Deflation isn't the pressing worry for the U.S. economy. It's the possibility of a "liquidity trap."
May 9, 2003: 8:30 AM EDT
By Justin Lahart, CNN/Money Senior Writer
NEW YORK (CNN/Money) - Let's be perfectly clear: The United States is in no danger of becoming Japan.
In Japan, for instance, they tend to drive on the left side of the road. U.S. drivers prefer the right. In Japan, a baseball game can end in a tie -- something that could never, ever happen in America. The Japanese also have these things you would swear were jelly donuts, until you bite into one and find out it's filled with sweet bean paste...
Yet despite all of these big differences, there are some disturbing similarities between what the Japanese economy went through to get to its current sorry state and what the U.S. economy is going through now. In the 1990s, Japan had a great big investment bubble. In 1990s the United States got a bubble of its own. The popping of the Japanese bubble led to stagnation in Japan's economy. Ditto for what happened after the U.S. bubble busted. Japan's central bank (eventually) cut rates to the quick, but the Japanese economy couldn't get back on its feet. Since the beginning of 2001 the Federal Reserve has cut its fed funds target rate 11 times, bringing it from 6.5 percent to 1.25 percent. And yet, here we are.
Now, when people start talking about the similarities between the Japanese and U.S. economies, they usually go rushing to the topic of deflation, the nasty phenomenon of falling prices that can really knock the stuffing out of the economy.
But deflation didn't come until rather late in the game for Japan. For most of the 1990s, the problem in Japan was something else: a liquidity trap.
Here's how it works: For some reason (like a busted bubble) everyone gets tremendously worried about the future. The central bank cuts rates, the government passes fiscal stimulus measures, but consumers and businesses are so jittery that they just stuff all that money into the proverbial mattress.
Or at least in Japan, a nation of savers, they stuff it into their mattress. In the United States, a nation of debtors, the money would go (and it seems to be going) to "balance sheet repair." Now both saving and getting oneself out of hock are noble things, but when everyone does it at once, it does the economy no good at all. It's what the economist Maynard Keynes called "the paradox of thrift."
How do you fix a liquidity trap? You print money until inflation is introduced to the economy. For savers, inflation means that the money they have in the bank today will be worth less tomorrow -- so they spend it. For debtors, today's debts will not cost them as much tomorrow, so they get less worried about their balance sheets and beginning to spend as well.
In its recent jawboning about inflation targeting, in its hints about possibly buying Treasury bonds, thinks Princeton economist Paul Krugman, the Fed is trying to introduce the idea that, by hook or by crook, it's going to make inflation happen.
"[T]he Fed has its eye on the ball," he wrote on his Web site. "It's not worried about deflation per se; it's worried about a liquidity trap."
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