- The Washington Times - Friday, December 20, 2002

Federal Reserve Chairman Alan Greenspan yesterday said the central bank will prevent the U.S. economy from falling into a destructive deflationary spiral like the one that caused the Great Depression.
Mr. Greenspan's first full-length speech addressing the trendy topic of deflation before the Economic Club of New York last night amounted to a virtual declaration of war against deflation, defined as a broad decline in prices and wages that causes cascading defaults and bankruptcies as consumers and businesses are no longer able to earn the income needed to pay off their debts.
The speech appeared aimed at calming fears in the financial markets that the United States could slump into a Japan-style liquidity trap, the only example of deflation in modern history.
Those fears have held down stock prices this year while giving a boost to bonds, which benefit from falling prices.
Alluding to Japan's experience in the past decade, Mr. Greenspan said Japan's "dysfunctional" attempts to control deflation by lowering interest rates to zero only after the problem set in are what prompted the Fed to move pre-emptively against any threat of deflation in the United States.
"The United States is nowhere close to sliding into a pernicious deflation," he said, but "a major objective of the heightened level of scrutiny is to ensure that any latent deflationary pressures are appropriately addressed before they become a problem."
The Fed chairman expressed confidence that the U.S. central bank can prevent any outbreak of deflation.
Moves might include not only cutting interest rates even further from their current 40-year lows, but also injecting money into the financial system through the purchase of Treasury bonds.
Still, he conceded that the Fed is dealing with economic forces that have not been seen for generations in the United States and the Fed can never know for sure whether the economy will respond to its medicine.
Despite some of the most aggressive rate cuts in the Fed's history in the past year, Mr. Greenspan said he is not sure the central bank has been successful at curing the economy's post-bubble woes, though he remains hopeful that the economic recovery will gather steam.
A destructive bout of deflation is most likely to arise in the aftermath of a bubble in stock or real estate prices like the one seen in the United States in 2000 and in Japan in the late 1980s, he said.
Ironically, the Fed contributes to the development of such bubbles by creating an environment of low inflation and economic stability that leads investors to believe they face minimal risks of default and bankruptcy which are most often experienced during recessions, he said.
Mr. Greenspan said that while the Fed cannot prevent the development of bubbles, it can prevent a spiral of tumbling prices from engulfing the economy after such episodes of "irrational exuberance."

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