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Deflation: What Happens When Prices Fall

Deflation: What Happens When Prices Fall

by Chris Farrell

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Deflation is one of the most feared terms in economics. It immediately conjures visions of abandoned farms and idle factories, streams of unemployed workers standing in breadlines. So when Federal Reserve Board Chairman Alan Greenspan started talking openly in 2003 about his fears of deflation, it sent waves of shock through the business press and the public.


Deflation is one of the most feared terms in economics. It immediately conjures visions of abandoned farms and idle factories, streams of unemployed workers standing in breadlines. So when Federal Reserve Board Chairman Alan Greenspan started talking openly in 2003 about his fears of deflation, it sent waves of shock through the business press and the public.

Many feared that the United States was entering a period of prolonged slump after a pronounced boom, much like Japan experienced throughout the 1990s. Others worried that a sustained fall in prices would have a cataclysmic impact on our nation's overhang of consumer debt. Yet another camp blamed low-wage manufacturing countries like China and high-volume retailers like Wal-Mart for becoming the engines of relentless deflation.

In this important new book, Chris Farrell explains that deflation need not presage a collapse. In the process he gives a new way of looking at our economic and our financial futures. More than an introduction to the subject, Farrell points out that deflation has always been a fundamental aspect of the business cycle. For much of the 20th century, deflation had vanished from the economic scene, but its return is no cause for panic. Instead, properly understood, deflation presents opportunities and pitfalls in equal measure for businesses, corporations, the government, and our national economy.

Editorial Reviews

Library Journal
While inflation seems endemic to most modern economies, deflation is a more difficult concept to grasp. Award-winning business journalist Farrell (BusinessWeek, NPR) delivers a highly readable and insightful work illuminating the little-understood phenomenon of deflation. To the casual observer, deflation seems closely linked to economic downturns, as most dramatically evidenced in the Great Depression. However, Farrell shows that deflation is more often linked to economic growth. The author explores the concept of a supply-side economy and highlights the role of the Federal Reserve Bank in stabilizing prices and guiding the nation's economy. He traces the roots of the Depression and "bad" deflation to the international gold standard, which could not keep pace with an evolving world economy. Far from being a harbinger of disaster, Farrell shows how deflation, kept in check, can be a healthy stage in the economic cycle. His clear exposition of a complex topic makes this an excellent choice for business collections in all types of libraries.-Carol J. Elsen, Univ. of Wisconsin Lib., Whitewater Copyright 2004 Reed Business Information.

Product Details

HarperCollins Publishers
Publication date:
Product dimensions:
5.14(w) x 8.92(h) x 0.75(d)

Read an Excerpt


What Happens When Prices Fall
By Farrell, Chris


ISBN: 0060576456

Chapter One

"An Unwelcome Substantial Fall in Inflation"

All is flux, nothing stays still. Nothing
endures but change.
-- Heraclitus

May 6, 2003, was an extraordinary day in Washington, D.C. The Federal Reserve held its Federal Open Market Committee (FOMC) meeting in its two-storied chandeliered boardroom at the central bank's white marble temple on Constitution Avenue. Now, there was nothing unusual about the FOMC gathering. The committee meets eight times a year to take the pulse of the economy and decide on monetary policy. The central bankers had a lot to talk about that day. The economy was struggling to gain traction following the implosion of the high-tech sector in the spring of 2000, the terrorist attack of 9/11, the recession, the recovery that felt like a recession, and the geoeconomic turmoil surrounding the U.S.-led invasions of Afghanistan and Iraq.

Still, the Fed had aggressively cut its benchmark interest rate 12 times since early 2001 to 1.25% -- its lowest level since 1961. Most Wall Street soothsayers predicted the Fed members would vote to stay the course. Conventional wisdom was right. The FOMC kept monetary policy unchanged.

What made the day memorable in U.S. economic history was a phrase in the FOMC statement released right after the meeting: "The probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level." Okay, "an unwelcome substantial fall in inflation" is hardly the sort of incendiary declaration that typically heralds revolutionary change. It lacks the punch of Karl Marx's "Workers of the world unite!" or Franklin Roosevelt's "There is nothing to fear but fear itself."

Yet the arid phrase "an unwelcome substantial fall in inflation" -- a new euphemism for falling prices -- stunned financiers, executives, and policy-makers around the world. It signaled a tectonic shift in the American economy. The most powerful economic institution in the world, led by Alan Greenspan, a legendary practitioner of the central banking craft, was no longer worried about accelerating inflation, capitalism's main economic villain of the past six decades. No, for the first time since the Great Depression of the 1930s, the specter haunting the Fed was deflation, a widespread, persistent decline in the average price level.

A few weeks later Greenspan abandoned any linguistic pretense. "We at the Federal Reserve recognize that deflation is a possibility," Greenspan testified before Congress. "Even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative."

Deflation is an unfamiliar, unsettling bogeyman -- with good reason. America's most notorious episode of deflation was also its last -- the Great Depression. There was a brief but largely forgotten episode in 1954–55. For most people, deflation is synonymous with a depression, an economic collapse, a social catastrophe. The terms deflation and depression are almost interchangeable. The prospect of a widespread decline in prices evoked disturbing images from the 1930s of soup kitchens for the unemployed and dispossessed, a stock market crash, and shuttered banks.

Of course, fringe forecasters like economist Ravi Batra, journalist Sir William Rees-Mogg, and market timer Robert Prechter had long warned about coming deflations, depressions, and economic Armageddons. Doomsaying made for the best-seller list, but most people rightly ignored these perpetual Chicken Littles. After all, one of Batra's best-selling books predicted a great depression starting in 1990. Oops. There had been brief scares that stirred unsettling parallels to the catastrophe in the 1930s, such as the stock market crash of October 19, 1987, and the savings and loan crisis of the late 1980s. But since both financial shocks failed to presage a major collapse in economic activity, most policy makers and economists quickly dismissed the odds of deflation or depression. The rare exceptions included the extremely astute economist and commentator Paul Krugman in The Return of Depression Economics and investment strategist A. Gary Shilling in Deflation.

Yet all of a sudden in the spring of 2003 it wasn't hard for mainstream Wall Street economists to sketch a picture of an America -- or the global economy for that matter -- on the precipice of a destructive deflationary spiral. "Like it or not, we are in uncharted waters, both in diagnosing the world's problems as well as in prescribing the remedies," said Stephen Roach, chief economist at the blue chip investment bank Morgan Stanley. "I never dreamt that I would live to see such profound challenges." Added David Rosenberg, chief North American economist for Merrill Lynch: "The concern for central bankers is whether a deflationary psychology takes hold that causes expectations of lower prices to fuel lower prices down the road and hence trigger a 'deflationary spiral.'"

What changed? Arithmetic, for one thing. Inflation, or a sustained rise in the overall price level, had been running between 1% and 2%, and 1% is close to zero and zero is close to negative prices or deflation. For another, the economy exhibited some disturbingly eerie parallels to the experience of the 1920s expansion and the 1930s depression.

The 1920s were an optimistic, adventurous decade. A "new economy" emerged, largely fueled by the automobile, electric power, and appliances such as refrigerators and radios. Inflation was dormant and trade between nations flourished. Big business invested enormous sums in plants and equipment to take advantage of the efficiency promise of mass production techniques and mass marketing tactics. Worker productivity soared by some 40%, and real (inflation-adjusted) earnings gained 23%. Prosperity allowed the government to plow budget surpluses into paying off the national debt and reduce the top income tax rate from 65% to 32%, as well as slash capital gains taxes. Investment in education doubled during the decade, much of it concentrated on secondary education. The percent of 17-year-olds with a high school diploma jumped from 16% to 26%. And the number of male college graduates more than doubled, while the ranks of their female peers with a sheepskin almost tripled.


Excerpted from Deflation by Farrell, Chris Excerpted by permission.
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Meet the Author

Chris Farrell, contributing economics editor at BusinessWeek, is an award-winning journalist who started writing about the New Economy in the early 1990s. His cover stories include "Stuck," "Why Are We So Afraid of Growth?," "The Economics of Aging," "Productivity to the Rescue," and "IPO Capitalism." In 1999 and 2000 he received the Gerald Loeb Award in business journalism for two radio documentaries, "The World Turned Upside Down" and "Minnesota in the Dot.com Age." He is cohost and economics editor for Sound Money, a one-hour weekly personal finance call-in show produced by Minnesota Public Radio and syndicated nationally. Farrell is chief economics correspondent for the public radio documentary unit American RadioWorks and a regular commentator for Marketplace. He was host and executive editor of Right on the Money!, a nationally syndicated half-hour public television show, and author of Right on the Money!: Taking Control of Your Personal Finances.

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