“About that deflation risk”

That’s the title of an entry in Krugman’s blog today:

There has been a distinct change in tone from the Obama team today, as they seem to have become suddenly aware that there’s a real risk that the stimulus plan will either fail to pass, or be emasculated to the point that it doesn’t come close to doing the job. Obama himself has warned of catastrophe if we fail to act, and – finally!- denounced the tax-cut philosophy. Meanwhile, Larry Summers has finally made the point I’ve been pushing for a while – that we’re at major risk of falling into a deflationary trap.

Do the math: if anything like the historical relationship between output and inflation holds, we’re looking at major deflation.

OK, maybe that relationship won’t hold – getting to actual deflation may take a deeper slump than merely reducing the inflation rate. And maybe a regression driven in part by 80s data isn’t a good guide to current events. But deflation is a huge risk – and getting out of a deflationary trap is very, very hard.

We truly are flirting with disaster.

The point is that we need the stimulus package and we need it now.  (Krugman’s view on tax cuts is widely shared by macroeconomists.  Simply put, right now we need jobs. Cutting taxes does not guarantee job creation as people may save the money instead.  Spending money on stimulus projects like infrastructure and education does create jobs.)

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