Hardly anyone seems to believe that recent events in the global economy and financial markets will lead to long-term price stability.*  So assuming a recession is upon us, what’s next: inflation or deflation?

State and local governments (but not their taxpayers) have a rooting interest in a moderate to high level of inflation (as opposed to the outright chaos associated with hyperinflation).  Over a few years, a faster-rising Consumer Price Index would tend to shrink the public sector’s real liabilities while pumping up revenues from sales and income taxes.  That’s what happened in the late 1970s, when inflation played an unsung role in New York’s recovery from the fiscal crisis.

Deflation would be another story. America’s last period of serious deflation was the Great Depression.  But the public sector was much smaller during the 1930s—and, in those days, wages and benefits for most government employees were not fixed for years at a time under long-term collective bargaining agreements. Modern state and local governments have previously experienced a combination of increasing unemployment, weak corporate profits and rising prices (the “stagflation” of the 1970s).  But they have never been tested by increasing unemployment, weak corporate profits and falling prices.

True deflation—as Japan experienced during its post-bubble “lost decade”—would mean very slow revenue growth for state and local governments, coupled with big increases in the real cost of fixed long-term liabilities, including pensions as well as debt.  States like New York, with a heavily unionized public sector and extensive public welfare commitments, would quickly find themselves even more deeply in the hole if they failed to take much bigger steps to curb expenditures.

So what’s the outlook?   Some believe the Fed’s aggressive injections of liquidity into the financial system have greatly increased the risk of inflation.

Others predict that falling demand and rising inventories will produce the opposite effect; for example, oil prices already have considerably deflated over the past few months.

And uber pessimist Nouriel Roubini, the NYU professor who predicted the scope of the current financial crisis, thinks we’re heading for “stag-deflation.” In that case, Governor Paterson and Mayor Bloomberg will need to set much higher budget-reduction targets.

* NOTE: Bad choice of modifier in the original.   Long-term price stability is a realistic expectation; the inflation v. deflation question is really focused on the mid-term.  Say, 3-5 years.

About the Author

E.J. McMahon

Edmund J. McMahon is a senior fellow at the Empire Center.

Read more by E.J. McMahon

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