Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.
But the adverse consequences of excessive money growth for financial stability and economic performance provoked a backlash. Central banks were finally pressed to rein in overissuance of money even at the cost of considerable temporary economic disruption. By 1979, the need for drastic measures had become painfully evident in the United States. The Federal Reserve, under the leadership of Paul Volcker and with the support of both the Carter and the Reagan Administrations, dramatically slowed the growth of money. Initially, the economy fell into recession, and inflation receded. However, when activity staged a vigorous recovery, the progress made in reducing inflation was largely preserved. By the end of the 1980s, the inflation climate was being altered dramatically.
The record of the past twenty years appears to underscore the observation that, although pressures for excess issuance of fiat money are chronic, a prudent monetary policy maintained over a protracted period can contain the forces of inflation. With the story of most major economies in the postwar period being the emergence of, and then battle against, inflation, concerns about deflation, one of the banes of an earlier century, seldom surfaced.
The recent experience of Japan has certainly refocused attention on the possibility that an unanticipated fall in the general price level would convert the otherwise relatively manageable level of nominal debt held by households and businesses into a corrosive rising level of real debt and real debt service costs. It now appears that we have learned that deflation, as well as inflation, is, in the long run, a monetary phenomenon, to extend Milton Friedman’s famous dictum.
To be sure, in the short to medium run, many forces are at play that complicate the link between money and prices. The widening globalization of market economies in recent years, for example, is integrating a growing share of previously local capacity into an operationally meaningful world total. That process has, at least for a time, brought substantial new supplies of goods and services to global markets. In addition, the more rapid rate of technological innovation, so evident in the United States, has boosted the pace at which our productive potential is expanding. These shifts in aggregate supply — whether foreign or domestic in origin — influence the relationship between money and prices. Moreover, the tie between money and prices can be altered by dysfunctional financial intermediation, as we have witnessed in Japan. Thus, recent experience understandably has stimulated policymakers worldwide to refocus on deflation and its consequences, decades after dismissing it as a possibility so remote that it no longer warranted serious attention.
The meaning of deflation and the characteristics that differentiate it from the more usual experience of inflation are subjects being actively studied inside and outside of central banks. As I testified before the Congress recently, the United States is nowhere close to sliding into a pernicious deflation. Moreover, a major objective of the recent heightened level of scrutiny is to ensure that any latent deflationary pressures are appropriately addressed well before they became a problem.
Central bankers have long believed that price stability is conducive to achieving maximum sustainable growth. Historically, debilitating risk premiums have tended to rise with both expected inflation and deflation, and they have been minimized during conditions of approximate price stability.
Although the U.S. economy has largely escaped any deflation since World War II, there are some well-founded reasons to presume that deflation is more of a threat to economic growth than is inflation. For one, the lower bound on nominal interest rates at zero threatens ever-rising real rates if deflation intensifies. A related consequence is that even if debtors are able to refinance loans at zero nominal interest rates, they may still face high and rising real rates that cause their balance sheets to deteriorate.
Clearly, it would be desirable to avoid deflation, but if deflation were to develop, options for an aggressive monetary policy response are available.
Certainly, lurking in the background of any evaluation of deflation risks is the concern that those forces could be unleashed by a bursting bubble in asset prices. This connection, real or speculative, raises some interesting questions about the most effective approach to the conduct of monetary policy. If the bursting of an asset bubble creates economic dislocation, then preventing bubbles might seem an attractive goal. But whether incipient bubbles can be detected in real time and whether, once detected, they can be defused without inadvertently precipitating still greater adverse consequences for the economy remain in doubt.
The conditions of extended low inflation and low risk were combined with breakthrough technologies to produce the bubble of recent years. But do such conditions always produce a bubble? It seems improbable that a surge in innovation in the near future would generate a new bubble of substantial proportions. Investors are likely to be sensitive to the need for asset prices to be backed ultimately by an ongoing stream of earnings. Hence, a further necessary condition for the emergence of a bubble is the passage of sufficient time to erode the traumatic memories of earlier post-bubble experiences.
If the postmortem of recent monetary policy shows that the results of addressing the bubble only after it bursts are unsatisfactory, we would be left with less-appealing choices for the future. In that case, finding ways to identify bubbles and to contain their progress would be desirable, though history cautions that prospects for success appear slim.
As I noted earlier, it seems ironic that a monetary policy that is successful in inducing stability may inadvertently be sowing the seeds of instability associated with asset bubbles. I trust that the use, by the central bank, of deliberately inflationary policy as protection against bubbles can be readily dismissed. While the current episode has not yet concluded, it appears that responding vigorously in a relatively flexible economy to the aftermath of bubbles, as traumatic as that may be, is less inhibiting to long-term growth than chronic high-inflation monetary policy. Moderate inflation might possibly inhibit bubbles, though at some cost of reduced economic efficiency. However, I doubt that such policies could be sustained or well-controlled by central banks. Among our realistically limited alternatives, dealing aggressively with the aftermath of a bubble appears the most likely for averting long-term damage to the economy.
In summary, as we focus on the dangers of bubbles, deflation, and excess capacity, the marked improvement in the degree of flexibility and resilience exhibited by our economy in recent years should afford us considerable comfort for now. Still, economic policymakers are having to grapple with what seems to be a much larger portfolio of problems than that which our predecessors appeared to face a half-century ago. The ever-growing complexity of our global economic and financial system surely plays a role. Moreover, the very technologies that have helped us reap enormous efficiencies have also presented us with new challenges by increasing our interconnectedness.
— The preceding is an edited version of a speech given by Alan Greenspan, chairman of the U.S. Federal Reserve Board, in December 2002 before the Economic Club of New York in New York, N.Y. The rest of the speech can be found at www.federalreserve.gov
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