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Why the Econ-Pundits Got It Wrong

Scholar questions those who complained of deflationary economy

Well-publicized forecasts of the catastrophic American deflation of 2002, trumpeted by such headlines as “The Deflation Monster Lives” and “Why We Should Fear Deflation,” never materialized, a Pace University economist said at a John Locke Foundation luncheon Friday.

Using monetary theories originating in the Austrian school of economics, Dr. Joseph T. Salerno refuted the many myths about deflation, including its definition, differing causes, and effects upon the American economy.

The first myth about deflation is its very definition, Salerno said. Before World War II, the terms “inflation” and “deflation” referred to increases and decreases in the supply of money. After the Keynesian Revolution of the mid-1930s, inflation took on the meaning of a general rise in prices, and deflation was now said to be a general fall in prices. While most economists and laymen agree upon these definitions, they disagree on how to measure these economic indicators.

Salerno asserted that modern-day economic analysts, such as Federal Reserve Chairman Alan Greenspan, erroneously calculate rises and falls in the economy by examining prices on the input side of the economy, measured by the Producer Price Index or indexes of raw commodities. They should, instead, examine the prices of the outputs of economy, such as the Consumer Price Index, which are the “final output and, hence, the rationale of all economic activity,” Salerno said.

The founder of Austrian economics, Carl Menger, first theorized that the price a consumer is willing to pay for a product will determine how much it costs to produce it. Salerno used the example of the price of pearls to illustrate Menger’s theorem. “Pearls are not expensive because a diver must risk his life to retrieve them from the ocean. Pearls garner a high price which motivates the diver to risk his life to retrieve them.”

This natural determiner of price can be disrupted by unnatural forces in the marketplace, such as minimum and set wages. Salerno claims that labor unions prevent an economy from naturally adjusting itself. Wages do fall during deflationary periods, but since prices fall as well, the loss of income is offset by the increased purchasing power of the dollar. If a market is not allowed to be malleable with the ebb and flow of the economy, an economy cannot recover, Salerno said.

With concentration on input prices, Salerno laid out the four types of deflation, contending that not all deflation is bad. These types focus on either the demand for money or the supply of it.

He argued that demand-side deflation, such as growth and cash-building, are actually indicators of a healthy economy. Growth-deflation reflects a decrease in prices based upon technological progress or greater capital goods. Salerno said such growth-deflation is best illustrated in the computer industry, where prices have exponentially fallen while quality, production, and profit have increased.

Cash-building deflation refers to trends in holding onto money, sometimes negatively referred to as hoarding. This increased demand for money in order to save it causes the value of dollars remaining in the marketplace to increase in value.

Salerno describes both forms of demand-side deflation as benign since they are natural (and not detrimental) effects of a free market. Neither violates property rights, since the consumer is choosing not only if he will pay, but also what he will pay.

Supply-side deflation comes in two forms: bank credit deflation and confiscatory deflation, one benign, one malign.

The last type of deflation, associated with the supply of money, is described by Salerno as the often ignored but most detrimental of the four, confiscatory deflation. As has occurred in Brazil, the former Soviet Union, and twice in Argentina, this type of deflation occurs when the government confiscates the savings of depositors in order to unnaturally recover from recession.

This confiscation is manifested by limiting how much and when depositors can withdraw their savings or in some cases freezing accounts. By limiting how much cash citizens have on hand, the poorest are most affected because they deal mostly in cash, instead of checks or credit. Such tactics can also buckle cash businesses, such as retail. With limited cash supplies, citizens are relegated in worse-case scenarios, back to the primitive form of bartering, as in Argentina, where land deeds and crops have been traded for automobiles and other goods.

Salerno did not imply that America was on a crash course to revert to bartering, but he did warn of the unnatural disruptions in an economy, which can cause such regression. And by dispelling the curse of deflation, he made the case for letting the market work naturally with deflation because it is a normal and expected behavior in an economy of free exchange.

Hood is an editorial intern at Carolina Journal.