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.
The views of this paper do not reflect official views of The Coast Guard
Bibliography
Beny Ada Wages and Employment in the United States National Industrial Conference Board
MacKenzie, DW Mythology of the Minimum Wage- in Taking Sides: Clashing Views on Economic Issues McGraw-Hill Contemporary Learning Series 2007
Rothbard, Murray: 1972 Herbert Hoover and the Myth of Laissez-Faire, in: Radosh, Ronald, and Murray Rothbard, A New History of Leviathan (NY: Dutton,), pp.111-145.
Rustici, Thomas: 1985 A Public Choice View of the Minimum Wage The Cato Journal pp 109-131
Vedder, Richard K. and Gallaway, Lowell E. 1997 Out of Work: Unemployment and Government in Twentieth Century America New York University Press
{ 34 comments }
Very good article. I think that Dick Fox would agree.
Very good article. I was a bit scared at first because I thought a Keynesian argument for why deflation is bad was coming. Absolutely correct. It’s government intervention by utilizing minimum wage laws that’s causing the problem.
Temporary deflation happens at the instant of every bubble burst. There was temporary deflation after the 1929 bubble and even after the dot com bubble. This deflation results from a temporary and sudden drop in consumer credit that reduces ability to pay, so firms naturally must cut their prices.
This temporary deflation turns into serious inflation, however, once the government “solves” the lack of credit by creating new currency. Once ability to pay (with debased currency) is reestablished firms start raising their prices to meet the new equilibrium of money supply.
Summing it up, deflation is a natural and temporary result of an inflationary bubble bursting, but the longer term inflationary trend will continue, and in the light of the 8 trillion dollar mega issue, it will spike very hard and fairly soon.
I am sad to say I’ve never even considered minimum wage or other price controls in the context of deflation.
I just assumed them as something that needed to be abolished for ethical and free market reasons only.
Great article.
“…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. …”
What suggests itself to me is that a given consumer purchase will be delayed only if a new, lower price can be foreseen that is so much lower that it offsets the combination of both time preference and consumer surplus. The baseline for comparison must already include the risk that a retailer will hold a half price sale next week.
Regards, Don
I agree that the article is very good and increased my understanding of the situation. It also points to the strong possibility that deregulation through political action, generally being gradual, will lead to problems that produce demands for reregulation of even greater intensity (witness the current environment and the blame heaped upon the repeal of the regulation instituted by Glass-Steagall). It may only be possible that through the complete failure of state institutions, out of the ensuing chaos, to build a free society. Unfortunately, that path does not have a good track record.
Like J Cortez, I have not considered minimum wages and other price controls in the free banking or deflation equation. While implicitly, people on this website would consider comprehensive deregulation, we sometimes forgot that to people who don’t read this website (Or any other websites with the same view of Mises.org), our arguments are not valid unless we make it explicit what we tend to take as granted, namely a limited government (Which is not currently the case around the world, less alone in the US).
Great article. I suspect that unintended consequences from partial reforms have prevented more complete reform many many times. It would be interesting to catalog how many times this has happened and what economic damage has resulted.
Not to be picky, but that word deflation can cause a lot of confusion. While you can use whatever terms you like, of course, it makes much more sense to define deflation as a decrease in the supply of money, which is a distinct phenomenon from falling prices. Generally falling prices can be caused by either (or both) of: (1) increased production of useful goods and services or (2) decrease in the supply of money. The former is a good thing, the latter is bad. Sane, stable monetary systems (i.e. the gold standard) are accompanied by falling prices, but not by deflation in this sense (since the supply of gold is continually increasing). See the writings of George Reisman, for example this blog article:
http://georgereisman.com/blog/2007/11/deflation-and-gold-standard.html
You are, of course, correct that fixing the price of one factor of production (labor) above the market price will always result in sub-optimal utilization of that factor (unemployment).
And in europe where I live these problems are much worse.
That is because taxes on alcohol and fuel are mostly money amounts, not percentages. So, when there is deflation taxation goes up in real terms.
This point has been made many times. Lord Harris pointed out that in the UK it was one of the main reasons for inflation in the 1960s and 1970s. The socialist-leaning governments made wage agreements with public sector unions for specific money amounts of wages. The government could rarely afford to keep the bargains so it debased the currency instead.
Eh? I relate the personal experience of delaying the purchase of a LCD TV instead of taking advantage of cuts this weekend in anticipation of further cuts later.
Has the US entered a hyper-deflationary period without anyone having noticed?
I am beginning to think reality took out a restraining order on you guys.
FDR imposed minimum wage after the Great Depression already began. Furthermore unemployment fell sharply after, not before minimum wage was enacted. I do however agree with the article anyway since FDR also artificially created jobs. The rest of US history seems to roughly support the minimum wage increase to unemployment increase correlation. Particularly when minimum wage remains unchanged for a number of years unemployment begins to fall. Conversely sharp increases for minimum wage, such as during the 1970′s seemed to correspond to unemployment running out of control.
FDR’s minimum wages wrought havoc in Peurto Rico. Also, the director of research for the NRA estimated that FDR’s minimum wages caused 500.000 blacks to lose their jobs. So there is little doubt about the effects of FDR’s minimum wages, especially for marginal workers.
to stochastic:
you may care to consult hulsman “deflation and liberty” (pdf available).
a useful critique of reisman/rothbard/mises and sennholz’s views on deflation is presented by bagus in this paper -
http://mises.org/journals/qjae/pdf/qjae6_4_3.pdf
even the giants can misstep.
Anonymous: If the LCD TV is being used to watch the upcoming Super Bowl, would you forgo the game THIS year and wait until next year to watch the game at home? The TV almost certainly would be cheaper next year versus this year, following that logic.
That argument isn’t valid in an economy that’s heavily consumer goods driven, and most are buying simply to keep up with the Joneses. People want to buy said products and get the utility from it NOW, rather than wait.
If no one bought goods when they were waiting for them to be cheaper, then we would have zero sales of computers. They are constantly dropping in price while simultaneously increasing in CPU/GPU power, but people are still buying them in the meantime, even knowing that the next powerful model is just around the corner.
Krinken,
do your statistics showing unemployment dropping the longer the minimum wage is in effect take into account the reduction that inflation causes in the real wage that the state mandated minimum represents. I.e why should I believe that the causal factor for reduced unemployment is the long duration of the minimum wage as opposed to the result of inflation driving the DMVP of labor upward in nominal dollars, making previously submarginal labor supra marginal?
DW:
I am sure the exercise in crafting the article (as well as the impossibility of addressing every one of the potential questions arising therefrom) would tend to make one keenly aware of the near-impossibility of adequately addressing such matters in particular (as opposed to in general, with due emphasis on related matters).
The seemingly simple matter of the effect of minimum wage rates is a case in point. I don’t see the matter in as quite a clear-cut manner as do you and most of the commentors. It’s more insidious than merely a simple fixing of a minimum price for labor that happens to exclude some significant number from employment—far worse: it’s a sabotage of entry-level labor AND skills acquisition, a monkey-wrench thrown into many rational sorts of labor arrangements and accomodations common in a fair number of societies. It would be my guess that one of its most profound effects has been to super-marginalize (and desocialize) enormous numbers of both urban and rural blacks and with a follow-on effect being a wipe-out of any chance for the marginal (beginning and especially black) entrepreneur, particularly in the various “trades.”
One of the problems in any argument about inflation and deflation is being precise in what we mean by the terms.
Another Mises article by Robert Higgs today tackled this topic (Nonsense About Deflation), and it too, needed clarification, which fortunately a poster did in the blog discussion.
Are we talking about “price deflation” or are we talking about “monetary deflation?”
They are not necessarily the same thing. Presently we are experiencing a price deflation, both in the consumer goods markets and in the stock market, despite massive inflationary expansion of the money supply by the Fed in an attempt to stop the tumbling prices. This is not a good thing, especially when the stock market prices are falling faster than consumer goods prices.
My parents are retired, and have seen their retirement income shrink dramatically as their stocks lose value (“value deflation”?). They are getting hurt by this, as they cannot enjoy the comfortably affluent retirement they worked hard to achieve for many decades. If price deflation were occurring at the same rate or faster than the shrinkage of the stock market, then it would not matter, because they would still have the same relative affluence and purchasing power on their shrinking fixed income.
If the money supply were actually shrinking — monetary deflation — at the same rate as the nominal value of their stocks, then they would be OK, as well, since the cost of living would have to drop to match the existing money supply. But the opposite is happening. The monetary expansion that the Fed is frantically inducing will not lead to a true deflation of the money supply, and the temporary drop in prices (price deflation) will be quickly reversed.
Higgs said: “does deflation actually loom at present? If it does, its occurrence will surprise me greatly, because the Fed has been creating base money as if there were no tomorrow, and if the bailouts continue, as seems likely, more of the same is virtually certain. So far, the huge spurt in base money has simply been absorbed and held by the banks in the form of (legally) excess reserves, but the likelihood that the banks will sit on $268 billion of excess reserves forever is nil. Once they feel more secure, their loans and investments will go forth in search of a higher yield than the Fed pays them (since a recent change in policy) on their reserves, and at that point the banking system’s money multiplier will kick in with terrific force.”
Take a close look at the Fed graphs he referred to.
When that massive true monetary inflation with its multiplier effect kicks in, my folks are gonna get clobbered by the price inflation. Their stocks may rebound, but they are effectively on a fixed income, which will not grow, nor can it possibly keep up with the massive inflation that will follow. And their stock market savings will not inflate in nominal value at the same rate as prices, because the stocks are valued based on the market’s belief in the underlying productivity of their company, not indexed to the inflation, which will hurt productive companies by driving up interest rates and business costs.
It took the stock market decades to recover from the 1929 crash. My parents will likely not live long enough to see their savings regain the nominal value they had earlier this year.
It is not price deflation that we should worry about, as that is simply a temporary adjustment to the reality of the bubble collapse and recession. It is the unwanted effect of the govt’s response, in an attempt to bolster prices and wages, that is the real terror.
California electric “deregulation” is an example of a partial deregulation. Retail prices were strictly controlled (so the fool/single bidder for power had to buy no matter what the wholesale price was).
Maturin,
Your parents need some inflation protection in their portfolio. While commodities have fallen along with everything else in the recent selloff, my guess is that they will respond quicker than stocks when the inflation is felt in prices. Gold is the obvious choice, but there are also commodity index etfs. There are also TIPS, but those are only indexed to the CPI.
Deflation, as a result of a fixed money supply (gold), in a free economy would actually be a good thing. If interest rates were set by the market, savers–seeing that their money will be worth more in the future—will be more likely to save. This would drive the nominal interest rate down. Borrowers would bear the risk of deflation and would have to figure that in their forecasting of their profits resulting from the investment they make with the money they borrow. It would make entrepreneurs more responsible and the economy as a whole more solid and robust. Just as suggested, a gold monetary standard would likely create slow, steady deflation–a sign of a healthy economy since production is increasing relative to a stable money supply.
Anon,
Are you putting off the purchase of gas for your car or breakfast cereal or printer paper because you expect the price to drop (or conversely, since dairy products and meat seem to be on the rise again, are you stocking up at the current low price?)
Most folks time large durable goods purchases to get a favorable price (emergencies discounted). This is not indicative of inflation or deflation in and of itself.
Did you forgo buying a $400 ink jet printer in 1993 because you expected to pick one up for $39.95 in 2008? Heck every time someone buys a new computer it is with the full understanding that it will be a discount model in a year or less.
Falling prices are always good for consumers and savers. In general this means more goods will be sold, not less (how many TVs are in your house now vs. the number in your parents home when you were a kid? how many pairs of shoes do you own v. the number your granddad had when he was your age?). Now a hyper-deflation would be disruptive to production, but this never really happens, because there is no mechanism in a fiat money system that would promote a rapid increase in the currency’s unit value. Hyper-inflation has and will occur for precisely the opposite reason. And it could well be the America will see it for the first time in 250 years.
Perhaps the idea of tying the minium wage to inflation isn’t such a bad idea then! Well, as long as there is deflation.
Q: Do minimum wages put upward pressure on prices or do companies simply do without the workforce and close up shop? I’m not clear now based on the comments and the article… would min wages be detrimental in a market of dropping prices (stable money supply) or only in a situation of unstable money supply (artificial inflation or “true” deflation)? (Or both situations.)
Has there been destruction of money supply in this recession that the printing of money is meeting? (That is, is the money supply truly being inflated or is it counteracting a deflationary force?)
Trying to get a handle on how bad things will get!
-r
redshirt,
only under a regime of inflation do minimum wages appear to put upward pressure on prices. Your second guess is closer to the truth in most cases (including the inflationary case). Minimum wages have the effect of pricing labor which can not provide a discounted marginal value product equal to or greater than the price floor out of the labor pool. Furthermore, it has the tendency of forcing the remaining labor to get more productive and put in longer hours to make up for the loss of the now submarginal labor. If this labor is unwilling to do so, the entrepreneur employing them may have to cut back or cease production.
Minimum wage can be detrimental in all cases, but is least detrimental when as Krinken suggested above, that the price floor is set low and changed very infrequently. This has the effect of allowing inflation to erode the real wages of labor and increase the nominal DMVP of all labor, thus repricing formerly submarginal individuals into a supramarginal condition. Its most pernicious effect is evident in a deflationary situation where real wages rise (but not nominal wages) and nominal DMVP falls, pricing formerly supramarginal labor out of a job.
Fractional reserve banking is subject to wild swings in money supply as the multiplier works in both directions, inflationary and deflationary. As reserves are removed from the banks, the banks must reduce their loans outstanding by the multiplier to remain “solvent” and to keep their minimum reserves. This has the effect of drastically cutting the money supply during recessionary times. The fed has been attempting to counter this by pumping reserves into the banks, but debtors are reluctant to take further debt and the banks are reluctant to lend out to the full multiplier. Thus the capability for great inflation is in place, but until confidence returns on both ends of the loan market, it will remain unrealized, and monetary deflation may be the greater force.
Stanley,
Thanks for understanding my previous posts on deflation.
I have to admit that the first paragraph really gave me heartburn.
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.
This is totally false. Deflation is not a sign of progress. It is a sign of a distorted monetary unit.
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.
I have had to counter exactly the same argument concerning “gradual inflation.”
I do like the argument that the minimum wage law makes deflation worse, but even without the minimum wage law deflation does tend to create unemployment.
As you know I believe the best solution is neither inflation nor deflation.
I did like Robert Higgs article.
As in the US, the UK we are seeing falling prices and the Bank of England is likely to cut interest rates to around 2%, their lowest level for half a century. While the short term outlook is for price deflation, I think 12 to 18 months out we will experience very high rates of inflation. I think Jim Rogers has it right when he suggests people need to invest in unimpaired assets such as commodities. The precious metals such as gold and silver are very attractive at given levels, especially with the extra trillions of dollars pumped into the global financial system. Buying the physical metal is preferable to using futures or ETF’s, as the transmission mechanism in futures seems t have broken down.
William Davies (and others),
May I ask you to think through the term “price inflation.” There is actually no such thing. Prices can increase or decrease but they do not inflate or deflate. They are what they are.
In a monetary sense inflation is when the value of the monetary unit is falling, depreciating, in value and deflation is when it is rising, appreciating, in value. Prices and monetary value do not necessarily move in the same direction.
Consider the present situation where there is a total lack of confidence in the economy because of the fear of what the government may do after one invests. You can drive down the value of the currency all you want but investors will not invest and prices will fall. The manifestation of the decline in the value of the monetary unit will not be seen until confidence returns to the market and transactions return.
Contrary to what many here profess inflation is not simply an increase in the money supply. Mises has it right when he recognizes that both supply and demand must be taken into account.
What I’m seeing in some markets is current stock is being sold at cost (or lower), but they won’t be re-stocked due to soaring prices of imports.
How this enters into the general deflation vs inflation question isn’t clear, but I don’t see why the general question even matters as much as the specific question.
Let’s not get mired in the old macroeconomic debates of meaningless aggregates.
dick fox says:
“In a monetary sense inflation is when the value of the monetary unit is falling, depreciating, in value and deflation is when it is rising, appreciating, in value.”
against what, precisely? shares, property or other financial assets, food, medical services? pick any index, and immediately you’re making arbitrary choices, exactly what leads monetarists astray.
Newson said:
dick fox says:
“In a monetary sense inflation is when the value of the monetary unit is falling, depreciating, in value and deflation is when it is rising, appreciating, in value.”
against what, precisely?
Presumably, he means against the stable asset that is gold (or perhaps silver!).
The entire analysis here (against minimum wages laws) assumes without foundation that the market will clear at a positive(greater than zero) real wage rate?
Or is the assumption that the market will not clear and involuntary unemployment is a necessary condition of the free market?
Considering how pathetically low the minimum wage is any argument pertaining to lowering it is an admission that no solution exists to better the living conditions of your fellow citizens.
I do agree though that more legislation certainly is not the answer either.
An overhaul of the pantents system and so on would probably be far more beneficial with respect to competition.
My analysis here assumes that wages clear at the discounted marginal product of labor, whcich is obviously above zero. The proof of this is A- goods exist, labor generates real results B- the wages of most woekers are already above the legislated minimum.
DWM PhD
My analysis here assumes that wages clear at the discounted marginal product of labor, which is obviously above zero. The proof of this is A- goods exist, labor generates real results B- the wages of most workers are already above the legislated minimum.
DWM PhD
Thanks for you reply.
Are you allowing for the costs of travel too and from work, or for daycare / childcare?
My understanding of the minimum wage is that it is a nominal price.
By removing it people are forced to decline work opportunities because the cost is greater than the revenue.
The only benefit here is too the government policy maker who can take the moral high ground and say “that person is voluntarily unemployed” – rather than “we as policy makers have destroyed the free market by our very existence”
Alan
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