During the 1990’s and into the 2000’s, many developing economies increased their ability to export cheap consumer goods to the US and other industrialized markets. All things being equal, this placed deflationary pressure on consumer prices in the US. In absence of activist monetary policy, we would have seen deflation as measured by the consumer price index. What we had instead was a Federal Reserve increasing the money supply to prevent deflation.
What we need to understand is three fold. Firstly, what signs was deflation trying to give the US economy? Secondly, what signs did the Fed give the economy instead? Thirdly, what were the consequences of getting our signals crossed?
- Pretend that we held money supply constant while cheap consumer goods flooded the US market. We would have the same amount of money chasing more goods, i.e. deflation in the short term and a reduction in real GDP in the long term. In the short term deflation causes consumers to cut back on consumption. Why buy today if stuff is cheaper tomorrow? Thus, the market’s natural response to an increased trade deficit would have been an increase in domestic savings and a reduction in said trade deficit.
- Being overly scared of deflation, the Fed kept their foot pressed down on increasing the money supply to generate a positive rate of inflation. In so doing they took interest rates to historically low levels. These low interest rates acted as signals to consumers, businesses, and the government that borrowing was unusually cheap. The result was an unprecedented increase in consumer, business, and government borrowing. This borrowing increased the current demand for foreign goods driving up the US trade deficit and destabilizing the international economic system.
- When the proper response was to increase savings rates, the Fed put up street signs that said borrow as fast as you can. In so doing the Federal Reserve aided the creation of asset bubbles and sowed the seeds of the global financial meltdown. Had the Fed allowed the market to naturally read the deflationary signs, the global meltdown could have been converted.
The moral of the story is that average prices are just as much signals to the macro economy as individual prices are to the micro economy. To think that the government or a central bank has more information than the economy on what the “right” prices are is preposterous. The recent financial meltdown’s causes can be traced right back to the doorstep of the Federal Reserve. Capitalism works best when prices are set by markets, not central planners.