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Why We Should Worry about Deflation

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02/12/2008

In a recent post on Mises.org Doug French argued that we should not worry about deflation. There are some sound theoretical reasons to favor deflation. Since increasing productivity brings prices down deflation is a sign of progress. Furthermore, the common arguments against deflation are not well founded. For example, some say that deflation could cause consumers to hold back on spending, and this could slow down the economy. The weakness in this argument is that people only change the rate at which they spend money if the price level is changing rapidly. During a hyperinflation people spend money as soon as they earn it because waiting to spend means losing much value. Conversely, if we had a hyper-deflation whereby prices fell 50% per day, then people might hold off on spending as their money gained significant purchasing power. Those who worry about deflation per-see ignore the fact that gradual deflation resulting from rising productivity has no effect on the timing of consumer purchases.

Why then should we worry about deflation? The answer is simple: because minimum wage laws combined with deflation result in rising unemployment. It is already the case that minimum wage laws cause high unemployment among teenagers and other low productivity workers. Minimum wages currently keep unemployment for teens in double digits. In some instances teenage unemployment rates have exceeded forty percent.

Deflation would automatically increase the real minimum wage, and with it unemployment. This is not only economic theory, we have seen this happen in US history. FDR imposed a system of 515 minimum wage rates for different categories of workers. Deflation during the Great Depression combined with these minimum wages rates to cause mass unemployment. FDR also used more informal means of raising wages. FDR exempted industry from anti-trust laws on the condition that they would keep wages high. Herbert Hoover also pressured industry leaders to resist nominal wage cuts. The efforts of Hoover and FDR to sustain high money wages resulted in economic disaster. It should also be noted that deflation during the Great Depression effectively increased US tariff rates. Deflation at this time would reproduce the results of the Great Depression because the government is still involved in rigging money wages.

A free banking system can function effectively, and such a system would likely produce a gradual decline in the price level, under the right conditions. The problem with advocating free banking and deflation at this time is that such proposals often do not go far enough. Deflation works only within the context of markets with freely adjusting prices and wages. The most obvious lesson therefore is that price and wage floors, in this case the minimum wage, make free banking unworkable. We need free banking and freely adjusting prices and wages. The larger lesson is that partial efforts to deregulate the economy usually have serious unintended consequences. Partial deregulation can open the way to new and potentially serious problems stemming from remaining controls.

The dilemma we face is simply this: partial acts deregulation and privatization are the easiest to enact, but the most likely to generate deleterious unintended consequences. It makes no sense to advocate limited reforms that will surely end in failure. On the other hand, we need more comprehensive reforms, but the task of raising popular support for bolder privatization programs is obviously difficult. What this all means is that the likelihood that we will see real solutions to our economic problems in the immediate future is low. However, the case for sweeping deregulation is strong, and public opinion can change.

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