Monday, September 8, 2008

Krugman is wrong about deflation

Paul Krugman yesterday argued that the U.S. economy is mired in a debt deflation very similar to what Japan experienced in the early 1990s. If he's right, we're in serious trouble. Japan's stock market fell from 39,000 to 8,000, inflation was negative for almost 10 years, and economic growth was very weak for decades.

I think it's very unlikely we will experience anything of the sort. To begin with, our inflation rate has picked up quite a bit in recent years, suggesting inflation, rather than deflation, is the problem. Inflation is being driven by a very weak dollar; Japan's yen actually soared just prior to its deflation, rising from 250 per dollar in 1985 to 125 per dollar in 1988. Big moves in currencies typically precede changes in inflation.

We do indeed have some deflation in the real estate market, but that's because prices overshot during the real estate mania of the early 2000s. That mania, in turn, was fueled by easy money (which typically produces just such booms) as well as lower taxes on real estate gains. This is a bubble that is popping, but it is not an economy-wide deflation.

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