NCPA - National Center for Policy Analysis

Deflation Is The Real Problem

September 30, 2002

One of the most puzzling aspects of the economy today is the apparent impotency of monetary policy. Increases in the money supply stimulate growth by putting upward pressure on prices. Higher prices for goods and services raise corporate profits, leading to increased investment and employment. Carried too far, the result is inflation. But at present, the economy's fundamental problem appears to be deflation --falling prices -- not inflation.

  • Deflation has the opposite effect of inflation, because when companies cannot raise prices, but instead must continually cut them, profits evaporate.
  • This causes stock prices to fall, which reduces net worth.
  • Eventually, consumers cut back on spending and banks restrict lending as credit quality deteriorates because stocks are often used as collateral for loans.
  • When stocks fall, therefore, it forces banks to call in loans and raise interest rates.

Deflation in a depressed economy accentuates the decline in economic activity by punishing borrowers and threatening the solvency of banks, which in turn restricts their lending. The spread or difference between the federal funds interest rate and interest rates charged to businesses has increased from 1.56 percent in 1996 to 2.17 percent now (see figure).

  • An increase in the spread is an indication of declining credit quality.
  • As more business loans go bad, banks must charge more to cover their losses and tighten standards for lending, thus making credit less available -- especially for small- and medium-sized businesses.
  • If credit quality is falling, then increases in the money supply are bottled up in the banking system, rather than being dispersed throughout the economy.
  • In other words, monetary policy is short-circuited and becomes ineffective for stimulus.

Bush Administration officials continue to talk about putting forward some new tax initiatives to jumpstart growth and investment. However, if the problem is a credit crunch that is short-circuiting monetary policy, then tax cuts may be ineffective. The administration needs to look into this possibility and see whether federal policies can reverse it.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, September 30, 2002


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