Re: The sky is falling! Now what? - Posted by Jim Locker
Posted by Jim Locker on July 11, 2002 at 11:53:21:
:Wouldn’t it be that if deflation occured, the interest rates will rise
No, of course not. You are confusing INflation and DEflation. Inflation is characterized by more and more money chasing the same goods and services. Consequently, the value of each unit of money is gradually decreasing, which provides an incentive to consume. We are used to inflation and our system (which is consumption based and depends on the flow of money) is structured around it. If deflation became widespread, interest rates would quickly hit zero and, defacto, could become negative. To see how this works, look at Japan.
Deflation is characterized by the widespread dropping of prices due to low demand. This feeds on itself; if your old car is running OK and you are concerned about your job, will you go buy a new car, when you know the price of the new car is dropping and you can buy it cheaper in a few months? When this happens, you will tend to hold onto your money. Multiply your action by the hundreds of millions of people that exist in this economy and you see that the flow of money drastically slows.
Reduced consumption leads to layoffs, which further reduces consumption which leads to layoffs… And in an attempt to stimulate demand, business and industry reduce their prices, but people are worried about money and expect further price reductions, so they hold off, so business and industry reduce their prices…
The result is that your dollar continually gains in purchasing power, but your ability to acquire more dollars becomes seriously impaired.
Now, the “traditional” Fed response to a recession is to lower interest rates to stimulate demand for money. But rates are already very low, and the Fed is about out of room to lower further. This is where the risk of deflation appears. If we slide back into recession as a result of the ongoing market meltdown - these accounting scandals really HURT - the Fed will not be able to control it by cutting rates further.
The idea that people will stop buying houses and start renting them assumes that there will be enough money circulating for this to happen. The problem is that, if this gets going, there won’t be enough money circulating. People won’t be able to afford your rents. So you’ll have to lower 'em.
The last time we had a serious deflationary environment was the Great Depression. At that time, there was lots of empty housing. There were also tent cities all over the place and “movers” - people on the road looking for work. Potentially, that could happen again.
Now, if the Fed can’t cut rates, the Fed can start spending. This is how we bought ourselves out of the Great Depression. The Federal Government created a lot of make-work jobs and spent money it didn’t have. This was inflationary since they were pumping money in, and stimulated consumption since this money was going to the many millions who didn’t have any money in exchange for work that often didn’t need to be done. Eventually, this practice halted the deflation and brought an end to the Great Depression. This is why I suggest that government deficit spending right now is a really good plan. We need to get some inflation back into the system.
We also need to restore confidence in the markets. To do this, some CEOs need to go to jail for a long time and do hard time.