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!
