The Specter of Deflation

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Six straight quarters of GDP growth have demolished the double-dip demon's credibility. With the clearing of the fog of war, it's also evident that the risk of a new recession has dropped sharply. While some observers are still waiting for more data, the reality is that we already have enough to make a call.

The growth rate of the Weekly Leading Index published by the Economic Cycle Research Institute, which correctly predicted the last recession, had risen to a 45-week high by late May, suggesting that a new recession is very unlikely.

But the "perfect" V-shaped recovery remains a fantasy. With business spending and hiring unlikely to surge anytime soon, the recovery will probably remain subpar.

The Deflation Dragon

The new enemy is deflation. To listen to some learned economists and policymakers, you'd think that the deflation dragon is already breathing down our necks. According to one poll, the majority of the general public already believes that.

The key parallel driving these concerns is Japan, where the popping of the 1980s asset-price bubble brought economic malaise and deflation in its wake. These concerns were telegraphed a year ago by a Federal Reserve paper attempting to draw lessons from the Japanese experience, concluding that in hindsight, the Bank of Japan had been too tight.

More recently, the research director of the Dallas Fed put the chances of U.S. deflation at one in four, arguing that because it's happened here before, it can happen here again. The International Monetary Fund has warned of a liquidity trap, where even if more money is printed, demand falls as people hold on to money in the expectation of lower prices. Last weekend a noted New York Times columnist added his voice to the chorus, opining that the risks of a deflationary quagmire "look uncomfortably high."

But all of this learned analysis seems to have missed a key piece of the puzzle when it comes to the circumstances that lead to deflation. And that's the role of recessions. Contrary to much that has been written, the history of deflation in both the U.S. and Japan shows that it's not slow growth per se but frequent recessions that are associated with deflation.