Krugman fears deflation

A new problem

There’s been some talk abut risks of deflation, but there’s one alarming comparison I haven’t seen made. The figure above shows that the CBO is currently projecting an output shortfall from the current slump comparable to the slump of the early 1980s. Actually, it’s very close: if you compare the CBO’s projections of unemployment from 2008 through 2012 with its estimate of the natural rate, we’re looking at cumulative excess unemployment of 13.9 point-years; that compares with 13.7 point years from 1980 through 1986. (If the natural rate — the unemployment rate that keeps inflation unchanged — is 5 percent, and the actual unemployment rate averages 7 percent over a year, that’s 2 point-years of excess unemployment.)

Now here’s the thing: the slump of the early 1980s produced the Great Disinflation, which brought the core inflation rate down from about 10 to about 4.

This time, however, we entered the slump with a core inflation rate of about 2.5 percent. If we experienced a disinflation comparable to that of the 1980s, that would mean ending up with deflation at a rate of -3.5 percent.

And bear in mind that neither the CBO nor the Obama team really explains where recovery comes from; it’s just assumed.

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. Tell me why this risk wouldn’t remain high, though lower, even with the Obama plan, which as far as I can tell is expected to reduce cumulative excess unemployment by about a third.