SYNOPSIS:

A followup on Friday's NYT column: first, Brad DeLong is quite right that there's no such thing as excess capacity for the economy as a whole. I've been vociferous about that myself in the past. What I meant to say was over-investment in short-lived business capital, mainly tech, relative to other resources - which is the sense in which an over-investment model of the business cycle can be justified - the same sense in which business as a whole can find itself with excess inventories. That's a longish story, and quite tricky to model - more when I have some spare time (hahaha!).

Now, about the risks. My back-of-the-envelope estimate of the current output gap is the same as his - 4 percent. That could be wrong - we don't really know how overheated the economy was at its peak. But let's take that number for a minute. Let's also notice that inflation, as measured by the GDP deflator, has come down quite a lot already. It was more than 2 percent in 2000-2001, now it's about 1 percent.

The experience of disinflation during the 1980s suggested that the economy's "sacrifice ratio" - the number of point-years of output gap needed to bring inflation down by one point - was about 4. That number may well have fallen since, as the economy has become more flexible. Now suppose that the average output gap over the next year is at least as high as it is now, surely a realistic possibility. Then by a year from now we could be looking at zero inflation as measured by the GDP deflator - we could indeed be looking at mild deflation. In short, concerns about future deflation in the U.S. are not wild and crazy: you can quite easily construct a deflation scenario using completely conventional models and not-too-pessimistic numbers.

Is this a bad thing? Zero inflation is not a cliff-edge, with an abyss on the other side. But the lower the inflation rate embedded in peoples' expectations, the higher the real interest rate when the Fed funds rate is zero - that is, a slide from mild inflation into mild deflation makes a liquidity trap that much more likely. Every time I read a news report describing low inflation numbers as good news, I shake my head in disbelief.

The more I think about it, the more baffled I get by the Fed's relaxed attitude. (Ben, are you reading this? Shake some sense into your new colleagues!) Nobody expects the output gap to decline much for the next few quarters; the Fed doesn't have an explicit inflation target, but if it did it would be something like the Bank of England's 2.5 percent. Isn't the case for action getting pretty strong?

Last point: Paul McCulley at PIMCO has corrected me. The Fed chairman is now properly referred to as Sir Alan Greenspan-san.

Originally published on the Official Paul Krugman Site, 8.17.02