Monday, November 24, 2008

THE SPECTRE OF DEFLATION?

An astounding thing happened in October. Both retail and wholesale prices fell record amounts, after having risen record amounts in the preceding months. The why is both a testimony to the severity of this downturn and points the path to a recovery.

October’s retail Consumer Price Index fell 1 percent due an 8.6 percent plunge in energy prices, the steepest decline recorded by the Labor Dept. since records were kept in 1947, according to CBS Marketwatch. Wholesale Producer Prices plunged even further—2.8 percent—the most in 50 years.

All are signs of a deflation danger that happened to Japan in the 1990s. No one wants it. Deflation last happened during our Great Depression, which depressed wages as well as prices for several years. One month’s results do not necessarily mean it could happen in the U.S, of course. The main reason for the massive amounts of federal aid flooding the markets with money is to prevent it from happening here.

But the flood has not caused banks to begin to lend again—except for residential loans backed by Freddie Mac, Fannie Mae, FHA and VA, for all intents and purposes. There are still some super-jumbo programs available from the few savings and loan banks left with rates in the low 6 percent range (3 and 5-year fixed ARMs, that is), if they use the 1-yr MTA Treasury index.

And that is the problem. The 10-year benchmark Treasury Bond recently dove to 2.99 percent—something not seen since the 1950s. This is while the money supply has been growing in double digits—19 percent annualized just over the past 2 months. But the monies have been used to buy more Treasury bonds and bills in a flight to safety, which is like putting money under the mattress, rather than lent out to businesses and residences.

This is the big danger of deflation—money being hoarded rather than spent. In other words, the price drops were signs that consumers and manufacturers have cut back on their spending. Both retail sales and industrial production have declined 4.1 percent in a year, according to the Federal Reserve.

Nobel laureate Paul Krugman sounded the alarm once again in his New York Times column. We should not only worry about Japan’s 10-year malaise of deflation, but the similarities of the current malaise with our own Depression. It began during Herbert Hoover’s lame duck administration with the Roosevelt Administration not yet in power. We should not wait for a new administration to act when every day brings more bad news.

“The prospects for the economy look much grimmer now than they did as little as a week or two ago,” said Krugman. “Yet economic policy, rather than responding to the threat, seems to have gone on vacation…Japan’s ‘lost decade’ in the 1990s taught economists that it’s very hard to get the economy moving once expectations of inflation get too low.”

What should be done? Our government needs to get banks lending again, for starters, as Prime Minister Gordon Brown required of British banks who received government aid. Some of the $700 billion authorized by congress, for example, can subsidize lower mortgage interest rates. The historical, 30-year fixed rate should be at 4.5-5 percent when Treasury bond rates have fallen this low.

This translates to at least a 10 percent payment reduction, making mortgages much more affordable. It would get so many more home buyers into the market at a time of rising housing affordability and declining home prices.

© Harlan Green 2008

No comments: