With all of the technology advances of the last decades, productivity has increased significantly, with more goods produced for a given set of inputs. The implication is that, over time, prices should decrease by a significant amount. As we all know, they have, instead, increased by a lot. The fundamental reason that prices do not go down as productivity increases is the Federal Reserve Bank policy of not allowing prices to fall.
The stated reason is that they believe that any deflation, however small, will lead to a disastrous deflationary spiral, meaning that, as prices go down, profits go down, people are laid off, demand declines, and prices go down even more. They point to the 1930s as an example of this. In a 2002 speech, Ben Bernanke, then-chairman of the Fed, gave the usual scenario: “The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.”
The 1930s disaster was accompanied by deflation, but it wasn’t cause by it. The deflation was preceded by a massive inflation, the bubble of the roaring twenties, and magnified by many disastrous government policies. Such damaging deflation, however, is not the only possible kind. By the very same logic that people and businesses can adjust to a mild, steady, and predictable inflation, they can also adjust to a mild, steady, and predictable deflation. Profit ratios don’t have to suffer, because, with such a deflation, costs also decline as revenues decline. Layoffs need not occur as long as everyone is able to adequately anticipate what is going to happen. The standard of living can increase while the cost of living decreases, especially helpful to the poor.
Wealth inequality has become a significant concern as a large segment of the population has not been able to participate in the out sized gains of the financial markets or benefit from the growth of the increasingly tech-driven economy. Those who did partake have had substantial gains. In a very real sense, the central bank is driving that inequality. In an attempt to keep consumer prices rising, albeit slowly, they create new money by buying debt securities. With those purchases, primarily government bonds on the bond market, it increases demand for the bonds, driving up their price. The interest rate on a bond is determined by the difference between the maturity price and the current market price, and thus, the higher the price, the lower the interest rate. In this way, Fed purchases drive interest rates lower.
The new money tends to increase prices, while at the same time, the artificially low interest rates make it more profitable to borrow to build factories and machines, as well as for companies to buy back their own stock, a particularly unproductive use of resources. As we have seen over the last ten years, in spite of relatively tame consumer price inflation, there has been a tremendous inflation of prices of financial and business asset prices. To put things in perspective, the Russel 3000, a broad index of the stock market, increased over three hundred percent from February of 2009 until it started to decline in September. That is not mild inflation by any measure. The increase in the money supply and the resultant artificially low interest rates caused massive inflation. It just wasn’t in consumer goods.
This means that holders of financial assets have benefited greatly from the actions of the Fed, while others did not benefit from lower prices of increased production and productivity. It is a perverse result that nobody seems to even want to even acknowledge.