Deflation worries from coast to coast

They are awfully worried about deflation these days - from coast to coast. Both the New York Times and the Los Angeles Times have run stories in recent days warning about the danger of falling prices:

• Investors brace for a case of deflation
  
• Fear of Deflation Lurks as Global Demand Drops
  

Ominously, the world's most popular doomsayer, Nouriel Roubini, is quoted in both.

It's as if the whole world is about to fall into some sort of a deflation vortex where we will all be transported back into a black-and-white 1930s breadline if prices fall.

Maybe we will. From the left coast, Tom Petruno writes:

Investors are constantly reminded to think about inflation when making decisions about their money.

Now there's a new wrinkle: the possibility of deflation. We've already had severe deflation -- falling prices -- in housing, stocks and commodities this year.

The question is whether that could spill into prices of goods and services across the board, as well as into wages, as the economy worsens.
...
Declining inflation is good for the economy, and consumers, in the long run. And in some businesses, such as tech, prices are always falling.

But if the CPI were to go negative for an extended period, that would signal that a potentially dangerous deflation had kicked in. It would suggest that demand was so weak that companies were slashing prices to a level that would gut their earnings, in turn fueling massive layoffs and wage cuts.

Could it happen?

Tom Higgins, chief economist at investment firm Payden & Rygel in L.A., isn't predicting a drop in the CPI in 2009. But he believes the risk of outright deflation is higher today than it was in 2002-03, the last time there was serious talk about a broad-based decline in prices taking hold.

Because the double whammy of falling home values and plummeting stock prices over the last year has sharply eroded many people's net worth, "I'd be much more worried about deflation today than in 2003," Higgins said.

It never ceases to amaze me how so many writers and economists place so much emphasis on the government's dubious consumer price index, extrapolating from that severely flawed representation of prices to predict all sorts of possible futures.

As noted here many times before, if you put home prices back in the inflation measure instead of the nefarious "owners' equivalent rent", you could argue that we've had deflation even with soaring energy prices for the better part of the last year.
Substituting a severely flawed and much maligned proxy for the biggest single component of the consumer price index will surely come to be recognized as one of the worst transgressions by economists in the post-war era.

It reduces talk of CPI "deflation" to something that is almost nonsensical, but the talk continues nonetheless.

In the New York Times, Peter Goodman notes:

As dozens of countries slip deeper into financial distress, a new threat may be gathering force within the American economy — the prospect that goods will pile up waiting for buyers and prices will fall, suffocating fresh investment and worsening joblessness for months or even years.

The word for this is deflation, or declining prices, a term that gives economists chills.

Deflation accompanied the Depression of the 1930s. Persistently falling prices also were at the heart of Japan’s so-called lost decade after the catastrophic collapse of its real estate bubble at the end of the 1980s — a period in which some experts now find parallels to the American predicament.
...
Through much of the 1990s, prices for property and many goods kept falling in Japan. As layoffs increased and purchasing power declined, prices fell lower still, in a downward spiral of diminishing fortunes. Some fear the American economy could be sinking toward a similar fate, if a recession is deep and prolonged, as consumers lose spending power just as much of Europe, Asia and Latin America succumb to a slowdown.

“That’s a meaningful risk at this point,” said Nouriel Roubini, an economist at New York University’s Stern School of Business, who forecast the financial crisis well in advance and has been warning of deflation for months. “We could get into a vicious circle of deepening malaise.”

Most economists — Mr. Roubini and Mr. Barbera included — say American policy makers have tools to avert the sort of deflationary black hole that captured Japan. Deflation fears last broke out in the United States in 2003, but the Federal Reserve defeated the menace with low interest rates that kept the economy growing. This time, the Fed is again being aggressive, dropping its target rate to 1 percent this week. And the government’s various bailout plans have also pumped money into the economy.

“If you print enough money, you can create inflation,” said Kenneth S. Rogoff, a former chief economist at the International Monetary Fund and now a professor at Harvard.

Dr. Rogoff's thesis is now being put to the test.

They say that "persistently falling prices" were at the heart of the worst economic contractions of the last century, but is that really true?

Isn't it interesting to note that all prior bouts of feared or realized deflation came after the bursting of massive asset bubbles - the U.S. in the 1930s, Japan in the 1990s, the U.S. again in 2003, and the entire world today?

Deflation is not to be feared - bursting asset bubbles are.

ooo

This week's cartoon from The Economist: