Battle against deflation continuous

The downward pressure on inflation since the 1980's occasionally ignited deflation scares. The usual response was more (debt-financed) spending. However, the higher the debts, the more harm a deflationary spiral will do to the economy. This explains why the authorities are putting everything to work to avoid a recession with deflationary threats.

In the  course of time therefore, solutions have been sought for smoothing out fluctuations in the business cycle. Restraining the economy slightly in good times, in other words, and stimulating the economy in bad times. Finally, two macro-economic tools emerged for managing the economy. Fiscal and monetary policy. Both actually boil down to curbing the economy when it is faring well through increasing savings and spending the resulting reserves when the economy is faring badly. The only trouble is that both tools were soon misused. Generally, this meant attempting to encourage the economy to grow even more rapidly in good times by suppressing savings. We already explained in previous reports that, in principle, the excess inflation in the early 1980's could easily have been curbed to 0% - 2%. The only problem was that there was far too little saving and far too much borrowing in the 1960's and 1970''s. This is what caused inflation to rise so high in that period, as it ensured that demand was always higher than supply. This did mean, however, that as soon as this situation started to reverse in the early 1980's, there was a risk of the economy declining rapidly, even causing deflation for some time.

The problem is that all kinds of loans were extended during the inflation period assuming that nominal wages and collateral would continue appreciating sharply (this is normal during inflation periods). These loans were also extended at high interest rates. This, too, is normal in times of high inflation. Everyone then starts saving more and borrowing less and the economy slides into recession. Suddenly, unemployment rises and wage rises fall. Consequentially, the value of the collateral no longer rises so rapidly or even falls. This causes many people to tighten their belts even further, generating a self-perpetuating process. The situation only really becomes nasty when deflation occurs. After all, the Federal Reserve can’t get interest rates to fall below 0%. This means that, in times of deflation, real interest rates remain high anyway, while they should fall to fight deflation. Deflation also encourages consumers to delay purchases as long as possible. This is why, under both Volcker and Greenspan, the Fed never dared to bring the situation back into balance after the 1960's and 1970's by getting people to save more and borrow less in the long term. If they had done, then deflation would have set in and the economy would have found itself in a self-perpetuating negative spiral.

This situation worsened substantially from the early 1990's onwards. After all, although the Fed had managed to curb inflation bit by bit by then, the whole process accelerated wildly due to a concurrence of circumstances. All kinds of markets were liberalized under Reagan, productivity rose far more rapidly than before as a result of modern electronics and, due to the fall of communism, it was suddenly possible to start mass producing in extremely low-wage countries. Due to these external factors, inflation – which was already too low – threatened to turn into deflation. The demand side therefore had to be stimulated far more to prevent this. The only way, again, was less saving and more borrowing.