The price is right: deflation has a bad name. But when productivity is increasing, prices should be allowed to fall

Mr. Selgin is an associate professor at the University of Georgia and author of the Institute for Economic Affairs Hobart Paper, Less Than Zero: The Case for a Falling Price Level in a Growing Economy.

IT'S official: We should all start worrying about deflation. That, at least, is the message most listeners took from Alan Greenspan's January 3 speech before the American Economic Association. The Consumer Price Index rose only 1.7 per cent last year, and, if critics of its current method of calculation are correct, consumer price inflation was probably close to zero. Producers' prices actually fell last year. By this reckoning, deflation really is staring us in the face. Steve Forbes, Robert Reich, the editors of the Wall Street Journal, and the chief economist at Merrill Lynch have all explained that, inflation having been vanquished, "deflationary pressures" are the new threat.

The Federal Reserve can prevent deflation. It need only expand its purchases of government securities, which it pays for with newly created Federal Reserve dollars that are subsequently deposited in commercial banks. In recent years, this expansionary monetary policy has more than compensated for the deflationary effects of productivity gains, replacing what might have been mild deflation with mild inflation. But the fact that the Fed can prevent deflation doesn't mean it should. Right now, we should be welcoming a long-awaited opportunity to watch the cost of living decline --something it has not done since 1955. The idea that deflation must be avoided at all costs traces back to myths that arose in the 1930s, when the Fed did allow it to proceed too far.

Myth #1: Deflation always means depression or recession. Actually, it depends on the cause. The deflation of the early 1930s was a genuine disaster, involving massive declines in production and employment. But what made that deflation so painful, besides its severity, was its underlying cause: a collapse of the money supply, which in turn led to a collapse in consumer spending. Deflation can also be a consequence of improvements in productivity, in which case it needn't be harmful at all. Such "benign," productivity-driven deflation was a common occurrence during the last part of the nineteenth century, when people routinely looked forward to goods' getting cheaper. Today, with productivity growing at more than 2 per cent annually, prices ought to be falling concomitantly.

Myth #2: Falling prices mean falling wages and earnings. Not if they're based on improvements in productivity. When productivity rises, the cost of producing goods and services declines. Prices of goods and services can then be cut painlessly, without any absolute decline in business earnings or wages. Last year, for example, workers' average weekly earnings rose by about 4 per cent, or more than twice the official rate of inflation. Had monetary policy allowed consumer prices to fall 2 per cent -- roughly the rate of overall productivity growth -- average money wages would have risen slightly above their 1996 level. But because of lower prices, average real wages would still have risen by more than 2 per cent, just as much as their recorded increase under mild inflation.

Myth #3: Deflation harms debtors. Again, not necessarily. Suppose, for example, that over the course of one year productivity unexpectedly rises 2 per cent and prices therefore unexpectedly fall 2 per cent. Then, although loans would be repaid in dollars more valuable than before, the dollars the borrowers made with the loan would also be more valuable. On the other hand, a productivity-driven deflation is very kind to pensioners and others living on fixed incomes: When lowered costs of production are reflected in lowered prices, persons on fixed incomes share in overall gains that would otherwise be enjoyed only by persons with flexible incomes. Why shouldn't the benefits of improved productivity be passed on to all consumers?

MYTH #4: A stable price level serves best to avoid booms and busts. When productivity isn't changing, a stable price level is indeed consistent with overall stability of consumer spending, business earnings, and profits. But all this changes when productivity is growing. In that case, monetary policy can keep the price level from falling only by artificially boosting consumer spending and industry earnings and, in the short run at least, profits. Although this might not sound so bad, it actually means trouble: high profits are fine when only certain industries experience them and others suffer losses, for then they serve as a useful signal for the reorientation of investment. But high profits all around are the result of unneeded Fed additions to bank reserves, which artificially lower interest rates. That, in turn, leads to overspeculation in asset markets, including real estate and stocks. Then comes a recession, when bad investments are liquidated.

During the late 1920s, for example, the Fed strove to maintain a stable price level despite ongoing improvements in productivity. The result was one of the more dramatic stock-market booms in history. Several noteworthy economists at the time urged the Fed to let the price level fall, thereby preventing the boom from getting out of hand. The Fed did not heed this advice until 1928, when a gigantic stock-market bubble was already set to burst.