Addressing The Threat Of Deflation

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As central banks continue to slash interest rates almost to zero, prices can plummet. It creates a liquidity trap, as it did in the 1930s and in Japan during the 1990s. Harvard economist Kenneth Rogoff outlines what deflation could mean for modern America.


Just in case you thought the only terrifying economic word that starts with a D was depression, we now are going to consider deflation. When prices go up when too much money is chasing too few goods, that's inflation. So deflation sounds like it ought to be fun. Well, economists know better. And so does the stock market. It went down yesterday, in part because of news that prices had fallen. Professor Kenneth Rogoff of Harvard joins us right now. And Ken Rogoff, what is so bad about falling prices?

Professor KENNETH ROGOFF (Economics and Public Policy, Harvard University): Well, it's - sometimes, you know, they tell us there's too much inflation, then there's too little inflation. The trouble with falling prices is that if it's other people's prices falling, it's fine. Prices of gas going down - that's good. Prices of imports going down - that's good. But if it's your wages going down, if it's all prices going down, that starts to get to be problematic.

There are a couple dimensions. One is anyone who holds debt is going to have to pay back in dearer dollars instead of cheaper dollars. And our economy is in a morass of debt at the moment. There's just way too much debt. Now, deflation isn't all bad, as I said, if it's coming from cheaper things from abroad. But what's causing this is that the economy is stalling. There's not enough demand for our goods and services. And that's what's driving prices down. So in some sense it's a symptom, but it also brings its own problems.

SIEGEL: What is the worst case risk here if there is deflation? What can happen to the economy if it's a prolonged problem?

Professor ROGOFF: Well, it's sort of a slow burn. It's a low-level fever. It has prices going down. So, wages don't tend to go down very easily. And that means that firms are going to be stuck with their wages, but selling their goods cheaper. And that's going to cause them to lay off workers. Those don't happen really quickly because we're not going to get raging deflation. It's going to be slow.

What really is hard is that right now, more than ever, we need very, very aggressive stimulus in monetary policy and fiscal policy. And as soon as the Federal Reserve lowers interest rates to zero, it can't go any further. And you can get in a trap of sorts where you're stuck, and prices are going down, and you want to get the economy moving, and it's hard. And the Federal Reserve has ways of doing it. They can basically print money. But it's much trickier and more complicated than traditional ways of conducting monetary policy.

SIEGEL: I gather that the price declines that we reported this week were pretty broad. But to what extend does this reflect this enormous swing we've seen in energy costs that relay to a barrel of oil, which went up hugely and then has come down very rapidly? Can that be powering all of this?

Professor ROGOFF: Well, in the short-term what we're experiencing right now is largely that commodity prices for oil, for agricultural goods, metals, wood, everything shot up, and now it's collapsing in the face of the global recession. And that's driving prices down. And for the United States, that's a manageable problem. But what we're worried about is what's coming next because demand is very, very soft.

People have seen the prices of their houses go down. Unemployment's going up. Life's becoming more difficult. And almost certainly consumers are going to pull back. I think retailers are very, very nervous about this Christmas. And what we're worried about is prices falling because of basically a demand strike in the economy.

SIEGEL: Right, right.

Professor ROGOFF: That is more pernicious.

SIEGEL: So it would be like saying, the good news is that house across the street that used to go for $500,000, you can get it for $300,000. Now the bad news is nobody has the money to be able to buy a house.

Professor ROGOFF: Exactly. And the house I have has gone down in value too.

SIEGEL: Kenneth Rogoff, thanks a lot for talking with us today.

Professor ROGOFF: My pleasure.

SIEGEL: That's economist Kenneth Rogoff, Professor Rogoff from Harvard University, talking with us about deflation.

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