Posted by Joseph Y. Calhoun, III

The Federal Reserve, backed by almost every mainstream economist, is determined to prevent deflation. In fact, Bernanke, in promising Milton Friedman that he wouldn’t repeat the mistakes of the Depression era Fed, was essentially promising that he wouldn’t allow deflation. Why is he so afraid so deflation?

The basic answer to that question is that Bernanke, and most economists today, view deflation as the cause of the Great Depression or at least as having caused it to last so long. They look at the GDP growth rates after Roosevelt devalued the dollar against gold and assume that if that had just been done sooner, the Depression would not have been so great. Of course, they have no explanation for why unemployment remained high during those middle 1930s years of high GDP growth, but that doesn’t stop them from believing in the tonic of inflation. But what if deflation was not the cause of the Great Depression? What if deflation rather than being a cause was actually evidence of recovery? What if the devaluation of the dollar is what extended the depression and made it Great?

The deflation of the early ’30s was not an unprecedented event. The US experienced a number of depressions and deflations in the 1800s but none of them were of the duration of the 20th century variety. In looking back at those previous episodes, it becomes clear that deflation is not the cause of depressions (to see another example of the Fed ignoring its own research, see this study from the Minneapolis Fed that shows that there is no link between deflation and depressions). Depressions are caused by the inflationary periods that precede all of the depressions in our history. The inflationary period is what causes the rise in debt levels that ultimately lead to depressions when they reach their limit. The deflation that occurs during the depression is merely a symptom of the recovery process. The mistake that was made in the 1930s that made the Depression great was that the recovery process was interrupted. And that is the same mistake we are making today.

How do I know that deflation is part of the recovery process? There is plenty of evidence today, that deflation, if allowed to run its course, would get us to a sustainable recovery sooner than if we fight it. As Mark Thornton points out in this article, several of the programs enacted to fight this recession are actually nothing more than deflation in disguise. Cash for clunkers effectively reduces the price of a car. The $8000 first time home buyers tax credit effectively reduces the price of a house. In other words, these programs are simulating deflation. Does anyone deny that these programs have resulted in higher demand? Why simulate deflation when the real thing is easily accomplished?

I think the main reasons for that are political. The deflationary period of the recovery is very difficult for those with high debts. As the value of money rises, debts become more onerous and hard to pay off. Bankruptcies are endemic and unemployment can rise to horrendous levels. The 25% unemployment of the 1930s was not unprecedented and indeed was fairly typical of past depressions. Generally though in depressions prior to the Great one, these periods were relatively short lived. The 1920-21 depression lasted roughly 18 months as did several of the 1800s depressions. 

From a politician’s perspective, 25% unemployment is a disaster. True or not, unemployment that high is bound to be blamed, at least to some degree, on the politicians in charge at the time. And that means that the only employment the politician is really interested in - his own - is threatened. Rather than accept that, inflation gives the politician an out. Further inflation will make the depression (recession) last longer, but unemployment will be lower throughout. The politician can then make the re-election claim that without his heroic efforts, things would have been worse. In other words the politician is willing to trade increased wavelength for reduced amplitude.  

Another reason to inflate and avoid deflation is that inflation helps all the right people while deflation only helps the average guy. As Matthew Lynn points out in this recent article at Bloomberg:

Deflation may be bad for particular interest groups, which happen to be very powerful. It is bad for chief executives. It is easier to keep your profits rising in a mildly inflationary environment. You can just jack up your prices a bit, and you can often cut workers’ wages by stealth by holding wages steady.

The banking industry, which has come to rely on inflation to make highly leveraged loans sustainable, also dislikes deflation. Likewise, it is bad for governments, which use inflation to reduce the value of their debts.

On the other hand, deflation is good news for savers, who get richer just by hanging on to their cash. And it is beneficial for consumers, who get cheaper prices. It is usually good for workers as well, as they can generally hold the value of their wages, even while prices fall.

I have argued before that inflation is one of the causes of rising inequality. When the Fed produces a new dollar today, who gets it first? Whoever that is - banks and the wealthy primarily - benefits and whoever gets it last - the poor - experiences only a loss of purchasing power. The political calculus is pretty easy to see in this case. The largest campaign contributors benefit from inflation. The majority of voters - debtors - benefit from inflation. What do you think a politician will do given those facts?

Deflation is not the evil it has been portrayed as. Deflation is natural after an inflation and is a symptom of recovery. All those Keynesians out there who believe that raising aggregate demand is the answer to the recession are the same ones who believe that we shouldn’t allow prices to fall. If you think about that for a minute, you’ll realize that those two positions are contradictory. How can you raise aggregate demand if you don’t allow prices to fall? Isn’t a fall in prices just what the doctor ordered?

Deflation is the default condition of a capitalist economy. In fact, that is exactly the point of a capitalist society. By raising productivity, the economy is able to produce the same basket of goods with fewer inputs. Or put another way, the basket of goods can be expanded without raising costs. The bottom line is that the same amount of money should be able to purchase an ever larger basket of goods as long as productivity is rising. The truth of this can be seen even over a relatively short period of time. In 1930, just prior to the Great Depression, the average person spent almost 25% of their income on food. In 2008, that percentage had dropped to just 5.6%. Why? Primarily that is a result of rising productivity in farming. In 1930 21.5% of the workforce was involved in agriculture; today the share is less than 2%. Think about all the things we wouldn’t have if 1/5 of the workforce was still needed just to keep us fed. Rising productivity - and deflation - is good.

Ben Bernanke and other economists learned the wrong lesson from the Great Depression. The problem is not deflation; the problem is the inflation that got us into this mess. And the only way to correct it without introducing new distortions is to allow the deflation to run its course. After that has happened, monetary policy should have the goal of producing a mild deflation that matches the rise in productivity. It won’t be helpful to debtors and it won’t benefit campaign contributors, but it will surely make life easier for the average American.