Is Deflation Always Bad?

OK...I can hear it now...what kind of question is that?  After all, widespread deflation occurred in the 1930s and look at that period.  More recently, Japan has been in a long-term stagnation deflationary period.  In the 1930s, prices fell and businesses couldn't sell their goods as consumers retrenched.  Consumers retrenched because businesses were laying people off.  An impasse resulted and the economy worsened - or so the story goes.  The stage was set for Keynesian prescriptions.

The only way out, according to today's predominant interpretation of history, was massive government spending via the buildup for WWII.  The forces of deflation had to be overcome!

This is taken as the bible by most economists, in particular those pulling the policy levers today.  The Bernanke/Geithner camp and a goodly part of the Federal Open Market Committee continually call for more stimulus and more quantitative easings.  A smugness has set in based on academic authority.

Could this be wrong?  Look again at the 1930s.  What role did the 1930s deflation play in getting  the economy going after WWII?   It, along with massive pent-up demand for truly wonderful products as the nation transformed itself to a peace time economy, surely was a factor.  In the 1920s, as the business sector boomed and the agricultural sector was in a depression, a new price structure was necessary.  This is what the deflation accomplished.

Closer to the present, what if the continual decline in the purchasing power of the dollar, i.e. inflation, had reached the point in 2003 where the economy needed a fall in the overall price level?  After all, housing prices were already rising robustly, along with college costs, medical costs, etc.

Maybe sometimes the price level (especially the way we measure it!) gets too high and needs to come down.  Furthermore, it is important to remember that price doesn't just fall because of inadequate demand.  There is also the supply impact and the spreading impact of competition.  Then and now, the spread of price information via the internet is unprecedented.  In short, the price search process has shortened significantly for many purchases from big ticket items down to the smaller items.

A Bit of History

After WWI, Great Britain tried to maintain an artificially high value of their currency.  A nation's exchange rate, of course, sets the prices of a nation's goods and services relative to the rest of the world. As a result of Britain's actions, resulting fundamentally from an excess of hubris, gold flowed out; and they begged the U.S. in the mid-1920s to lower interest rates.  The U.S. complied, and stocks roared (even while the agricultural sector suffered), setting the stage for the run-up to 10/1929.

There is a parallel with the 2003 Fed with Bernanke covering the country talking up the evils of deflation and pointing to Japan and their economic stagnation because they were not following sufficiently aggressive macro policies.  Chairman Greenspan bolstered this theme ,and the Fed pushed short-term interest rates down to 1% in mid-2003.  Just like in the late 1920s, stocks took off and hit an all time peak in 2007.  This, with an already strong housing and auto market and the 2003 action, poured gasoline on the fire.

As a result, the cost of housing dropped after the 2003 rate cut, even as the printed price rose!  Mortgage brokers got funds practically for free and, thereby, issued mortgages which required no down payment, options with no payment against principal, etc.  Adjustable rate mortgages ballooned (pun intended)  and the gold rush was on.  The 2003 rate cut was then followed by a sharp rate increase.  It was as if you bought a car for $14,000 and then surprise - the real price is $20,000!  Those who fell into this trap are sometimes among those blamed for the crisis!

Today, the problem may be that prices are too high; and the Fed is desperately trying to inflate the economy by pushing them higher.  It stays stuck on the belief that the only way to get consumers to spend is to scare them into thinking that prices will be higher tomorrow.

Here's some news:  a big part of the economy is in good shape.  Those who have a job see that they have exceptional opportunities in front of them.  Many are watching prices drop and are interested in taking advantage of the new price structure.  There is a lot of talk about the values now available in housing. This process needs to proceed which, in turn,  needs the Fed to get out of the way to let it work. Otherwise, the recovery process could take years if not decades.