On January 3, 1998, Alan Greenspan delivered a speech regarding the problems of price measurement. During this speech he discussed some of the characteristics of deflation and, as a result of his mention of the "D" word, the speech is now commonly referred to by the media as "Greenspan's Deflation Speech".
When delivering a speech Greenspan is always acutely aware of the constraints imposed by his position as Fed Chairman and the understanding of his audience. This is probably why his most candid speeches are those which have been given outside the US and his least revealing discourses are delivered during his regular appearances before Congress. However, all Greenspan speeches have one thing in common - precision. He is extremely careful in his choice of words, a characteristic which can sometimes make his language seem arcane. Strangely enough, it may be this desire for precision and clarity which creates confusion in the minds of those whose job it is to report on the utterances of the world's foremost central banker. They appear to be so preoccupied with finding hints on the future direction of interest rates and/or sensational headlines that they miss the intended message.
I have discovered, through careful reading of several Greenspan speeches, that most of what he says is not reported by the news media and the small component which is reported is usually misrepresented. I have also discovered that his speeches often incorporate lessons in economics, covering such important topics as the operations of central banks, the characteristics of fiat monetary systems and gold-based money, the nature of inflation and deflation, and the problems associated with accurately measuring the overall change in prices within an economy. A Greenspan speech is a rare opportunity to learn from a man who is not only one of the greatest economists of the past 50 years, but one who is in a position to directly affect the monetary policy of the western world.
It has been noted by Larry Parks at the FAME website (http://www.fame.org/fedwatch/fedwatch.htm) that Greenspan uses qualifiers such as "presumably" and "possibly" when he is stating a position which does not coincide with his personal beliefs. When making a statement which is consistent with his own beliefs he uses no such qualifiers. Distinguishing between the qualified statements and the direct assertions contained within a Greenspan speech can therefore provide us with clues as to how the Fed Chairman views the economic world.
Re-printed below is the section of Greenspan's recent speech in which he discusses deflation, with my comments shown bracketed and in RED italics. A transcript of the entire speech can be found at http://www.afr.com.au/content/980107/verbatim/verbatim1.html
"The remarkable progress that has been made by virtually all of the major industrial countries in achieving low rates of inflation in recent years has brought the issue of price measurement into especially sharp focus. (When Greenspan mentions inflation in this context he is using the popular meaning for the term, that is, the overall change in prices as measured by an index representing a basket of goods and services) For most purposes, biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, inflation has become so low that policy makers need to consider at what point effective price stability has been reached. Indeed, some observers have begun to question whether deflation is now a possibility, and to assess the potential difficulties such a development might pose for the economy. (Note that Greenspan uses the qualifier "some observers have begun to question", indicating that he does not hold this opinion)
Even if deflation is not considered a significant near-term risk for the economy, the increasing discussion of it could be clearer in defining the circumstance. Regrettably, the term deflation is being used to describe several different states that are not necessarily depicting similar economic conditions. One use of the term refers to an ongoing fall in the prices of existing assets. Asset prices are inherently volatile, in part because expected returns from real assets can vary for a wide variety of reasons, some of which may be only tangentially related to the state of the economy and monetary policy. Nonetheless, a drop in the prices of existing assets can feed back onto real economic activity, not only by changing incentives to consume and invest, but also by impairing the health of financial intermediaries -- as we experienced in the early 1990s and many Asian countries are learning now. (In other words and contrary to popular opinion, falling asset prices and deflation are different things. However, economic activity and consequently the banking system can be adversely affected by a drop in asset prices)
But historically, it has been very rapid asset price declines -- in equity and real estate, especially -- that have held the potential to be a virulently negative force in the economy. I emphasize rapid declines because, in most circumstances, slowly deflating asset prices probably can be absorbed without the marked economic disruptions that frequently accompany sharp corrections. The severe economic contraction of the early 1930s, and the associated persistent declines in product prices, could probably not have occurred apart from the steep asset price deflation that started in 1929. (Here Greenspan seems to be warning about the negative impact on the economy of a stock market crash, as opposed to a steady decline. He has studied the 1929 crash and is undoubtedly aware that the Fed did not react appropriately at the time, thus a sharp reduction in asset prices was eventually followed by a complete monetary collapse. The same mistakes were NOT made in 1987 when the Fed, under Greenspan's stewardship, injected substantial liquidity into the economy immediately following that year's stock market crash. This is also an indication that any future sharp correction in the stock market will be met with a large increase in the money supply.)
While asset price deflation can occur for a number of reasons, a persistent deflation in the prices of currently produced goods and services -- just like a persistent increase in these prices -- necessarily is, at its root, a monetary phenomenon. Just as changes in monetary conditions that involve a flight from money to goods cause inflation, the onset of deflation involves a flight from goods to money. Both rapid or variable inflation and deflation can lead to a state of fear and uncertainty that is associated with significant increases in risk premiums and corresponding shortfalls in economic activity. (If any one part of this speech should have been flashed across TV screens and newspapers around the world, it is this paragraph. Deflation is a monetary phenomenon and involves a flight from goods to money. Accordingly, what we are seeing throughout most of Asia at the moment is inflation, not deflation. Nobody in Korea or Indonesia is in a hurry to exchange goods for Won or Rupiah. In fact, stores have become empty as the people desperately try to obtain all the goods they can before the purchasing power of their currencies reduces further. The Asian "tigers" have been inflating their currencies at astronomical rates for many years and the trend continues.)
Even a moderate rate of inflation can hamper economic performance, as I have emphasized many times before; and although we do not have any recent experience, moderate rates of deflation would most probably lead to similar problems. Deflation, like inflation, would distort resource allocation and interfere with the economy's ability to reach its full potential. It would have these effects by making long-term planning difficult, obscuring the true movements of relative prices, and interacting adversely with institutions like the tax system that function on the basis on nominal values.
But deflation can be detrimental for reasons that go beyond those that are also associated with inflation. Nominal interest rates are bounded at zero, hence deflation raises the possibility of potentially significant increases in real interest rates. Some also argue that resistance to nominal wage cuts will impart an upward bias to real wages as price stability approaches or outright deflation occurs, leaving the economy with a potentially higher level of unemployment in equilibrium. (Greenspan is confirming that deflation must be avoided)
Greenspan goes on to discuss the relationship between productivity and price, whereby a general reduction in prices can be accompanied by good investment returns in an environment of rapid productivity growth (such as experienced in the technology sector). He also talks in detail about the difficulty of factoring quality improvements and new product features into the price measurement equation.
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In a previous article (Currency Turmoil in 1998 - posted at the bottom of this webpage) I stated that the US dollar should continue to strengthen during 1998, with the major downside risk being political (the US may pursue deliberate policies to depreciate the dollar in order to reduce the trade deficit). However, it is becoming apparent that Greenspan and Rubin, both of whom understand the over-riding benefits of a strong currency (low interest rates and large investment capital inflows), are holding sway. Therefore, even in the face of high rates of money supply growth the US dollar will remain the strongest of the fiat currencies. It appears that it is now only Mr. Clinton himself who can derail the dollar.
The reader is invited to respond to Milhouse's wisdom via email: sas@hk.gin.net
Milhouse
2 February 1998
Also by Milhouse:
Currency Turmoil In 1998
Japanese Monetary Problems
Gold Versus The Dollar
European Monetary Union
US Money Supply and the Demand For Gold
US / Japan Trade - Reality Versus Perception
Is Gold Still a Store of Value ?
Central Banks and Their Gold
The Intrinsic Value of Gold
Gold & Disintegration of U.S. Economic Influence
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