Deflation is defined by (mainstream) economists as ‘a sustained period of decline in a broad measure of prices, that is, a persistent decline in broad price indices’. Let’s accept that definition for the moment.

Donald Luskin –a famous financial analyst in the US– described Deflation  as the greatest threat an economy may suffer. He was talking about the US economy in 2001. Let’s see what he said about the deflation threat:

that’s going to be a world of hurt. If you thought inflation was a nightmare, wait till you live through a deflation. Prices of everything eventually go down — stocks, real estate, wages…the whole thing. You’re a little poorer every day.

And if you’re in debt, then you’re really in trouble. You’ll still have to make those same mortgage payments even though the value of your house is going down every month.

But that doesn’t mean that deflation is any bed of roses for lenders, either. Sure, it’s nice to have locked in a stream of payments in money that will buy you more and more apples and paper clips and houses as prices collapse. But you’ll never get the money, because the borrowers will all default. We’re seeing that happen already, with corporate bond defaults running at record levels.

So, deflation is a nightmare for everyone. Of course, deflation is seen as a permanent phenomenon, a downward spiral which would send and keep the whole economy in a deep hole. But the smart academic guys and the wise central planners have the cure to avoid this.

After the paragraphs above, Luskin gives us some hope. Well, not so, when one reads it in 2010. If you thought Krugman was nuts for asking Greenspan to create a housing bubble in 2001-2002, how should Luskin be described for saying the following?:

There’s still time for Alan Greenspan to save the world again, before we slip over the edge into a savage deflationary spiral, the evil mirror image of the inflationary spiral of the 1970s. But at this point the cure probably won’t be achieved simply by lowering interest rates…. No, to cure this recession Alan Greenspan is going to have to abandon interest rate targeting and focus on simply manufacturing the money that the economy needs.

Whoa. May I wonder whether the current crisis have something to do with Greenspan’s solution at that time? Such a weird way to save the world…

I see Luskin’s proposal not so different from some policies that have been proposed in recent times to fight against deflation. Now for instance, raising inflation expectations is being discussed among the Federal Reserve officials. Will the outcome of these policies be similar to that of Greenspan’s “solution” to deflation?

[More on Deflation soon]