The reason for the government's extraordinary efforts? The same reason used by Alan Greenspan, past Chairman of the Federal Reserve and other government officials back in the recession of 2001-2002: an alleged fear of deflation. Remember that deflation is defined to be generally falling prices in an economy; this includes asset prices like stocks and housing as well as everyday consumer goods. The fear of deflation is based on the idea that falling prices will weaken consumer demand, weakening job growth, reducing prices still further, further weakening the economy. But is this often-repeated statement, and the associated fears based upon deflation, really accurate?
Further, why should a recession, which is a normal part of the economic and business cycle, automatically give rise to fears of "dangerous" deflation? The U.S. has had dozens of recessions in its history and until recent times, deflation, and certainly flat prices, were not seen as an economic threat, as they are now. Indeed, over the entire 19th century, roughly the first half of our nation's history, the price of a basket of goods actually decreased, by an average of about 1% per year. This was primarily due to efficiencies and improved productivity in its production of goods and services. Indeed, flat prices or slightly
deflationary prices are normal, reflecting productivity improvements, not something to be feared.
But wait? Wasn't it deflation that turned what would have been a recession in the early 1930s into the Great Depression? Certainly asset prices fell as the stock market bubble burst, which coincided with the reversing of a credit explosion, as well as a structurally weak banking system. But what caused the recession to then turn terminal was the government's misguided efforts to restrict global trade, severely reducing foreign markets for American-made products.
Further, and unbelievably, tax rates were sharply increased during the midst of the 1930's depression. The top income tax rate for individuals was increased from 25% to 63%, while corporate income taxes were doubled. This had the predictable result of stiffling business innovation and job-creation and reducing saving, spending, and economic incentatives, among working Americans. During the 1930s prices generally fell, but it was not deflation that caused the economy to deteriorate but simply a by-product of previous excess speculation and on-going government policy mistakes.
So overall, does economic growth really suffer with deflationary or flat prices, as opposed to an inflationary economy, as our leaders and the media often state? Generally speaking, the evidence does not support that theory. During the entire 1800s, economic growth was roughly comparable to average growth during the following 110 years (generally 1% to 2% in long-term yearly "real" economic growth throughout our nation's history).
There appears to be great fear right now, judging by the words of government officials, financial commentators, and media, that consumers aren't spending enough. Specifically, Their spending "only" increased 3.6% for all of 2008. Believe it or not, that was the lowest measured increase since 1961! Given the generally high levels of consumer debt and low savings rates, you would think this would be welcome news from economic commentators. Likewise, the personal savings rate, which had been down to 0% in recent years, has rebounded in recent months to over 3% (yet still just 1.7% for all of 2008). Is this really "excessive" saving?
Of course not. Citizens in many European countries save more than 10% of their income while average residents in India, China, Korea, Hong Kong, and others in Asia, often save 20%, 30%, even 40% of their income. By comparing economic growth and savings over a country's history as well as comparing countries to each other, it is well-established that economic growth is based on the level of savings and investment, as well as productivity. No surprise then that for decades, many of these high-saver countries have seen much higher growth rates compared to the U.S. It's surprising that the majority of our elected officials, as well as heads of the Federal Reserve and Treasury Departments (who should know better), state, at least publicly, that spending, not saving, is the key to economic growth. A first-year economics student, and certainly the chairman of the Federal Reserve, knows that real, long-term economic growth is based on high levels of saving, investment and productivity. While it's true that a reduction in spending will have a short-term effect on certain industries, particularly retailers, higher savings rate produce higher economic growth over the long-term and a much more balanced economy and financial system.
Some economists are puzzled as to why our economic expansion in recent years has produced sub-par growth rates. One very important reason is explained by our meager savings rates. Even this low economic growth was due in part, to savers in other countries who were able to buy our stocks, bonds and businesses. In effect, they have been doing the saving for us. We can only wonder (with great fear) what will happen if those foreign savers decide to invest in their own countries instead of ours, which they appear to be in the process of doing.
So then, back to our original question: what is the real reason for the great fear of deflation among government officials? I think it's fairly clear that the real reason is not their concern for the economy as a whole, but are primarily concerned with asset prices like real estate and stocks. The reality is that our economy has become so dependent upon rising asset prices and debt has grown to such enormous levels that the government feels it cannot allow any meaningful slowdown in asset prices. If such prices fall, which they have done the past couple years, this results in lower tax revenues, which makes it more difficult to pay back those debts.
Governments need strongly rising asset prices in order to have a chance to come close to balancing their budget and be able to pay the interest on their mountain of debt. Since 2001, the U.S. government has added an average of more than $500 billion each year, which increased to more than $1 trillion the latest fiscal year. Trillion dollar deficits may continue for years. Given these incredible increases in government debt, not to mention the debt of Americaï¿½s consumers, businesses and financial companies, the government has a strong interest in creating high inflation to enable the government to make their interest payments on their debt. Given these debt realities and excesses, even flat prices asset prices will not suffice.
So when you hear the government talking about the dangers of deflation, what they're really saying is that asset prices aren't rising quickly enough. Since much of the taxes we pay, including income taxes, property taxes, corporate taxes, and capital gains taxes, rise as inflation rises, the government needs to have inflation to pay its bills and pay for its taxpayer promises. If there's no inflation, then taxpayers won't pay higher taxes each year. The government needs inflation and it works tirelessly to create it. We'll look into this a bit more, and how it impacts your finances, next time.