Economists seem to be deathly afraid of deflation, but what gives rise to their fears? The scenario they evoke is that, when prices decline, people expect that prices will decline further. They will hold off on purchases, because tomorrow or next week or next year they will be cheaper. Decreased demand slows production, leading to lay-offs and unemployment, which leads to decreased spending, decreased demand, decreased prices, etc, in an ever-widening spiral.
The evidence typically used is the Great Depression, where they observed that there was severe deflationary pressure, greatly diminished productivity, and mass unemployment. They argue that once deflation started, there was nothing that the government could do about it, causing the most wrenching period in in United States economic history. That justification underpins the policy of the Federal Reserve Bank (FRB) to never, ever allow deflation to occur. When people trust that the Fed will keep inflating, it will be able to short-circuit a dangerous downward spiral. That scenario embeds a number of assumptions that are dubious at best, ignoring multiple factors.
The FRB actually caused significant deflation in the 1930s and was not just a victim of an unforseen spiral. It was deliberate, even if it is now widely recognized to have been an error. Secondly, the bust was a direct result of the Fed-induced bubble of the 1920s, and not just some random change in people’s preferences. Thirdly, the tremendous economic manipulation by the government deepened the depression, not a deflationary spiral. “Regime uncertainty,” as economist Robert Higgs put it, was a major impediment to recovery throughout the 1930s.
The logic for an inflationary spiral is just the reverse of a deflationary spiral. People expect prices to be higher in the future, and therefore buy now instead of waiting, causing shortages and more inflationary pressure. Since there is an upper limit to employment, production fails to keep up even as demand accelerates, causing a never ending upward spiral in prices. Neither case makes room for actual economic behavior and reality.
If people and businesses can take a slow, steady inflation into account, they can certainly do the same with slow and steady deflation. Producers who expect falling prices and, by implication, revenues can also expect falling costs of production, enabling them to maintain profit margins. The idea of “sticky wages” is a manifestation of the inflation mentality, but if everyone understands that prices will continuously fall, wages will adjust appropriately over time, as they had in times before activist governments. Average wages don’t have to increase if prices don’t.
If the FRB has the tools to maintain low and steady inflation, it also has the tools to maintain a slow and steady deflation. All it has to do is keep a steady money supply, and prices will naturally decline as productivity increases. More goods in the economy with a steady supply of money means that it takes fewer dollars to buy goods and services. That would be a great thing. The poor, the elderly, and anyone on fixed incomes would not fall behind. The cost of living would decline slowly and steadily as productivity increased, and the standard of living would increase.
Price increases of 2-3% from year to year don’t seem to be a big deal, but over the course of a decade, the value of the dollar decreases by up to 30%. That’s a big deal. Your income has to increase by 30% just to stay even with the cost of living, something the the poor and fixed income recipients have great difficulty with. Monetary policy is certainly complicated, but a deflationary spiral is an excuse for inflation that benefits powerful interests, not a reasonable justification to devalue the dollar.