Paul Krugman gives a run down on the big news coming out of Switzerland on Thursday. This gives him, and us, a chance to view what deflation really is by giving a little history on the world economic crisis from Swiss perspective.
Wikipedia defines deflation as: a decrease in the general price level of goods and services…deflation increases the real value of money –- the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time.
Sounds good, huh? Well Krugman has been worrying about deflation for some time. Deflation, it should be noted, is the converse of inflation – like Bizzaro is to Superman. But it is inflation you hear everyone on the right talking about. Nobody, except Krugman, is worried about deflation. And to be sure, deflation is something to worry about.
But let’s begin by setting the scene. According to PK (using Keynesian doctrine), the US and other nations, fell into a liquidity trap back in 2008. In a liquidity trap policy makers can do very little to repair the economy. The main tool in the Fed’s bag of tricks is its ability to cut interest rates. When those interest rates are cut to zero you have hit what is commonly called the zero lower bound, a point at which you can cut no longer.
So everything the Fed has done in the recent years (by not raising the interest rate and risking inflation) has been to avoid its dark cousin deflation. Krugman’s article a few days ago gives us a living breathing example of what could go wrong when a country is in the grips of deflation, and it is something to behold. Krugman:
…you need to understand is that all the usual rules of economic policy changed when financial crisis struck in 2008; we entered a looking-glass world, and we still haven’t emerged. In many cases, economic virtues became vices: Willingness to save became a drag on investment, fiscal probity a route to stagnation. And in the case of the Swiss, having a reputation for safe banks and sound money became a major liability.
Here’s how it worked: When Greece entered its debt crisis at the end of 2009, and other European nations found themselves under severe stress, money seeking a safe haven began pouring into Switzerland. This in turn sent the Swiss franc soaring, with devastating effects on the competitiveness of Swiss manufacturing, and threatened to push Switzerland — which already had very low inflation and very low interest rates — into Japanese-style deflation.
Turns out, Krugman explains, when these factors are in play it is very hard to avoid deflation. The Swiss tried. They set a base price for the franc, then pegging the price of the franc to the price of the euro. Then it simply tried to buy massive amounts of euros. That seemed to work for three years.
But that brings us to Thursday’s news. Krugman writes:
… the Swiss suddenly gave up. We don’t know exactly why; nobody I know believes the official explanation, that it’s a response to a weakening euro. But it seems likely that a fresh wave of safe-haven money was making the effort to keep the franc down too expensive.
So the Swiss has decided to not only stop buying euros but also cut interest rates to -.75% (zero lower bound be damned). So depositors will get less money each time they deposit their cash in Swiss banks.
Krugman stresses the issue is not contained to Switzerland. This issue of deflation threatens Europe, Japan possibly China and could even effect the United States if we are not careful. He concludes:
… you really, really shouldn’t let yourself get too close to deflation — you might fall in, and then it’s extremely hard to get out. This is one reason that slashing government spending in a depressed economy is such a bad idea: It’s not just the immediate cost in lost jobs, but the increased risk of getting caught in a deflationary trap.
It’s also a reason to be very cautious about raising interest rates when you have low inflation, even if you don’t think deflation is imminent. Right now serious people — the same serious people who decided, wrongly, that 2010 was the year we should pivot from jobs to deficits — seem to be arriving at a consensus that the Fed should start hiking very soon. But why? There’s no sign of accelerating inflation in the actual data, and market indicators of expected inflation are plunging, suggesting that investors see deflationary risk even if the Fed doesn’t.