession,
arguably due to a poorly-timed tightening of interest rates by the Federal
Reserve. Not long after, an asset bubble burst (in this case, the overly
leveraged stock market), leading step by step to loss of wealth, defaults on
loans, undercapitalized banks, and bank failures. As banks deleveraged by
reducing the ratio of credit to deposits, they ceased writing loans, causing a
credit crunch which further damaged businesses and the underlying “real” economy.

At the same time, nervous depositors yanked their money from
banks and dumped it in the Mattress Savings and Loan, withdrawing it from
circulation and slowing the economic recovery further. Meanwhile, fiscal policies
enacted by the Hoover administration were ineffective (and sometimes
ill-judged) and the Federal Reserve’s monetary policy is generally considered
to have been nothing short of disastrous. To be fair, they were hampered by the
rigidity of the gold standard then in effect.

As economic historians (and just about everybody else) like
to point out, that same description holds true for the current U.S. situation.
However, there are a few important deviations. For example, investors are hoarding
money in Treasury securities rather than mattresses, and the Federal Reserve
has aggressively loosened monetary policy since the initiation of the crisis in
the summer of 2007.

One of the most important of these deviations is the abandonment
of the gold standard in 1971. A strict adherence to a gold standard is
inherently deflationary, as there’s only so much gold to spread around while
the population worldwide is increasing. As pointed out by Ben Bernanke, the
head of the Federal Reserve System and an expert on the economics of the Great
Depression, the strictness with which a nation stuck to the gold standard was
directly related to how deeply that nation was affected [http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm].

Real-world defense

In a speech delivered November 21, 2002 [http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm#fn17],
Bernanke stated that the first line of defense against deflation is to prevent
it by maintaining an interest rate above zero, which is why the Federal Reserve
does everything in its power to ensure you spend more for food and clothing
this year than you did last year.

Should the first line of defense fail for whatever reason,
the second is to inject sufficient liquidity (money) into the economy to shock
the system back to health. In his November 21 speech, Bernanke mentions the
famous solution offered by Milton Friedman (the father of monetarism) of
throwing money from helicopters, as good a liquidity injection as any other. The
comment earned Bernanke the nickname of “Helicopter Ben” among journalists for
some time.

As the Great Depression and other recessionary episodes
(such as the Lost Decade in Japan) have shown, slow or inappropriate monetary
policy can exacerbate a downturn into deflation or delay recovery significantly.
Seven decades of economic research and study are now being applied in a
real-world model by a student of the first round. We’ll find out if it works.

Related posts:

1. Inflation, Deflation, Recession
2. Inflation With Gary North Or Deflation With Mish
3. Central Banks: The Neurosurgeons of the Global Economy
4. 10 Points Americans Must Understand About the Economy
5. Defend the Gold Standard