WHAT IS DEFLATION RISK?

Why the urgency of putting so much money into the various stimulus plans? Treasury Secretary Geithner’s addition to TARP, a mix of public and private investments, could cost as much as $1.5 trillion. The congressional stimulus bill, called the American Recovery and Reinvestment Plan or ARRP, will cost approximately $790 billion, while the Federal Reserve could be lending and/or guaranteeing more than $1 trillion in debt, and so on.

The recent plan unveiled by Treasury Secretary Geithner highlighted the difficulty of getting banks to lend again. Its centerpiece was a public/private proposal to relieve banks of their toxic—or nonperforming—assets. But if there is no market for these assets, then banks have no idea what they are worth. This is the main reason they are hoarding their monies—bailout funds included.

And so some kind of government guarantee is needed to bolster their value(s). Otherwise, as Citibank Chairman Vikram Pandit said, they would be irresponsible to unload these assets at today’s fire sale prices. Actually, should banks do so, they might very well reveal themselves to be insolvent.

The result is a stalemate, which is causing wages and prices to begin to spiral downward. Hence the urgency of the various plans. Such a deflationary spiral is the most debilitating form of a recession. In fact, that is when a recession becomes an actual depression, as it did in Japan during the 1990s and our Great Depression.

Most Americans have no experience of one, therefore cannot conceive of its damage—when wages as well as prices are in a prolonged slump. This leads to the opposite of the wage-price stagflationary spiral experienced in the 1970s that drove the inflation rate to 14 percent—and unemployment rate above 8 percent.

Nobelist Paul Krugman is one of those sounding the alarm. He maintains that we could see a real 3 percent drop in prices if the so-called ‘output gap’, or difference between normal Gross Domestic Product growth and the negative growth during a recession/depression, is as high as the Congressional Budget Office predicts.

That is why so much money is being thrown at the deflation problem. The ARRP stimulus is targeted at creating jobs, whether by directly subsidizing industry, or indirectly with tax cuts. The Treasury plan is designed to heal the banks’ balance sheets so they will lend again. Both plans have to work before our economy will be able to recover.

Harlan Green © 2009