Paul Krugman has a great op-ed piece in today’s New York Times. He notes the the conventional wisdom in economics circles is that the time has come to slash budget deficits in order to staunch anticipated inflation. The problem with this approach is that we have only started a recovery from the worst economic disaster since the Great Depression. The world economy is not yet strong enough to bear anti-growth cost-cutting.
When the financial crisis first struck, most of the world’s policy makers responded appropriately, cutting interest rates and allowing deficits to rise. And by doing the right thing, by applying the lessons learned from the 1930s, they managed to limit the damage: It was terrible, but it wasn’t a second Great Depression.
Now, however, demands that governments switch from supporting their economies to punishing them have been proliferating in op-eds, speeches and reports from international organizations. Indeed, the idea that what depressed economies really need is even more suffering seems to be the new conventional wisdom, which John Kenneth Galbraith famously defined as “the ideas which are esteemed at any time for their acceptability.”
The real risk right now, as reported in another article in today’s Times, is a risk of deflation.
If the European Central Bank has one monetary dragon it considers essential to slay, it is inflation.
Keeping inflation under control is the central bank’s primary legal responsibility, and as Europe struggles to overcome economic problems caused by the sovereign debt crisis, inflation has remained the bank’s primary focus.
But some economists say it has become a driving obsession that has blinded the bank to a potentially bigger threat to Europe: deflation.
The central bank’s doubters grew louder after it made a big show of taking measures to cancel out the supposed inflationary impact of the government bond purchases it began on May 10 to help keep Greece and several other euro zone countries from defaulting on their debts.
Many economists regard deflation as more dangerous than inflation, because it prompts consumers to delay purchases as they wait for lower prices, creating a downward spiral of lower demand and production. Deflation is also bad for debtors like Greece, because they may have to pay back money that would be worth more than it was when they borrowed it.
