The Paul Reveres of the economics profession are riding their horses, warning Americans, “Deflation is coming! Deflation is coming!” From Paul Krugman to Joseph Gagnon to the various mainstream news publications, the message is the same — the government needs to induce inflation now, or else the economy will sink further into the Slew of Despond and unemployment will increase.
A recent U.S. News article declared,
When the price of cars or sweaters or iPods declines, it’s a break for consumers and a welcome sign that economic productivity is improving. That helps drive up living standards. But when the price of everything drops, it’s an alarming development that portends stagnation.
. . . .
After the crisis arrives and the depression begins, various secondary developments often occur. In particular, for reasons that will be discussed further below, the crisis is often marked not only by a halt to credit expansion, but by an actual deflation — a contraction in the supply of money. The deflation causes a further decline in prices. Any increase in the demand for money will speed up adjustment to the lower prices. Furthermore, when deflation takes place first on the loan market, i.e., as credit contraction by the banks — and this is almost always the case — this will have the beneficial effect of speeding up the depression-adjustment process.
Most people, including the majority of economists, make their error in the failure to see that the initial effects are not permanent, provided the government and the monetary authorities permit these adjustments to occur. Just as inflation has a very real and harmful effect upon the relative values of factors of production, deflation also has an effect on the factors, but the effect over time is to return those factors to their proper proportional values, according to consumer preferences.
To put it another way, the economy right now needs deflation, yet all of the public voices are shouting that what we really need is for the economy to take another “hair of the dog.” Rothbard explains,
Just as inflation is generally popular for its narcotic effect, deflation is always highly unpopular for the opposite reason. The contraction of money is visible; the benefits to those whose buying prices fall first and who lose money last remain hidden. And the illusory accounting losses of deflation make businesses believe that their losses are greater, or profits smaller, than they actually are, and this will aggravate business pessimism.
It is true that deflation takes from one group and gives to another, as does inflation. Yet not only does credit contraction speed recovery and counteract the distortions of the boom, but it also, in a broad sense, takes away from the original coercive gainers and benefits the original coerced losers. While this will certainly not be true in every case, in the broad sense much the same groups will benefit and lose, but in reverse order from that of the redistributive effects of credit expansion. Fixed-income groups, widows and orphans, will gain, and businesses and owners of original factors previously reaping gains from inflation will lose. The longer the inflation has continued, of course, the less the same individuals will be compensated.
Some may object that deflation “causes” unemployment. However, as we have seen above, deflation can lead to continuing unemployment only if the government or the unions keep wage rates above the discounted marginal value products of labor. If wage rates are allowed to fall freely, no continuing unemployment will occur.
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Right now, the Austrians seem to be the economic version of Cassandra, predicting the future and giving sound advice, only to be rejected by most academic economists and certainly the politicians. Krugman last year demanded that the government “stop the pain” via inflation and dramatic increases in government spending.
Unfortunately, more doses of inflation will not stop the pain, at least any longer, and the more the government inflates and recklessly spends, the worse the pain will be. The very “cure” of inflation will be what makes the economy sicker. However, if we would be willing to experience the real economic pain just a little longer, a real recovery would be around the corner. In fact, had the authorities more than two years ago agreed to stop the foolishness of promoting inflation and malinvestments, we would be in recovery now.
Unfortunately, there is going to be no recovery, at least for a long time. Deflation is the answer, but few are listening. Rothbard understood this fact intimately. Those who reject his wise counsel will live to regret it.
(Read more from mises.org)