An asset bubble adds to deflation risk
18 September 2002
In the midst of a prolonged global economic slowdown and stock market downturn, there is growing recognition around the world that the main threat to future prosperity is deflation. However, some of the suggestions on how to deal with the impending deflation fail to recognise the threat posed by an asset bubble.
In June, the Federal Reserve published a discussion paper, "Preventing Deflation: Lessons from Japan's Experience in the 1990s", which clearly stated that the Federal Reserve would prefer to set interest rates too low and risk inflation than set rates too high and risk emulating Japan's "lost decade" of economic stagnation.
Picking up on the Federal Reserve's stance in that paper in a BusinessWeek Online article on 15 September, Christopher Farrell wrote: "Recent criticisms of Fed Chairman Alan Greenspan for supposedly missing the dangers of the late 1990s bubble are misplaced, however. The fundamental monetary-policy issue of the coming decade isn't about when and how to prick an asset bubble. No, the troubling problem for the Fed will be developing adequate tools to prevent incipient deflation."
What Farrell fails to see is that the way to prevent incipient deflation is precisely to prick the asset bubble. My previous article showed that Greenspan should have recognised the bubble earlier and could have done something about it. The question now is: Should he have done something about it? In my opinion, the answer to that question is yes. If Greenspan had deflated the stock market bubble a few years earlier, the deflation threat now would be considerably smaller.
One has to recognise the fact that price levels in the US were too high. While inflation had been low in the US in the 1990s, it still left US prices higher than in other countries, especially with the increasing impact of cheap China-made goods on the world market. That made US manufacturers uncompetitive and hence, created a persistent current account deficit. Once price levels became excessive, the Federal Reserve's efforts to avoid deflation and maintain those prices by easing monetary policy ended up feeding an asset bubble.
Andy Xie of Morgan Stanley had written on 29 October 2001 in the Global Economic Forum: "We note that the Fed made the mistake by sticking to price stability in the 1990s. They should have allowed prices to decline. Japan made the same mistake in 1980s, when the currency realignment created deflationary pressure in Japan."
An earlier deflation of the bubble would have required smaller adjustments in the economy, making any resultant downturn less painful. For one thing -- bearing in mind the extreme overvaluation of stock prices on Nasdaq -- over-capacity in the high tech sector, particularly in telecommunication, would not have been so pronounced and debt so debilitating. As it is, that over-capacity and debt will be a drag on the world economy for a long time to come.
Ultimately, it is useless -- and very probably counter-productive -- to try to keep deflation at bay by creating an asset bubble. While it is only fair to recognise that Greenspan was trying to balance the forces of deflation and asset inflation, the fact is that he allowed an asset bubble to form during his watch -- even if inadvertently -- and probably aggravated the risks from deflation. Therefore, criticism of him can hardly be considered misplaced.
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