How to hedge deflation
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PORT WASHINGTON, N.Y. (MarketWatch) — If you don’t like falling prices, then stop restricting the quantity of money available to purchase goods and services.
Before we get started, let’s agree on one thing: Falling prices are not always bad. A large number of people actually like it when tags shrink.
For example, consumers — especially those on fixed incomes — love falling prices. They can’t get enough of them. Look how they have reacted to the decline in prices of gasoline and oil. What’s better than paying less for an important commodity like gasoline and having money left over to save or spend?
As nice as this is, falling prices can’t last forever — nor should they. This is because of a number of developments that deflation can lead to.
Chief among them is a squeeze in business profits. This occurs when firms can’t sell their products or services for as much as they anticipated. As a consequence, companies will soon stop buying materials and supplies, waiting for them to go lower. The same goes for consumers.
You can see where this will lead. As consumers hold off on spending, business will delay buying, leading to further declines in spending, and so it goes. Before you know it, the economy has fallen into a recession.
That said, recessions in this country are nothing new. Indeed, the United States has experienced 33 recessions over the past 180 years, according to the arbiter of the business cycle, the National Bureau of Economic Research.
But are we really trapped in a deflationary vortex as some wags would have us believe? I don’t think so.
If we do fall into a deflationary spiral, it’s our own fault.
Economics 101 teaches us how to avoid (or mitigate) a deflationary downturn: You just make sure that economic policy is not restrictive. Unfortunately, you don’t learn this in Political Science 101, where this lesson is usually lost.
Simply put, you don’t slash government spending when the reverse is called for. What is more, you don’t raise interest rates when they should be held steady or pushed lower, if there is room.
Even the daddy of all deflationary downturns, the Great Depression, eventually came to an end. Would you like to know how? Simple, it was the advent of World War II, which required massive amounts of government spending along with a supportive monetary policy.
Prices not only stopped falling, they shot up until restrained by controls. When these controls were lifted after the war, prices resumed rising.
Right now, the U.S. is not in a deflationary spiral. Ask anyone who has been sick, or bought a myriad of other goods or services. The decline in the consumer and the producer price indexes is due mainly to the above-mentioned drop in prices of gas and oil.
To be sure that this does not spread, we must employ the correct economic policy. The Federal Reserve needs to ignore the entreaties of those who want it to tighten up while inflation is still quiescent.
For their part, the politicians inside the Beltway need to remember that cutting government spending is not always a good thing. When the economy is below full employment, such as it is today, it needs more, not less help from fiscal policy.
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