I have characterized the current situation as a “good-deflation” macroeconomic equilibrium where consumers see low price growth as helpful in maintaining moderate spending in a jobless economy, producers see low price growth as helpful in maintaining costs, and the FED is able to maintain historically low interest rates without worrying about inflation.  If the recovery remains job-less and weak then the probability that the economy could switch to a “bad-deflation” equilibrium is uncomfortably high.

The business press has commented that today’s inflation data provides validation of Chairman Bernanke’s decision to proceed with a second-round of quantitative easing, QE2.  I do not think that QE2 will provide much stimulus, in part because it is already priced in and because there are too many other structural economic problems, see my exposition here.

While the low inflation number reported today adds to my nervousness about slippage toward bad-deflation, it is not the case that QE2 is validated by today’s data.  QE2 alone is not enough.  The large variety of structural problems that still exist must be addressed to promote macroeconomic health.

Seeing a problem and knowing how to solve it are two different things.  So, we’re going to see lots of silly ideas proposed.  We’ll see demands for more government spending.  We’ll see demands for less government spending.  We’ll see demands for higher taxes.  We’ll see demands for lower taxes.  We’ll see demands for more consumer spending.  We’ll see demands for more consumer saving.

All of these recommendations can’t be correct.  In fact, they are all beside the point.  I’m not saying the proposals won’t have any impact.  They will, but the impacts will either be marginal or they will be some time in the future.  Our problem is immediate and very serious.  Here’s what we need to do to avoid a lost decade:

• Fix the financial sector
• Stop paying interest on deposits at the Fed
• Lower effective borrowing costs with an investment tax credit
• Reduce regulatory uncertainty and big-business bias
• Increase immigration

Any vigorous recovery needs a vigorous financial sector, and ours is not.  Fed policy has been ineffective, because the money multiplier has tanked, even as the monetary base soared.  There are two reasons for this: The Fed is paying banks to deposit at the Fed, and the banks–burdened with over-leveraged balance sheets, huge charge-offs, and bad assets–are in no shape to lend.  Fix the banks, and stop encouraging them to park money in Washington, and we’ll have a start on real recovery.

We have an investment problem; there isn’t any.  That’s because, even at zero, borrowing costs exceed expected returns on investments, and the future regulatory environment is extremely uncertain.  We can’t lower interest rates below zero, but an investment tax credit would effectively lower borrowing costs.  Do that and remove regulatory uncertainty, and our businesses will invest.  While we’re at it, let’s reduce big business’ regulatory advantage.

Finally, we don’t have any problems that couldn’t be fixed by a few million new immigrants.  We’d see an immediate increase in housing demand and construction.  Our inner cities would be renewed.  Our economy would see a burst of creativity, energy, and new business formation.

Most of the June PPI deflation was due to declining food prices. Producer prices are up from a year ago, where of course a year ago, prices were at record lows after being pummeled by the Great Recession.

Monthly consumer price growth has also been negative since April, while year-on-year CORE consumer price growth has been falling since December of 2009 and is at a 49-year low.

These price changes are occurring against the backdrop of contracting Retail spending and slowing manufacturing growth, according to the latest (June) data.

We teach our students about multiple-equilibria, especially in the context of macro and international models. The typical cause of multiple equilibria, as opposed to a unique equilibrium, is alternate expectation possibilities. In certain situations, agents’ expectations might easily change from one possibility to another.

Think of an over-simplified condition where three equilibria are possible. The best equilibrium is one that would be difficult for the United States economy to achieve at this time, one where job growth was 1.5 percent, GDP growth was 3.5 percent and inflation was 2.0 percent.

Another possible equilibrium could be one where deflation strangles the economy, where debt-laden and cash-strapped consumers decide to hold off on purchases thus causing a large fall in the 71% component of GDP that is consumer spending. This is the worst of our three possible equilibria, and the one that causes economists to lose sleep at night.

A third possible equilibrium, an intermediate one, is where consumers see low price growth as helpful in maintaining moderate spending in a jobless economy, producers see low price growth as helpful in maintaining costs, and the FED is able to maintain historically low interest rates without worrying about inflation.

The third possible equilibrium is, in part at least, a result of technological improvement. Any $1,000 dollars spent today on a personal computer, or any $100 dollars spent on a cell phone purchases the consumer a product that is dramatically more functional than what was available just a few years ago.

I believe that, at the moment, we are in a situation that is essentially the third equilibrium. Absent some unforeseen event, the possibility of achieving the first equilibrium seems remote for now. The possibility of achieving the second equilibrium is unfortunately all too high.

My hope is that we stay in this relatively desirable intermediate equilibrium, but of course there is no guarantee of this. The factors that drive an equilibrium shift, including today’s lower consumer confidence data, will be the topic of another blog.

Why would this be happening? Could it be that domestic expenditure growth is decelerating? We will not know this for a few weeks yet until April consumption data is released.

If it is true that domestic demand growth is falling we have a number of potential concerns, the first of which is that the recovery would be in jeopardy. Just as serious though, if demand growth and Core prices both fall then we may be heading toward deflation.

Deflation is particularly scary in the context of our current Macroeconomic situation: the fundamental weaknesses that exist would be exacerbated if households and firms stopped spending because they believe that prices are going to get cheaper.

I think Fed policy has been too tight. Instead of paying interest on excess deposit, they should be charging a fee. Of course, many disagree and worry about inflation, and that is what I thought I was reading as Shelton proceeds with her thesis that the Fed’s policy may be fueling a new asset bubble. This is pretty standard stuff, boringly standard in fact. I was about to quit reading and go on to something else when I came to a paragraph that stopped me cold:

“Deflation is seen as the bugaboo of Keynesian economics. But it can actually serve to spur economic activity as lower prices enable struggling consumers to get back in the game, and enterprising individuals can build businesses using tangible assets that yield valid profits.”

That paragraph is breathtaking, so wrong on so many levels, so counter to what we know to be true. I couldn’t believe that an economist would say that. So, I looked for her tag line. Sure enough, it says she’s an economist. I did a web search. She’s got at least one book out. She’s in the WSJ frequently. She’s all for a gold standard.

Shelton received her Ph.D. in Business Administration at the University of Utah, and she’s a professor at the Duxx Graduate School of Business at Monterrey, Mexico. One observer—goes by Federalist on the web, but I couldn’t find a name—described her as having few credentials. I don’t think that is exactly true. She has impressive credentials, just not as an economist.

Let’s correct her paragraph:

No one is going to mistake me for a Keynesian, but I’m certain that deflation is bad. Economists in general, not just Keynesian, know deflation is bad. I don’t know of one credible economist, from a top 50 school, with a Ph.D. in economics, who believes that deflation is not bad.

Shelton goes beyond saying deflation is not bad. She claims deflation is good, stimulative, spurring economic activity, “enabling struggling consumers to get back in the game.” Amazing.

Here’s the story on deflation: As prices fall, no one has an incentive to purchase anything, the cost will be less tomorrow; consumption and investment decline. Borrowers pay with deflated dollars, making real interest rates very high, again leading to less investment and consumption. Wages don’t adjust quickly, leading to unemployment, 25 percent in the depression. Asset values decline, but debts become more burdensome, leading to credit defaults and over-leveraged banks, businesses, and consumers. Lending, borrowing, consumption, investment, and economic activity decline.

One problem of smart people pontificating outside their field is that they come up with ideas that sound good, don’t hold up to serious analysis. Economists have performed a huge amount of research on inflation and deflation, empirical research and theoretical research. The profession has rejected the thesis that deflation is good. The risk is that someone with authority listens to someone like Shelton and tries to implement her recommendations. That would be tragic. Bad policy leads to a bad economy, and the costs of a bad economy are immense and not just financial. Serious recessions change lives, usually for the worse. Careers, families, and lives are destroyed. It is a shame that Shelton has a mouthpiece as big as the Wall Street Journal.

Why do we care about this? This helps keeps interest rates low and provides support for United States borrowing. It also maintains the many-decade-long pattern of relatively low United States savings rates and relatively high Asian-country savings rates.

There is another, more current, story behind this activity. Bond holdings are insurance against expected deflation. We here at CERF have been saying that the risk of United States Deflation is higher than risk of Inflation for six months now. It is now clear we are not the only ones with this opinion.

However, inflation is not inevitable. For inflation to occur, increases in the monetary base have to be translated to an increase in money supply. This is the money multiplier that we teach in elementary macro-economics, and it depends on bank lending, something that is just not happening. Even if the money supply increases, velocity declines could offset the inflationary impacts.

We are seeing an alarming increase in deflation around the world. The BBC reported today that Japanese prices have fallen 8.5 percent in the past year. Prices have also been falling in Germany, Spain, Britain, Ireland, and Switzerland.

It is virtually impossible to imagine a recovery if the United States slips into deflation. So far, we’ve had small increases in prices. Let’s hope that continues.