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Does Deflation = Depression?

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Wages Of Depression

Lee E. Ohanian, 09.02.09, 12:01 AM EDT

Hoover-era lessons for today's policymakers.

Federal Reserve policies over the last year have been partly motivated to not repeat some of the policies of the 1930s, including deflationary monetary policies. Current Fed policy has helped avoid deflation, which certainly has been important, but historically, deflation per se doesn't always create massive depressions.

Professors Andrew Atkeson of UCLA and Patrick Kehoe of Princeton have studied deflation and depression and state that with the exception of the 1930s, "in the rest of the data for 17 countries and more than 100 years, there is virtually no evidence of a link between deflation and depression." This suggests that there were factors present during the 1930s but not at other times that intensified the impact of deflation on the economy.

My research suggests that economic policies are important for understanding why the Depression was initially so severe, and why deflation was more depressing during the 1930s. Specifically, this research suggests that President Herbert Hoover's policies that created and fostered industrial cartels, and that kept industrial wages above their market-clearing levels, were important factors.

Hoover's views about competition differ considerably from today's economic thinking. Economists today typically favor vigorous competition in many market settings, as competition fosters the lowest prices for consumers and results in only the most efficient producers surviving. But Hoover thought that there was too much competition in the American economy in the 1920s. Hoover believed that industrial synchronization and cooperation, and codes of "fair competition" among business in the same industry, would generate superior economic outcomes. Not surprisingly, Hoover's initiatives that helped industry develop collusive trade groups fostered high industrial concentration and substantial monopoly distortions during the 1920s.

Hoover's views on wage policy, and his interpretation of the fact that high wages and prosperity go hand in hand, also were different. A number of economists today interpret high real wages as reflecting high worker productivity that results from a skilled labor force working with a large stock of capital and efficient technologies. In other words, worker productivity drives real wages and prosperity.

But Hoover interpreted this correlation differently and believed that increasing wages in and of themselves were important for promoting prosperity, while he apparently discounted the impact of raising wages above worker productivity on business hiring decisions.

Full article at: http://www.forbes.com/2009/09/01/herbert-h...-e-ohanian.html

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If inflation, consequence of increase in money supply relatively to the size of the economy, means a stealth tax, then clearly the opposite does not necessarily imply something bad. In fact, inflation is needed by the "buy low, sell high" brigade, i.e.e the unproductive sector of the economy or asset speculators. If you keep money supply constant and productivity and the amount of goods and services increases, things become cheaper without any depression. The only problem is with bankers and BTlers etc: there is no easy way for them to make money. Wasn't this what happened in the US in the late 19th century that the economy prospered in combo with prices going down approx.20% during 1880-1900?

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The paper is very interesting, and can be read here:

http://minneapolisfed.org/research/sr/sr331.pdf

An important thing to note is that the paper was written in 2004, given that, two things stand out to me.

Firstly the example of Japan is downplayed, but Japan's experience of the last 5 years has continued to be one of very low growth which would discount the comparisons with Italy and France given in the paper. Japan's recession has been almost continuous for 20 years, and in the last few months their fiscal position has deteriorated markedly.

More importantly is the relevance of the quote below:

B. Outside the Great Depression

While the debate about the Great Depression episode is ongoing, our interest lies mainly in looking

for a robust relationship in a broader historical context. If we find none, the Great Depression may

have been a special experience with little to offer policymakers considering a deflationary policy

today. And that is what we find.

In 2009 it is fairly clear that we are in the biggest globally coordinated recession since the 1930's. This is Great Depression 2. The strong link between deflation and depression in GD1 is surely relevant today.

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The current economic system does not allow deflation.

If you have debt expansion as the source of growth, deflation cannot be allowed under any circumstances.

However deflation is a natural part of the economic cycle.

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If inflation, consequence of increase in money supply relatively to the size of the economy, means a stealth tax, then clearly the opposite does not necessarily imply something bad. In fact, inflation is needed by the "buy low, sell high" brigade, i.e.e the unproductive sector of the economy or asset speculators. If you keep money supply constant and productivity and the amount of goods and services increases, things become cheaper without any depression. The only problem is with bankers and BTlers etc: there is no easy way for them to make money. Wasn't this what happened in the US in the late 19th century that the economy prospered in combo with prices going down approx.20% during 1880-1900?

Yes, keeping the money supply steady, should provide a sound foundation for businesses. As automation efficiencies are made, products should get cheaper and labour should be redirected to new areas as/when this happens. Rinse and repeat and products should gradually get cheaper.

The problem is, deflation makes debt more expensive. In a sane world, we (as a nation) wouldn't all be in loads of debt, so deflation wouldn't be a problem. Unfortunately, we live in an insane world, where the credit boom has been propped up, every time it started to self correct itself, building up the risk of a deflationary collapse (extend credit = inflation + boom, repay credit = deflation + bust).

Essentially, if we were tending about the mean of an amount of money, with some credit being created, then some being destroyed, the inflation/deflation cycle would work just fine - much like a sine wave (pic). However, we have kept on supporting the credit expansion part, meaning that we have pushed the first quarter of the sine wave ever higher. What does this mean for the second quarter? A deflationary collapse.

We have reached peak credit, where people are saturated with debt, so it is clear that we can't keep increasing it any further, but there are a few things to consider:

1. We have grown accustomed to the inflation caused by decades of credit expansion. Going back to 80s prices now, would seem alien. So much credit has been pumped into the system that we have lost sight of the original prices, in a (relatively) debt free world.

2. The only way we can stop deflation is by printing enough money, to put a floor under the prices, at a defined point (i.e. replacing broad money with narrow money). The problem being, we will then remain an expensive country to live in (EDIT: assuming we give the money to the banks), as people will be shackled with huge debts still and everything will be very expensive still - businesses will struggle to compete. Unless reserve ratios are tightened in tandem, it would risk another credit fuelled boom, leaving us with an even bigger mess to deal with too. We would also have lost decades, as growth struggles to catch up with the inflated prices, while in the mean time everything is still very expensive.

EDIT: If we give the money to the people, it creates a rather different dynamic though - it would shrink people's debts, but it would debase the currency, making any imports expensive. It would also steal wealth from the previous generation (who may then have worthless savings). Any other countries holding Sterling would also be burned, but then there was always a risk of that (especially in light of the way things are going). It would have a positive effect of encouraging investment within the UK though, due to the imports being expensive. Banks would likely fail and monetary reform should be ushered in too, to prevent a repeat.

3. The alternative of letting the deflation run to its course, would be a sharp shock. Cascading business failures, repossessions, large scale unemployment all happening relatively quickly. Once back at the bottom, we could start rebuilding though. The roads, buildings, factories would all still be there, as would the people to work in them. The banks and all their debt would be gone, but new banks could spring from the ashes, designed to be sustainable. With all the debt money wiped out, we would be starting afresh, cleansed, tougher and keen to fight another day.

Is there a way we can combine 2 and 3? Well, we can put a floor under prices at a lower point, deciding to let some stagnation happen, some debasement happen, to try to keep the wind down orderly.

More radically, we can wipe out all money - all debts and all savings. Essentially, you have 3, happen in an instant. Some would lose fortunes, some would be free of debt. New money could be issued and distributed evenly, businesses which were useful and profitable would quickly prosper, while those making loses would quickly fail. Order, out of chaos. You would have to hope we were self sufficient though, as our currency wouldn't be worth dirt to anyone else (and we don't have much gold/oil), until trust was regained. Can I see it ever happening? No. Would it be a good thing? Depends how you look at it.

EDIT: tweaked a bit

Edited by Traktion

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