Price deflation is a decrease in consumer prices. It is usually associated with long and sustained recessions. Such decrease in prices is led by a reduction in total consumption. Total consumption in the country is dependent on several factors such as the total money invested in stock as well as the total hoarding of money by the producers and wage earners. Price deflation is not necessarily the evil it has been made out to be, since falling prices increase the standard of living of the poor, while reducing that of the business owners.
The first long deflationary phase in the U.S. was from 1873-1896. During these years, production increased due to excessive savings/investments and high productivity, while the money supply grew at a slower pace, causing a mismatch between the total money available for consumption and the value of products on sale, and resulted in a fall in prices. According to economist Murray Rothbard`s book, History of Money and Banking in the United States, during this phase, general prices in the country fell 1% on an average each year. This translates into a fall of about 20% over 23 years. Therefore, a person with stagnant wages grew 20% richer. This was also a time of growing national income and increased wealth. In fact, the GDP of the country doubled between 1879-1888, and it was the most productive decade in the nation's history, a record held until today. Ironically, this era has been called a depression by many economists, solely based on the price declines witnessed during this period.
According to economists from a certain school of thought, falling prices necessarily lead to decreases in production, high unemployment and a lower standard of living. As a result, if the production were to increase but fewer dollars were used to purchase the final products, there would be a price decrease, which would necessarily be considered a sign of trouble and reduce future production.
However, this is far from the truth, since the increase in production may have been caused by an increase in productivity, in which case, the business does not suffer a loss in revenue. Or, even if the increase in production was driven by excessive savings, which lead to an increase in production, it is far from certain that businesses would suffer a big enough loss to force them to reduce production. It is only during times of large price declines, caused by a larger mismatch between the production increase and monetary inflation that depressions begin. The period noted above did see falling prices, but the economy did not slip into perpetual recession, since the price decreases were mild and did not cause a significant shift in the profit margins.
It is important to understand what led to a lower than normal increase in money supply, which in turn decreased prices. The U.S. economy was on a Gold Standard during those years, and the scarcity of Gold led to a slowly growing money supply, eventually causing a decrease in consumer prices. This led to populist uprisings against the supporters of sound money, primarily the Republican Party, and called for a change from the monometallic standard (Gold) to a bimetallic standard (Gold and Silver) because Silver was more inflationary due to its abundance.
The justification provided by the Democrats, who supported the change, was that falling prices reduced the revenues of the farmers, who in turn, found it difficult to pay off their debts. Farmers may have been victims of falling prices, and defaults to their creditors may have increased, but historical figures clearly show that the agricultural business revenues, as a whole, grew about 20% between 1880 and 1890. Hence, it can be assumed that the general business conditions may not have been gruesome. In addition, as noted above, the average price decline each year was about 1%, hence the reduction in expected profits was not very big.
Also, it has been noted in Sidney Homer’s History of Interest Rates, 2000 B.C. to the Present that the interest rates during this entire period continued to fall. If falling prices ever lead to reduced production and fear, the first effect seen in the economy is through increased interest rates, as banks and other creditors reduce the supply of credit, since the chances of loss are high.
However, the yields on the Railroad bonds fell between 1879 and 1889, from 5.98% to 4.43%. Despite these successes, this era has been demonized by a particular class of economists, specifically those leaning towards populism, since it is politically beneficial to patronize the poor debtors rather than the creditors. William Jennings Bryan, the presidential candidate in the 1896 election, proposed moving to a Gold/Silver standard to ease the burdens on the debtors.
Deflation is bad only in cases where debtors default in large numbers, causing the creditors to become risk-averse, and if it is difficult for businesses to reduce costs. As long as businesses can swiftly reduce costs such as wages, and businesses have less debt on their balance sheets, even higher price declines caused by hoarding or insufficient monetary inflation would not lead to a decline in production. One of the reasons why the Great Depression became severe was that the debt in the country had reached historical levels, and normal price declines could not be tolerated by either households or businesses.
Inflationists often use the threat of a repeat of the Great Depression to scare people into accepting and preferring high doses of inflation to low price declines. Most central banks in the world have a policy of achieving a regular 2% annual inflation to ensure deflation does not strike. This inflationary bent leads to the boom-bust cycle, since inflation causes interest rates to rise, which then lower the supply of credit and cause businesses to shut. Compare this to the era of Sound Money, or the Gold Standard, where prices fluctuated freely and did not have a bias towards debtors, who benefit with inflation since higher incomes make repayment easier. The creditors on the other side, lose purchasing power as prices in the country rise, while their interest incomes do not. In a free market economy, prices generally tend towards stability over a longer period, and do not favor any political or business interests.
Deflation does not create any reductions in production, as is understood from the deflation of the 19th century. Deflation can only be a formidable enemy if supported by the problem of high debt and rigid costs. The coming deflationary spiral, unfortunately, will be the offshoot of such high debt and the rigidity of wages in the nation. The free markets cannot provide a swift remedy for the ensuing economic decline, but they offer the only solution, which is the reduction in these debt levels through higher savings and defaults. Government programs such as Cash for Clunkers do provide immediate help to the buyers and sellers, but do nothing to address the major imbalances of high debt.
As noted above, the problem is not deflation, but high debt, but programs such as Cash for Clunkers are solely directed towards creating inflation. It is not very predictable whether the government will be able to prevent deflation in the short- term and whether the government would hurt the economy through excessive government debt, but it is a certainty that the government programs are not beneficial and cannot change the direction of the economy in the next decade.