Chris Farrell is the economics editor for public radio’s Sound Money and Marketplace shows. Among all of NPR’s highly intelligent staff, Farrell says the fewest dumb things, which is remarkable given that his beat is the economy and investing. His latest book, Deflation: What Happens When Prices Fall, is one of the few places where you will find deflation and outsourcing properly portrayed.
Farrell explains what price deflation is and what causes it. The major theme of the book is that we have entered an era of deflation and that this is not the horrible phenomenon that it is often portrayed to be. The main drivers of deflation are global competition, outsourcing, and the emergence of our Wal-Mart style economy, all of which provide the competition that drives down the prices of goods and services and increases our standard of living. On this account, Farrell can be seen as supportive of the views of Austrian school economists.
The distinction that Austrians make between monetary deflation (inflation) and price deflation (inflation) is not made in the book explicitly, but it is recognized when he distinguishes between "good" price deflation due to competition and "bad" monetary deflations that result from collapses in the money supply (e.g., the Great Depression). Despite having recognized the Fed as the source of both the Great Depression of the 1930s and the Great Inflation of the 1970s, Farrell is optimistic in the ability of central banks. His prediction of deflation also runs counter to some Austrians who see plenty of monetary inflation and anticipate an upward trend in the Consumer Price Index. However, I would still rank this book as better balanced and more informed than most books produced by academic economists and business writers.
The book is a classic case of bad timing. It was released the same week that Greenspan announced the Fed was no longer worried about deflation and when the latest release of the Consumer Price Index indicated strong inflationary pressures building in the economy. However, Farrell does plenty of hedging in his multi-decade forecast of the economy and he freely admits that there will be strong inflationary spikes along the way. He even recommends TIPS (inflation-protected Treasury bonds) to protect your portfolio against the ravages of inflation.
The basis for Farrell’s optimistic outlook for long-run price deflation, and the reason he is willing to stick his neck out and declare, "this time things are different," is none other than the dreaded outsourcing of jobs to cheap foreign workers. The story begins with Fed chairman Paul Volcker, who raised interest rates in the early 1980s, threw the economy into depression, and broke the Great Inflation of the 1970s. In the wake of these events, there was the rise of Wal-Mart and other retail discounters, low-cost high-quality technology imports from Asia, Internet competition, integration of China into the world economy, and the expansion of the international outsourcing of labor.
Farrell is correct that the basis of lower prices and higher standards of living is the movement toward open markets and competition and away from government control of the economy. Austrian school economists have long recognized that price deflation is not an economic problem, and our author even quotes George Selgin, the first contemporary Austrian to address the topic, to show that price deflation is benign or beneficial. He also uses the term I coined, Apoplithorismosphobia, to describe the irrational fear of deflation. Farrell shows that the gold standard protected against price inflation and he also reports that mainstream economists have recently conceded that price deflation during the classical gold standard period was a good thing. [For more on the Austrian perspective on deflation see the special issue of the Quarterly Journal of Austrian Economics (Winter 2003, Volume 6, Number 4) and see Joseph Salerno's and Guido Hülsmann's papers on the subject.]
But how well will this work when you no longer have gold money and a government bureaucracy is in charge of setting interest rates? Quoting Hayek on the role of markets, information, and discovery, and Paul Romer on increasing returns, we are reassured that things are different, that the Fed has learned its lesson, and that the bond vigilantes are going to help make everything all right. However, he also does admit that there will be problems and recognizes the current bubble in housing.
Of course, there will be plenty of missteps along the way during that process of discovery. The most spectacular explorations will be market bubbles reminiscent of the dot.com boom and bust. Bubbles are fascinating. The characteristic of any market bubble is well known: the rise in speculative fever; the piling into the hot investment of the moment to earn outsize rewards; and the crash, when prices plummet at a frightening speed. In hindsight, it’s always puzzling how so many people could be so stupid with their money. (Farrell, p. 56, emphasis added)
Despite this puzzle, Farrell wants to side with a Schumpeterian-Real Business Cycle theory of business cycles which views bubbles as rational and based on fundamentals. On the surface, this view seems reasonable, but what it lacks is a cause for the shift in fundamentals that inflates and deflates bubbles and drives business cycles. What causes technology to "shift" in the first place and why don’t entrepreneurs react to investment excesses?
Here the Great Depression is the test case. On the one hand, the mainstream view is that the Federal Reserve engineered the prosperity of the 1920s by maintaining price level stability, but failed to provide enough monetary stimulus after the stock market crash so they could continue to adhere to the gold standard. Their failure turned a normal market correction into a depression. On the other hand, Austrians also blame the Fed, but they see the monetary inflation during the 1920s, which maintained price level stability, as the cause of the stock market bubble. They see the government’s attempts to save banks, maintain employment, and to keep prices high as the primary reason why the crash resulted in a depression that was so severe and long lasting.
Notice that the mainstream view provides no cause for the bubble and boom, other than it was the rational thing to do and that technological developments "just happened." In the Austrian view, the Fed’s attempt to maintain price level stability meant that it had to expand the money supply by increasing the supply of bank credit. The result was an expansion of investment and technology beyond normal limits, a general constraint on commodity prices, and wide-ranging distortions of relative prices in the economy.
I think it is obvious that the Austrian view is correct. As I have previously reported, even the founding father of mainstream economics in America and history’s greatest proponent of monetary stability, Irving Fisher, found a similar result, in that monetary inflation during the 1920s had been hidden in price inflation figures and price indexes because new technology had sharply driven down costs.
Fisher is famous for his pre-crash pronouncement of perpetual prosperity, but after the fact he tried to identify the cause of the stock market crash and depression. He found most explanations failed to explain what he called "new eras" — when technology allowed for higher productivity, lower costs, more profits, and higher stock prices. His best explanation supports the Austrian view: "One warning, however, failed to put in an appearance — the commodity price level did not rise." He suggested that price inflation would have normally kept economic excesses in check, but that price indexes have "theoretical imperfections."
During and after the World War, it (wholesale commodity price level) responded very exactly to both inflation and deflation. If it did not do so during the inflationary period from 1923—29, this was partly because trade had grown with the inflation, and partly because technological improvements had reduced the cost, so that many producers were able to get higher profits without charging higher prices.
Farrell must also implicitly understand that the mainstream view has some fundamental problems because he is one of the few economic writers to give the Austrian "liquidationist" view of business cycles a hearing. In sharp contrast to mainstream economists, Austrians view market crashes and depressions as the correction mechanism for the investment and organizational errors of the previous boom. In the Austrian view, the "correction" should be allowed to run its course and should not be hampered by easy money policies, fiscal policy stimulus, or regulations on trade or employment.
Farrell dubs the Austrians of the Great Depression period as "many of the best minds of the era" who supported liquidation of the speculative excesses of the boom. He cautioned that "this isn’t to say the liquidations were right," but he does quote Brad DeLong, who concluded his analysis with the backhanded compliment that the "railroad booms and busts of the late nineteenth century are not inconsistent with a "liquidationist" perspective."
Despite a lack of agreement on business cycle theory, Farrell’s perspective on deflation, technology, globalization, and outsourcing will be very informative for readers. He also correctly identifies many of the problems in the American labor market (although I would strongly disagree with some of his suggested reforms). He also correctly suggests that protectionism and farm subsidies should be done away with and that the result would help both America and the rest of the world, particularly the less developed world. Three cheers for Deflation!
Mark Thornton [send him mail] is an economist who lives in Auburn, Alabama. He is author of The Economics of Prohibition, is a senior fellow with the Ludwig von Mises Institute, and is the Book Review Editor for the Quarterly Journal of Austrian Economics. He is co-author of Tariffs, Blockades, and Inflation: The Economics of the Civil War.