Suppose computer prices are the same this year as last year. Is that a problem? Most people (including economists) would say no. Now, suppose that the computers you can buy this year cost the same as the computers you bought last year, but they are 10 percent better. Is that a problem? Well, the folks who get really concerned about deflation would say yes. (Our price measures adjust for quality.) On the face of it, it is difficult to understand how the economy can be harmed by the fact that goods and services are improving in quality. But, those who believe that modest rates of deflation are harmful are in fact troubled by such quality improvements. If we have a measured rate of deflation of less than 1.0 percent, then prices would almost certainly be rising without adjusting for quality improvements, so the implication is that the economy is being harmed by the improvement in the quality of goods and services. Deflation does mean that real interest rates would be higher than if prices were flat with the same nominal interest rate, but demand is not that sensitive to modest changes in real interest rates. The concern over deflation confuses cause and effect. In a weak economy prices may be falling. But it is not falling prices that make the economy weak. The bulk of the economics profession, as well as the media, somehow managed to overlook an $8 trillion housing bubble as it was growing. Even as it is now collapsing, they are still missing it. The economy is taking a big hit for an incredibly simple reason. Homeowners have lost an enormous amount of equity and therefore they are cutting back their consumption. When they cut back their consumption, companies lose business and profits. Some go out of business. This will lead to sharp declines in investment, which we have already been seeing. There is no need to look to credit crunches or deflation. The problem is quite simply a massive lost of housing wealth, compounded by the recent loss of stock wealth. The only cure will be finding alternative sources of demand. In the short-term, government will have to fill the gap. In the longer term, it will be necessary to get the dollar down so that the country's trade is closer to balance. It really is simple.
--Dean Baker
