SKOPJE, Macedonia, Sept. 25 (UPI) -- In a series of speeches designed to defend his record, Alan Greenspan, until recently an icon of both the new economy and stock exchange effervescence, reiterated the orthodoxy of central banking everywhere. His job, he repeated disingenuously, was confined to taming prices and ensuring monetary stability.
He could not and, indeed, would not second-guess the market. He consistently sidestepped the thorny issues of just how destabilizing to the economy the bursting of asset bubbles is and how his policies may have contributed to the froth.
Greenspan and his ilk seem to be fighting yesteryear's war against a long-slain monster. The obsession with price stability led to policy excesses and disinflation gave way to deflation -- arguably an economic ill far more pernicious than inflation.
Deflation coupled with negative savings and monstrous debt burdens can lead to prolonged periods of zero or negative growth. Moreover, in the zealous crusade waged globally against fiscal and monetary expansion, the merits and benefits of inflation have often been overlooked.
As economists are wont to point out time and again, inflation is not the inevitable outcome of growth. It merely reflects the output gap between actual and potential GDP. As long as the gap is negative -- i.e., while the economy is drowning in spare capacity -- inflation lies dormant. The gap widens if growth is anemic and below the economy's potential. Thus, growth can actually be accompanied by deflation.
Indeed, it is arguable whether inflation was subdued -- in America as elsewhere -- by the far-sighted policies of central bankers. A better explanation might be overcapacity, both domestic and global, wrought by decades of inflation that distorted investment decisions.
Excess capacity, coupled with increasing competition, globalization, privatization and deregulation, led to ferocious price wars and consistently declining prices.
Quoted by The Economist, Dresdner Kleinwort Wasserstein noted that America's industry is already in the throes of deflation. The implicit price deflator of the non-financial business sector has been -0.6 percent in the year to the end of the second quarter of 2002. Germany faces the same predicament. As oil prices surge, their inflationary shock will give way to a deflationary and recessionary aftershock.
Depending on one's point of view, this is a self-reinforcing virtuous -- or vicious -- cycle. Consumers learn to expect lower prices -- i.e., inflationary expectations fall and, with them, inflation itself. The intervention of central banks only hastened the process and now it threatens to render benign structural disinflation, malignantly deflationary.
Should the USA reflate its way out of either an impending double-dip recession or deflationary anodyne growth?
It is universally accepted that inflation leads to the misallocation of economic resources by distorting the price signal. Confronted with a general rise in prices, people get confused. They are not sure whether to attribute the surging prices to a real spurt in demand, to speculation, inflation or what. They often make the wrong decisions.
They postpone investments -- or over-invest and embark on preemptive buying sprees. As Erica Groshen and Mark Schweitzer have demonstrated in a National Bureau of Economic Research working paper titled "Identifying inflation's grease and sand effects in the labor market," employers, unable to predict tomorrow's wages, hire less.
Still, the late preeminent economist James Tobin went as far as calling inflation "the grease on the wheels of the economy."
What rate of inflation is desirable? The answer is: it depends on whom you ask. The European Central Bank maintains an annual target of 2 percent. Other central banks -- the Bank of England, for instance -- proffer an "inflation band" of between 1.5 percent and 2.5 percent. The Fed has been known to tolerate inflation rates of 3 percent to 4 percent.
These disparities among essentially similar economies reflect pervasive disagreements over what is being quantified by the rate of inflation and when and how it should be managed.
Part 2 of this analysis will appear Thursday
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