Even though President Barack Obama and Federal Reserve Chairman Ben Bernanke have done everything but promise American families their own printing press to crank out money, the chattering classes claim that the deadly threat to the economy is not inflation, but rather deflation. For example, recent Nobel Prize winner Paul Krugman recently declared:
[W]e entered the slump with a core inflation rate of about 2.5 percent. If we experienced a disinflation comparable to that of the 1980s, that would mean ending up with deflation at a rate of -3.5 percent.
And bear in mind that neither the CBO nor the Obama team really explains where recovery comes from; it’s just assumed.
So tell me why we aren’t looking at a very large risk of getting into a deflationary trap, in which falling prices make consumers and businesses even less willing to spend. Tell me why this risk wouldn’t remain high, though lower, even with the Obama plan, which as far as I can tell is expected to reduce cumulative excess unemployment by about a third.
We also see headlines like “Deflation risk stalks global economy” (Oxford Analytica’s Daily Brief Services) and read warnings of deflation from St. Louis Federal Reserve President James Bullard, who:
urged policymakers to take steps to guide the economy away from the deflationary outcome, warning that failure to prevent ongoing deflation could be “particularly pernicious,” warning that the already crumbling housing market could see further deterioration.
“With sustained deflation, the foreclosure experience that we have seen in the subprime market could generalize to a wider spectrum of homeownership,” he warned, an outcome that would likely prolong the recession.
The scenario supposedly works as follows: (1) consumer prices fall, (2) producer prices then fall, cutting the “purchasing power” of workers, (3) consumer prices fall even more, and (4) payrolls fall even more. This allegedly is a never-ending process until the economy is obliterated in Krugman’s “deflationary trap.” Thus supposedly the only thing that can stop the bleeding is for government to print money and spend it directly in the economy–which Keynesians call “fiscal policy.”
However, there is another story that never seems to be told: deflation is not an act of destruction but rather the economy’s healing itself from the inflationary boom that has busted. That’s right; far from being disastrous, deflation is a sign that the economy is moving in the direction of recovery.
The key to understanding this is realizing that money is not a neutral good. As a medium of exchange used in a proper way, money is a productive marvel that makes the modern economy a possibility. However, we should not forget that in an economy, there are real relationships between goods and factors of production. When these relationships are in reasonable balance, the economy does not fall into the boom and bust stages.
However, when government authorities expand the amount of money, they also change the relationships between goods and factors, which means that we have relative changes in the values of things. Certain goods and factors during the early stages of an inflation-fed boom become more valuable relative to other things. (We saw this during the housing boom, when housing prices skyrocketed even though prices of other goods were not rising as quickly.)
Resources quickly are poured into the production of these highly valued goods, but that boom cannot be sustained. As the Austrian theory of the business cycle tells us, the overvalued goods and factors now find their real value is less than what originally it was predicted to be, which means that in order for the economy to get back into balance, prices for those goods and factors used to make those goods must fall.
Contra Krugman, this is not a downward spiral. It is the economy getting things back into balance so a recovery can begin. When the government tries to reflate the financial bubbles, as we see now, such actions actually prevent the recovery from occurring. That is what happened during the 1930s with the New Deal, and apparently the government today wants to repeat that sorry tale.
