It seems crazy. Don’t save and spend more than you earn, year after year. Not a good way to run a household or a business. But running a country? Maybe it’s not so bad.
There’s an economic term here central to understanding the issue: the “real rate of interest.” This refers not to the numerical amount of money you get in your savings account, but the real value you get by keeping it there. Let’s say that you are getting an annual rate of 2% on a deposit of $100,000. Compounded monthly, that’s an annual payout of $2,018.44. Doesn’t sound too good for that much bread.
But what if prices of homes, cars, and furniture, appliances, and everything else you would want are falling? Why buy a hot new car when you may be able to get a better model next year for less? Why buy a new, more expensive home when prices are still falling, so you risk losing more equity? Maybe the 2% you’re getting isn’t such a bad deal. That’s real interest rate: the 2% of interest plus what you’re saving by not buying stuff that you could purchase for less later.
Let me pause here and say something about deflation. Deflation is when prices are actually falling. In the 12-month period ending in March 2009, the Consumer Price Index or CPI—a government computed economic benchmark—declined by .4%, the first time the index had declined over a 12-month period since 1955.1 But there are persuasive arguments that the fall in prices has been much more serious than CPI indicates, largely because it accounts for changes in housing expenses by a model based largely on rents, which have been far less impacted during the housing crisis than actual properly values.2
So what does this have to do with the recession we’re in? Very simple: what’s good for the individual is not necessarily good for the group. Putting off big purchases while prices are falling may be a responsible way to run a household, but when this happens across the whole economy it ravages the companies that manufacture and sell these products, not to mention all the other industries that profit from these sales—parts suppliers, shippers, advertising firms, etc.
But what if inflation is looming? That sports car may be more expensive next year, so get it now. Housing prices are going up, so better lock in and get that homestead while you can. Unless interest rates go up high enough to counteract the rise in prices, the incentive will be to spend more.
This arguably impacts financial instruments as well. Ask yourself why you became interested in investing in the first place? Chances are that at least on some level you were concerned that if you didn’t you would fall behind the pack. And when inflation kicks in, the pack is running faster.
So, to sum up, here’s how it should work. We are in a recession that continues (despite its complex causes) in part because consumers are not spending, choking business, and in turn fueling unemployment. To respond, the United States prints more money to create a greater deficit. The growth of the deficit creates fear of inflation.3 This fear in turn prompts investors to invest in business ventures and move money from cash to riskier assets with higher potential yield, including as bonds and equities, rather than risk watching the value of their wealth diminish by keeping it in cash when inflation shifts into high gear. The increase in investment in turn fuels the economy, creating jobs and lifting financial markets, which in turn increases consumer confidence and leads to more spending.
Or at least that’s the theory.
- Economic News Release USDL-09-0388, Bureau of Labor Statistics, U.S. Department of Labor, April 15, 2009, http://www.bls.gov/news.release/cpi.nr0.htm. [↩]
- Sunshine, Mark, “Deflation is Worse than CPI Indicates,” November 25, 2008, http://seekingalpha.com/article/107926-deflation-is-worse-than-the-cpi-indicates; Paulos, George J., Housing and the CPI (2006), http://www.freebuck.com/articles/gpaulos/061104gpaulos.htm. [↩]
- See Eggertsson, Gauti B., “Great Expectations and the End of the Depression, Federal Reserve bank of New York Staff Report No. 234, December 2005, http://www.ny.frb.org/research/staff_reports/sr234.pdf, which argues that the Roosevelt’s administration effectively addressed the Great Depression by overtly stimulating inflation to counter excessively high real interest rates. [↩]