Senior officials of the Federal Reserve now warn that the United States faces a Japan-style deflation and a prolonged period of stagnation like Japan’s “lost decade” of the 1990s. The New York Times’ website reports:
On Thursday, James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the Fed’s current policies were putting the American economy at risk of becoming “enmeshed in a Japanese-style deflationary outcome within the next several years.”
The warning by Bullard, who is a voting member of the Fed committee that determines interest rates, comes days after Ben S. Bernanke, the Fed chairman, said the central bank was prepared to do more to stimulate the economy if needed, though it had no immediate plans to do so.
Bullard had been viewed as a centrist and associated with the camp that sees inflation, the Fed’s traditional enemy, as a greater threat than deflation.
But with inflation now very low, about half of the Fed’s unofficial target of two percent, and with the European debt crisis having roiled the markets, even self-described inflation hawks like Bullard have gotten worried that growth has slowed so much that the economy is at risk of a dangerous cycle of falling prices and wages.
The Federal Reserve has conducted the most stimulative monetary policy in its history, keeping the federal funds rate (the overnight lending rate to banks) at only 0.25 percent, while purchasing over $2 trillion in securities from the markets. And that has not helped at all.
Now St. Louis Fed President Bullard wants the United States to consider a “quantitative easing” in the form of direct purchases of Treasury securities from the market. That’s what the Fed has been doing, and that’s what the Japanese did, in massive size. It didn’t help there, either.
It is disturbing to hear such idiocy from senior officials of the central bank. In all the American recessions and recoveries of the past four decades, big businesses shed jobs permanently and startups created new jobs. There is an enormous literature on this phenomenon, which I have reviewed in the past. The Census Bureau and the University of Maryland recently calculated the net creation of jobs by age and size of business, and the results show that new and businesses create most new jobs.
Source: University of Maryland and Census Bureau
The Fed and the administration claim that the problem is that small businesses can’t get bank loans. The problem, they insist, is monetary policy. Big businesses are being rewarded for laying off workers, stripping down to bare bones, and earning profits on their core businesses. They are—wisely, given the fecklessness at the rudder in Washington—hoarding cash; they don’t want to borrow.
But startup small businesses shouldn’t be financed with bank loans (except for secured financing of inventories and receivables). Most small businesses fail. This is Portfolio Theory 101. If you own the stock of 100 startups, and 99 go bust but one becomes Microsoft, you get rich. But if you are a bank, and you lend money to the 100 startups, and only 1 can pay you back, then you go bust.
Thus startups are financed with equity, not debt. This is taught to first-year finance students.
It doesn’t occur to the somnolent wizards of Constitution Avenue that the way to lure capital back to entrepreneurial activity is to increase the after-tax reward to entrepreneurs, by eliminating the capital gains tax, for example, or, even better, eliminating all taxation of capital income. Monetary policy has nothing to do the case. Monetary policy best addresses currency stability. Tax incentives best address economic growth.
Demographics drive deflation, and our demographics are not good. First, an aging population saves, and savings are deflationary. As people near retirement, they must substitute future goods (savings instruments entitling them to consumer in the future) for present goods (consumption)—so the price of present goods falls.
The government may attempt to substitute its own spending for household spending but it never quite works, no matter how many public works projects the government sponsors. Japan poured more cement than anyone else—and the decade was still lost.
As I wrote in July 2009, America’s demographic profile has a disturbing resemblance to Japan’s at the beginning of the 1990s,the beginning of its famous “lost decade.” Its population had just began to age dramatically. Over the decade, the elderly dependency ratio rose from 17 percent to 25 percent. As the Japanese aged, their appetite for savings naturally and rationally grew, and they had to save more and more as their stock portfolios and home values crashed. But the more they saved, the worse the economy did. The government lowered interest rates to 0.25 percent or less and ran up spectacular government deficits and couldn’t change the aging population’s desire to save as much as they could. The result was deflation: falling asset values and a strong yen.
Fast forward to America in 2010, with an elderly dependency ratio of 19 percent, a little higher than Japan’s in 1990. By 2020, it will rise to 25 percent, almost as fast as Japan’s. Americans also have seen their stock prices and home values crater, and—again, naturally and rationally—have suddenly shown an insatiable appetite to save rather than spend.
There’s a second reason aging drives deflation. Old people are creditors, young people are debtors. Inflation transfers wealth to debtors from creditors, because the debtors pay back their debt in cheaper dollars. A country with a preponderance of old people will show strong political pressures against inflation. That’s why the Japanese never objected to deflation. As an aging people, too many of them benefited.
Japan Dependency Ratios Medium variant 1970-2020
United States of America Dependency Ratios Medium variant 1970-2020
Source: United Nations
There is nothing that the United States can do about its aging demographic in the short run. The deflationary headwind is built into our aging population. But that should increase our sense of urgency about the need for pro-growth economic policy, including a pro-family policy that eventually will bring down the average age of the population, so that we don’t end up a geriatric ward like Japan two generations from now. America can’t afford to lose a decade.
David P. Goldman is a senior editor at First Things.
David Goldman discusses Japanese style deflation on CNBC's Kudlow Report.