FacebookTwitterGoogle+RedditEmail

Is the Economy Too Simple for Economists to Understand?

by DEAN BAKER

The collapse of the housing bubble and the subsequent devastation to the economy caught almost the entire economics profession by surprise. Federal Reserve chair Alan Greenspan, along with other people in top policy positions, were left dumbfounded. They didn’t think a prolonged downturn was possible. They were wrong in a really big way.

The current group of central bank chairs and other top policymakers would like us to believe that they’ve learned their lesson and now everything is under control. They want us to think they actually have a clue about how the economy operates. There is good reason to believe otherwise. The European Central Bank (ECB) recognizes that inflation has been running below its 2% inflation target and is likely to stay below that target for several years to come. But the ECB has reassured the public that’s prepared to act, making sure that the eurozone doesn’t see deflation. That the bank cares about the inflation rate crossing zero and turning negative is a sign that it has no clue about how the economy works.

The point here is incredibly simple – apparently too simple for the ECB to understand. The inflation rate in the eurozone is too low right now. If it falls below zero and turns negative, this problem becomes more serious, but there is no qualitative difference between a drop from 1.5% inflation to 0.5% inflation and the drop from a 0.5% inflation rate to a -0.5% inflation rate.

To understand this dilemma, you just have to understand what the inflation rate is. It’s an aggregate of millions of different price changes. When the rate of inflation is near zero, there will be tens of thousands of prices that are falling. But these will be outweighed by the prices that are increasing, thereby making the aggregate inflation rate positive. What possible difference can it make to the economy if the mix of falling prices and rising prices goes from 45% falling and 55% rising to the opposite?

Another factor that shows the absurdity of deflationary fears is another pretty simple one: prices in our indices are quality adjusted prices. The price that people pay for a car or a computer may rise year-to-year, while the inflation index shows a decline for these items.

This would happen if the statistical agency calculated that the quality improvements were larger than the price increases, leading to a fall in the quality adjusted price. So we are supposed to believe that the economy is in trouble if the quality of computers and cars starts to increase more rapidly?

One of the oft-repeated deflation horror stories only needs a moment’s thought to realize its absurdity. Supposedly, if prices start to fall, then consumers will put off purchases. Really? If the price of a $30 shirt is falling at an annual rate of 0.5%, will many people delay buying a new shirt for six months to save 8 cents? Even in the case of a $20,000 car, delaying the purchase for a year only saves a consumer $100.

Of course, the quality adjusted price of computers has been falling for decades. This sector has not exactly been struggling.

Sometimes we hear a story of a deflationary spiral, wherein deflation reduces demand, leading to more deflation and a still further drop in demand. It’s a great story, but no one has seen anything like this since the start of the Great Depression. Even in the Japanese deflation horror story, the rate of annual deflation never exceeded -1.0%.

Incidents of runaway deflation, like hyperinflation, are extremely rare and would occur under extremely unusual circumstances. Both may make for good fairy tales for the kids, but they are not the sort of thing with which serious people need concern themselves.

While the concerns about deflation can be dismissed as silly children’s tales, there are two reasons that we should be troubled by their appearance in policy discussions. The first directly relates to current policy.

The eurozone is suffering from a lower than desired inflation rate now. With the overnight interest rate near the zero bound, the real interest rate cannot fall further unless the inflation rate rises. Since a lower real interest rate would help move the economy to full employment, the ECB should be trying to raise the inflation rate, not saving its ammunition against the risk that the inflation rate would turn negative. The menace of deflation provides an absurd excuse for inaction.

The other reason that we should be troubled by deflation talk is that it seems our top policymakers still don’t have the most basic understanding of the economy. The failure to see the bubbles was not a one-time lapse in judgment, it stemmed from seriously confused thinking about the economy. There really was no excuse for an informed economist not to recognize these bubbles and the threats they posed. It doesn’t appear that much has been learned in the last six years. The basic problem is that the economy is far too simple for economists to understand.

Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University. 

This article originally ran on the Guardian.

 

 

Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.

More articles by:

CounterPunch Magazine

minimag-edit

August 23, 2016
Diana Johnstone
Hillary and the Glass Ceilings Illusion
Bill Quigley
Race and Class Gap Widening: Katrina Pain Index 2016 by the Numbers
Ted Rall
Trump vs. Clinton: It’s All About the Debates
Eoin Higgins
Will Progressive Democrats Ever Support a Third Party Candidate?
Kenneth J. Saltman
Wall Street’s Latest Public Sector Rip-Off: Five Myths About Pay for Success
Binoy Kampmark
Labouring Hours: Sweden’s Six-Hour Working Day
John Feffer
The Globalization of Trump
Gwendolyn Mink – Felicia Kornbluh
Time to End “Welfare as We Know It”
Medea Benjamin
Congress Must Take Action to Block Weapon Sales to Saudi Arabia
Halyna Mokrushyna
Political Writer, Daughter of Ukrainian Dissident, Detained and Charged in Ukraine
Manuel E. Yepe
Tourism and Religion Go Hand-in-Hand in the Caribbean
ED ADELMAN
Belted by Trump
Thomas Knapp
War: The Islamic State and Western Politicians Against the Rest of Us
Nauman Sadiq
Shifting Alliances: Turkey, Russia and the Kurds
Rivera Sun
Active Peace: Restoring Relationships While Making Change
August 22, 2016
Eric Draitser
Hillary Clinton: The Anti-Woman ‘Feminist’
Robert Hunziker
Arctic Death Rattle
Norman Solomon
Clinton’s Transition Team: a Corporate Presidency Foretold
Ralph Nader
Hillary’s Hubris: Only Tell the Rich for $5000 a Minute!
Russell Mokhiber
Save the Patients, Cut Off the Dick!
Steven M. Druker
The Deceptions of the GE Food Venture
Elliot Sperber
Clean, Green, Class War: Bill McKibben’s Shortsighted ‘War on Climate Change’
Binoy Kampmark
Claims of Exoneration: The Case of Slobodan Milošević
Walter Brasch
The Contradictions of Donald Trump
Michael Donnelly
Body Shaming Trump: Statue of Limitations
Weekend Edition
August 19, 2016
Friday - Sunday
Carl Boggs
Hillary and the War Party
Jeffrey St. Clair
Roaming Charges: Prime Time Green
Andrew Levine
Hillary Goes With the Flow
Dave Lindorff
New York Times Shames Itself by Attacking Wikileaks’ Assange
Gary Leupp
Could a Russian-Led Coalition Defeat Hillary’s War Plans?
Conn Hallinan
Dangerous Seas: China and the USA
Joshua Frank
Richard Holbrooke and the Obama Doctrine
Margaret Kimberley
Liberal Hate for the Green Party
John Davis
Lost Peoples of the Lake
Alex Richardson-Price
The Fight for a Six Hour Workday
John Wight
Why Palestine Matters, Even on the Pitch
Brian Cloughley
Hillary Clinton’s War Policy
Patrick Cockburn
A Battle to the Death in Syria
David Rosen
The Great Fear: Miscegenation, Race “Pollution” and the 2016 Election
Ben Debney
Worthy and Unworthy Victims of Child Abuse
David Barouh
Liberal Myths: Would Al Gore Have Invaded Iraq?
Graham Peebles
Democratic Revolution Sweeps Ethiopia
Ismael Hossein-Zadeh
How Parasitic Finance Capital Has Turned Iran’s Economy Into a Case of Casino Capitalism
David Swanson
The Unbearable Awesomeness of the U.S. Military
Robert Fantina
The Olympics: Nationalism at its Worst
FacebookTwitterGoogle+RedditEmail