The Paradox of Thrift and the Paradox of Deflation

[Kurt_and_Hunter]

Damnification
Paul Krugman
January 30, 2009

...The paradox of thrift is the best-known example: when everyone tries to save more in an economy in which interest rates are up against the zero bound, everyone’s income falls, and we’re worse off than before. The paradox of deleveraging has gotten currency, too: everyone tries to shrink their balance sheet, and the result is plunging asset prices, which leave everyone worse capitalized than before.

But there’s at least one more form of damnification that has me really worried: the paradox of deflation. An individual company or worker can preserve a business or a job by accepting a lower price; but when everyone does it, we get debt deflation — a rising real burden of debt, which weighs on the economy — and also start to have deflationary expectations built into lending and investment decisions, which further depresses the economy. And once you’re in a deflationary trap, it’s very hard to get out.

If you ask me, the really scary report today wasn’t the GDP release, although that was plenty bad, but the employment cost index, which shows wage gains falling off fast. Wages aren’t declining, yet (although stories of wage cuts in particular firms are, I believe, more common than at any time since the 1930s); and we don’t have actual deflation in consumer prices, yet; but we’re moving in that direction. And we’re only in the early stages of a slump that, in the words of the CBO director,

absent a change in fiscal policy, CBO projects that the shortfall in the nation’s output relative to potential levels will be the largest– in duration and depth– since the Depression of the 1930s.

This really should be the key point in the stimulus debate. Yes, the effects of fiscal policy are uncertain; yes, running up large debts is risky; but doing nothing is even riskier, because there’s a high probability that if we don’t act strongly deflation will get embedded in the economy. We may be damned if we do, but we’ll almost surely be damnified if we don’t.

http://krugman.blogs.nytimes.com/2009/01/30/damnification/