The business press is warning us about the newest economic peril, which turns out not to be a peril at all. Alongside collapsing production, rising unemployment, and falling government revenue, we are being warned about the supposed menace of falling prices.
Now, on its face, you might not think this sounds so bad. Prices in technology like computers and calculators have fallen like a rock in the last twenty years, and no one is the worse for it. Generally, if stuff costs less tomorrow than today, the purchasing power of your income grows and your standard of living goes up.
Falling prices also reward savings, which grow even without earning interest. You might even think a little deflation would be much-needed reparation for a century of inflation that has eroded the value of a 1900 dollar to a nickel.
But for many observers, deflation is regarded as an economic calamity. "This is potentially a very bad problem," says this year’s Nobel Laureate George Akelof of Berkeley.
Before refuting that idea, let’s examine whether it even exists. The main evidence is the fall in the wholesale price index, which declined 1.6 percent from September to October. Break the data down, however, and you find that most of the fall came through lower energy prices. This has been heavily influenced by a huge number of factors, including falling demand and OPEC’s gearing up production on US insistence.
Now, falling energy prices are just what the doctor ordered for the onset of winter and the travel season, especially for the airline industry. But for an administration focused on "stabilizing" the price of oil (translation: keeping it higher than it should be), this slight decline requires immediate action.
So Bush has ordered that the "strategic reserve" be boosted by millions of barrels to "strengthen the long-term energy security of the United States." The real reason was put delicately by MSNBC: to "signal US intentions to help stabilize world oil prices."
To understand how this works, imagine you produce tennis shoes at a time when the prices keep going down. Then imagine that the government offered to create a strategic tennis shoe reserve. You might just like the idea, and, if you had the power to bring one about, and have others pick up the tab, you might just do it.
As for other prices, we can only wish they were falling. Inflation is still rising 2.6 percent per year, which is another way of saying that every dollar you hold is losing value every year. Even among all wholesale goods excluding energy, prices are up 0.8 percent from last month.
In any case, sector-specific falling assets prices is a feature of any recession and not a sign of anything unusual. Looking at the Fed’s wildly expansive monetary policy, it would appear that deflation is a far-flung prospect. Besides, so long as I can remember, there have been warnings about the deflation that somehow never arrives.
But what if it did? What would be the problem? There are three main arguments.
First, it is said that deflation increases the burden of debt. If you owe $20,000 on a car, and prices fall and increase the value of the dollar, the real amount that you owe increases. This is another way of saying that real interest rates are rising even if they appear to stay the same. This fact alone discourages borrowing.
So what? If you are concerned about long-term production, saving is better than borrowing. It’s too bad for the debt-ridden among us that their burden grows, but every act of borrowing is a speculation of sorts. There is no guarantee that says the value of your debt must always fall. And discouraging debt, as versus discouraging savings as inflation does, is a good thing — and not something to be regretted.
Second, deflation disarms the Fed. The conundrum here is that as the Fed lowers interest rates to encourage borrowing to stimulate the economy, deflation works at cross purposes to discourage borrowing and encourage stockpiling money for the future. Interest rates only appear to be falling precipitously because deflation takes all the zip out of this strategy.
I’m sorry, but there’s just no reason to get weepy-eyed about this. It’s bad policy to "stimulate" an economy rather than let it take its own course. The managers at the Fed shouldn’t be permitted to steal the dollar’s purchasing power just to make their central-planning schemes easier to implement.
Third, deflation causes falling profits, which in turn hurts business. But profits don’t necessarily fall. As implied in the computer example above, there is nothing necessarily incompatible between falling prices and the flourishing of business. It just means that business must scramble to stay competitive, and what’s wrong with that?
As for the consumer, a world of gently falling prices would be a paradise, and we know it’s a viable model because that’s what took place during the 19th century, an age of (mostly) sound money. So to those who warn of deflation in our future, we should say: please, Br’er Fed, don’t throw us in that briar patch.