Deflation Studies

Via Instapundit, here's a look at the lurking specters of inflation and deflation. Central bankers are supposedly trading copies of an old book about the Weimar Inflation in an effort to understand the forces that can be set loose if/when highly indebted governments give in to the temptation and let the printing presses rip:

As it happens, another book from the 1970s entitled "When Money Dies: the Nightmare of The Weimar Hyper-Inflation" has just been reprinted. Written by former Tory MEP Adam Fergusson -- endorsed by Warren Buffett as a must-read -- it is a vivid account drawn from the diaries of those who lived through the turmoil in Germany, Austria, and Hungary as the empires were broken up.

Near civil war between town and country was a pervasive feature of this break-down in social order. Large mobs of half-starved and vindictive townsmen descended on villages to seize food from farmers accused of hoarding. The diary of one young woman described the scene at her cousin’s farm.

"In the cart I saw three slaughtered pigs. The cowshed was drenched in blood. One cow had been slaughtered where it stood and the meat torn from its bones. The monsters had slit the udder of the finest milch cow, so that she had to be put out of her misery immediately. In the granary, a rag soaked with petrol was still smouldering to show what these beasts had intended," she wrote.

Grand pianos became a currency or sorts as pauperized members of the civil service elites traded the symbols of their old status for a sack of potatoes and a side of bacon. There is a harrowing moment when each middle-class families first starts to undertand that its gilt-edged securities and War Loan will never recover. Irreversible ruin lies ahead. Elderly couples gassed themselves in their apartments.

Foreigners with dollars, pounds, Swiss francs, or Czech crowns lived in opulence. They were hated. "Times made us cynical. Everybody saw an enemy in everybody else," said Erna von Pustau, daughter of a Hamburg fish merchant.

Great numbers of people failed to see it coming. "My relations and friends were stupid. They didn’t understand what inflation meant. Our solicitors were no better. My mother’s bank manager gave her appalling advice," said one well-connected woman.

Not sure what anyone needs to "learn" about the social and economic effects of inflation. The history of Weimar Germany is as much a part of the cultural conversation as Kristallnacht or the League of Nations. In other words, well read people know what's going on. Americans over the age of 40 should have some memory of the Great Inflation, even if it has been wiped from the history books. Profligate governments love inflation, but the voters end up hating it and finally rising up and rebelling against the elites who fanned the inflation. Often you end up with a Hitler or - more likely - Juan Peron taking power; but sometimes you get lucky and the inflation leads to Ronald Reagan. Whichever way it works, the people who start the inflation are never in charge when it ends. That's the real risk of inflation for the elites. Even if they don't say this out loud, they know this deep down.

On the other hand, there's deflation, which central bankers profess to fear, yet often fails to arise. Japan's Lost Decade has been the most compelling deflationary episode in the modern era, one that has played out in real time in the second largest economy in the world with the eyes of journalists, policy makers, economists, and the business world upon them. And yet, no one knows what's going on:

The old bogeyman of deflation has re-emerged as a worry for the U.S. economy. Here's something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works.

Deflation is usually associated with a Great Depression-like drop in demand. Consumer prices, incomes and asset prices fall. Interest rates go to zero, as low as they can go. As prices and incomes fall, the cost to borrowers of servicing debt does not, sucking life out of the economy and pushing prices down further. A bad situation, in short, gets worse.

In 1932, U.S. consumer prices fell 10% and between 1929 and 1933 they fell 27% in all.

But Japan's experience has looked nothing like this. Rather than being deep, destructive and concentrated in a few years, deflation has been a surprisingly mild, drawn-out affair. Consumer prices have been falling in Japan for 15 years, but never by more than 2% in any single year. Japan's deflation has been a morass, but not the destructive downward spiral many economists predicted. Why? And what does it portend for the rest of the world today?

Economists don't have good answers. "We don't know how deflation works," says Adam Posen, a member of the Bank of England's monetary policy committee who has been studying Japan since 1997. "We don't have a way of rationalizing steady, several-year flat deflation," he says.

How can this be? How can we not even have an idea how deflation works? How can we not know what's happening in Japan, which is hardly a mysterious Hermit Kingdom. Where's Paul Krugman? Where's (fill in famous progressive economist here)? Sounds like a good research topic!

The problem, I suspect, is not that we don't know; but that the elites don't want to know. After all, Japan hasn't just had 20 years of deflation. The deflation began with the bursting of a housing bubble exacerbated by (1) a government which propped up its financial sector, rather than allow insolvent banks to fail and (2) engaged in an epic bout of stimulus spending that left Japan with towering debts. Sound familiar? And none of it has worked. At all. In fact, the only things that worked were the Koizumi Reforms, which sought to privatize government entities like Japan Post, among other things. Privatization of government services worked?? Don't want to say that out loud!

And given Japan's experience, isn't deflation preferable to inflation? Japan is still, after all of its troubles, the second largest economy in the world. Japan has remained a wealthy, productive society. Its heavy industries have remained prosperous and innovative (indeed some have obtained a real global reach). They're building robots, for God's sake! Most important, Japan has not suffered the economic and social upheaval that accompanies inflation. This is not to say that Japan's deflation has been a picnic. The Japanese equivalents to Generation X have had their prospects stunted to help "pay" for the profligacy of earlier decades. Jobs are not as permanent or as plentiful as they once were. But, this is not as troubling as a bout of inflation destroying the yen. At least, it shouldn't be.

I'm not going to pretend to understand what monetary policy is better than the other. But it sure is curious that inflation seems to be the default preference for the elites, and the only restraint is their knowledge that the beginning of major inflation would also be the end for them.

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