Tipping Point

So, do large government deficits always produce inflation? And where is the evidence of impending inflation in today’s economy? It may appear in the future, but it is not evident yet, at least not dramatically so. Even with all the deficits and Quantitative Easing, for the first eight months of 2013, the monthly inflation rate has averaged just 1.6 percent. Deflation, which occurs when price levels decrease, can be very difficult for central bankers to control and most would rather cope with inflation than deflation. Governments can increase interest rates to combat inflation—as Paul Volcker did—but they cannot reduce interest rates below zero. The yield on U.S. 13–week Treasury Bills has been barely above zero for the last five years.

Deflation can be tenacious. For two decades, Japan has had the most extreme deficit spending of any industrialized nation—its total debt is over 230 percent of its GDP, as compared to Greece’s debt of 175 percent of GDP. Yet Japan has experienced what has been called “The Lost Decades” of 1990 to 2010 in which the economy has struggled against persistent deflation. Interest rates have been near zero in Japan for over a decade, without producing inflation. Japanese Prime Minister Abe is taking drastic measures to try to re-inflate the Japanese economy. The situation in the U.S. is not exactly the same as in Japan—there are dissimilar reasons for Japanese deflation—but many similarities do exist. The U.S. faces deflationary pressures such as high unemployment, sagging commodity prices and a slowing velocity of money., and its economy and price levels are becoming less and less responsive to the Federal Reserve’s Quantitative Easing policy.

The tipping point for deflation comes when demand for goods and services  contracts, reducing prices, which in turn, slows down the economy, further reducing demand. High unemployment tends to be deflationary, since competition for jobs reduces wages—which further reduces demand. So down the spiral goes, and once it begins, it is very difficult for governments to reverse. That was the situation for many of the world’s economies during the Great Depression of the 1930s.

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