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No shrink supply Original Source Link: (May no longer be active)    http://www.twincities.com/mld/twincities/business/columnists/edward_lotterman/4424301.htm http://www.twincities.com/mld/twincities/business/columnists/edward_lotterman/4424301.htm Posted on Sun, Nov. 03, 2002 REAL WORLD ECONOMICS: Deflation is not a threat as long as Fed is competent EDWARD LOTTERMAN Columnist Don't stay awake at night worrying about deflation. That is my advice to people who query me about whether the United States runs the danger of following Japan into a prolonged economic funk. That troubled nation has edged into deflation repeatedly during the last decade and many Americans who follow international news apparently have qualms that it might happen here. Economists need to be careful about making sweeping statements, but it is pretty safe to say that significant or prolonged deflation can only occur when a central bank is grossly incompetent. The Federal Reserve's Open Market Committee, which will meet on Wednesday, is not. The Fed cannot solve all problems, but with prudent action it can prevent significant changes — either up or down — in the general price level. The fact that students and members of the general public increasingly ask me and other economists about the dangers of deflation is both heartening and disheartening. It is a positive sign in that it demonstrates an awareness of symmetry in the economy. Inflation and deflation can be harmful, and competent policy makers should try to avoid both. What is discouraging is that such questioners seem convinced that deflation is some dark and mysterious force that somehow raises its ugly head for no reason and against which there is no defense. Nothing could be further from the truth. Nobel laureate Milton Friedman is well known for this observation: "Inflation is always and everywhere a monetary phenomenon." Substitute "deflation" for "inflation" and his assertion retains its validity. What Friedman meant is that inflation does not result from some sort of "spontaneous generation" the way medieval scientists thought maggots appeared in rotting meat. Inflation occurs only if the amount of money that households and businesses have to buy things grows faster than the amount of goods and services available for purchase. Friedman essentially said that if you don't want inflation, the solution is simple: Don't let the money supply grow too quickly. It is equally true that if you don't want deflation, you should not shrink the money supply. And if deflation appears to be setting in, a central bank such as the Fed can counteract it by increasing the money supply. The Fed failed tragically in 1919-1920 and again in 1929-1932 by letting the money supply shrink precisely when it should not have done so. The Bank of Japan tightened the money supply to abort a speculative bubble in stock and real estate prices in the late 1980s and then erred badly in keeping money too scarce for most of the ensuing decade. Japan has other fundamental structural problems to deal with in the relationship between banks and businesses and between government and the private sector. Sound monetary policy cannot guarantee a healthy economy, but it is a necessary condition. If the Bank of Japan had not been as restrictive as it was, Japan would be in better shape than it is. With a quarter century of hindsight, it is easy to see how silly much public debate about inflation was in the 1970s. Do you remember a U.S. president handing out buttons emblazoned with WIN for "Whip Inflation Now" and the wage and price controls of the Nixon administration? Former Federal Reserve Board Chairman Paul Volcker demonstrated how simple it was for the Fed to control inflation. It was not easy — indeed, it was painful for many sectors for a prolonged period. But the recipe for getting rid of inflation was no mystery. The process would have been easier if the president and Congress had not run massive deficits at the same time, but that is not the Fed's fault. Some would retort that Volcker's Fed had unlimited scope to raise interest rates in 1979-1982 but that today's open market committee has already lowered short-term rates to near zero. That is true, and it is true that we have never had negative interest rates. No bank has ever paid people to borrow money. But the absence of negative interest rates is only true in terms of nominal rates, before any adjustment for inflation. In the 1970s, many people had mortgages or student loans with interest rates well below inflation. "Real" (adjusted for inflation) interest rates were negative. The fact that nominal rates are at zero need not stop a central bank from further expanding the money supply to keep the general price level from dropping. Worry about terrorism or the Middle East or whether your candidate will do well in the election. Worry about the heartbreak of psoriasis. But don't worry about the specter of deflation haunting the U.S. economy. It doesn't exist. -------------------------------------------------------------------------------- Edward Lotterman is an economist and writer living in St. Paul. He can be reached at elotterman@pioneerpress.com.

3 week rally Auto sales fall Cut to eisenhower rates Deflation coming { December 3 2002 } Deflation fears Deflation launched great depression Deflation this way Deflationary cliff Double dip economy Dow wsj layoffs Ecnomy races ahead Fed cuts half point { November 6 2002 } Gold perfect asset { October 3 2002 } Housing bubble Inflation or deflation { December 14 2001 } Manufacturing fell Manufacturing sinking New advisors No shrink supply Payrolls tumble { January 10 2003 } Pre election surge Rally comic relief Real estate deflation { August 23 2002 } Sink cisco outlook Soft patch Stocks fall profit fears Treasury secretary resigns upi Treasury secretary resigns Two economic advisors gone { December 5 2002 } Unemployment up Unemplyment up { November 1 2002 } Files Listed: 31

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