Commenter Zack sent the following Paul Krugman links and quotes, which deserve promotion from the comments section.
"But deflation is a huge risk — and getting out of a deflationary trap is very, very hard.
We truly are flirting with disaster."
"So we're really heading into Japanese-style deflation territory"
"So tell me why we aren’t looking at a very large risk of getting into a deflationary trap, in which falling prices make consumers and businesses even less willing to spend."
"But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising."
"What I take from this is that deflation isn’t some distant possibility — it’s already here by some measures, not far off by others."
"Worst of all is the possibility that the economy will, as it did in the ’30s, end up stuck in a prolonged deflationary trap."
As we know, it didn't turn out that way. We have had positive inflation for 6 years.
Why does this matter? Normally, it doesn't and it shouldn't.
To repeat points made earlier, economics should be science, not witchraft. We do not say "the witch doctor said it would rain, and it did!," and follow him for a while. At a minimum, we measure a forecaster's ability by collecting all his or her forecasts, not just the good ones -- or the bad ones. More deeply, personal prognostication is a nearly useless test of economic models. Prognostication mixes judgement, opinion, forecasts of what politicians will do and what shocks will hit the economy, along with economic models, in ways that tell you little about the models. If a climate scientist tells you he thinks it will rain this weekend and it's sunny instead, we do not say "well, climate science is bunk." You can only "test" a model once it is written down in a way that anyone operating the model can agree what its prediction is. Finally, there are a lot of other shocks hitting the economy; a forecaster that was right 60% of the time would be a genius in this business, so one blown forecast is meaningless. If anyone else had written these, they could reasonable respond "it's still a danger, we only avoided it by the Fed's QE and huge deficits."
But I don't write endless posts excoriating "inflationistas" for the lack of their largely mischaracterized inflation forecasts, crowing about how I'm always right about everything, damning others for failing to learn from evidence, and Bulverizing (look it up, here too, a great word) about their evil motives. So a few look-in-the-mirror-why-don't-you quotes are appropriate. I've been too lazy to look up these quotes, so I thank Zack for doing it.
This also will matter Monday -- I have a piece coming out that mentions the failure of the widespread "deflationary spiral" forecast. These quotes offer a nice documentation.
By the way, yes, at the time I warned of the risk of inflation, and that didn't happen either. I was quite clear it was a risk not a forecast. California has a risk of earthquakes. And the failure to see one in six years does not prove geologists are all mendacious morons. There are precedents for the inflation risk. Reinhart and Rogoff pointed to quite a few cases in which after a "quiet period," banking crises are followed by sovereign debt crises or defaults.
As I see it, that risk remains, though it has declined a lot. The reason it declined is that our government, and the European governments, kept their eyes on long-term budget issues. Our Administration has from the beginning always promised long-term budget repair, despite Keynesian theory that says if you want to stimulate, you keep quiet about future taxes or spending reductions. No point in waking up the Ricardian genie. You might complain the Administration wasn't serious enough, but they were always saying there would be a long term plan, and bond markets evidently bought it. Many in Congress too have had their eyes on long-term budgets, and long-term fiscal solvency depends if anything more on Congress than on this Administration.
The Europeans have gone through several rounds of "austerity," despite Keynesian and especially Krugmanian excoriation. (True, they started with counterproductive high-marginal-tax austerity, but Europe seems quickly to have learned that less spending and structural reform are a better path.) They came darn close. If Italy and Spain had defaulted, we would likely be having a different conversation today.
Doing so, our and Europe's governments persuaded bond markets that the currency and debt are safe -- maybe even too safe - -and avoided, for now, the sovereign debt fate Reinhart and Rogoff warned about. If I erred in overestimating the inflationary risk, I erred in underestimating the fiscal sobriety of all our governments, and I overestimated the extent to which they believed the Keynesian advice to ignore, default, devalue, or inflate away debt. That's why no earthquake in 6 years hasn't changed all that much my views on the "model," in this case of underlying causes of inflation.
On the "spiral" or "vortex." Perhaps there are a few true-blue Keynesians reading who can help me out. I understand the idea that deflation leads to high real rates leads to lower demand leads to lower output leads to more deflation. ("Understand" ≠ "Agree".) I don't see how the model ever predicts this to end. Is there some clear "and it bottoms out when x y z?" In my model, it bottoms out when you hit the top of the present value Laffer curve, and future taxes cannot hope to pay back the deflationary increase in the real value of the debt. But I don't know where it ends in the standard old-Keynesian model. Positive eigenvalues are positive eigenvalues. Maybe some wealth effect of government bonds (Another way to put "my model")? But why doesn't that stop the spiral in the first place? Is it right to characterize the model's prediction as an endless spiral to zero? If not why not?
Update: Commenter JZ sends the following link, and it's only fair to include it.
" ... back when the crisis started, I did expect to see deflation, Japanese style, if it went on for an extended period. I was wrong ... "