Warning: More doom ahead

For the wealthiest countries, a debilitating combination of economic stagnation and deflation might happen as markets for goods go slack because aggregate demand falls. Given how sharply production capacity has risen due to overinvestment in China and other emerging markets, this drop in demand would likely lead to lower inflation. Meanwhile, job losses would mount and unemployment rates would rise, putting downward pressure on wages. Weakening commodity markets—where prices have already fallen sharply since their summer peak and will fall further in a global recession—would lead to still lower inflation. Indeed, by early 2009, inflation in the advanced economies could fall toward the 1 percent level, too close to deflation for comfort.

This scenario is dangerous for many reasons. A number of central banks will be close enough to setting interest rates of zero that their economies fall into a triple whammy: a liquidity trap, a deflation trap, and debt deflation. In a liquidity trap, the banks lose their ability to stimulate the economy because they cannot set nominal interest rates below zero. In a deflation trap, falling prices mean that real interest rates are relatively high, choking off consumption and investment. This leads to a vicious circle wherein incomes and jobs are falling, with demand dropping still further. Finally, in debt deflation, the real value of nominal debts rises as prices fall—bad news for countries such as the United States and Japan that have high ratios of debt to GDP.

As orthodox monetary tools become ineffective, policymakers will turn to unorthodox approaches. We'll see traditional fiscal policy, in the form of tax cuts and spending increases, but also worldwide bailouts of lenders, investors, and financial institutions, as well as borrowers. Central banks will inject massive amounts of cash into financial systems to unclog the liquidity crunch. More radical actions, such as outright purchases of corporate and government bonds or subsidization of mortgage rates, might also be necessary to get credit markets functioning properly again.

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