Is ‘Deflation’ Likely?

September 5, 1960

“Not inflation, but deflation is the new official worry.”

Such is the explanation now offered in some Washington reports for the action of the Federal Reserve authorities in lowering reserve requirements to add $3.6 billion to the money-and-credit-creating powers of the nation’s banks, in twice reducing the discount rate within three months, and in forcing down the prime lending rate. It is also put forward as the explanation of the increased spending programs in Congress, and pressure for medical care for the aged, higher farm price supports, and a higher minimum wage.

The slump in steel output, in construction, in appliance sales, the squeeze on profit margins, the relatively high levels of inventories and unemployment, are among evidences cited for the “deflation” that is feared.

There is nothing new in this fear. If one looks back over the record of the last twenty years, one finds a steady progress of inflation, with the total supply of bank deposits and currency up 270 percent between 1939 and 1959, and consequently with wholesale prices up 136 percent, and consumer prices up 113 percent, for the same period (see this column May 2).

Yet all during this twenty-year period it may be doubted whether a single week went by without at least somebody in Congress or the press expressing the fear that “deflation” might be just around the corner unless the economy were given a fresh inflationary shot in the arm.

MISUSE OF TERMS

These fears, to the extent that they are real, rest upon a misuse of terms and a confusion of thought. There has never been the slightest danger of “deflation” since 1933 in the true sense of a major contraction in the supply of money and bank deposits. Inflation means an increase in the supply of money and bank credit. The rise of commodity prices and living costs which almost inevitably follows is not the inflation but the consequence of the inflation. But by a still further extension of the two terms, any prosperity is called “inflation” and any recession or unemployment is identified with “deflation.”

This can lead to endless confusion. For, as illustrated in Germany and elsewhere since World War I, a sharp business recession and heavy unemployment can occur in the very midst even of a hyper-inflation.

Inflation works its apparent magic only in the short run, and only as long as final prices are rising faster than wage rates and other costs, so that employment and activity are stimulated by attractive profit margins or prospective profit margins. But if wage rates, taxes, or other costs rise as fast as or faster than selling prices, and start squeezing profit margins or inflicting losses on marginal firms, activity will fall and unemployment rise.

MONETARY MANAGERS

A new hike in minimum wage rates, and an extension of coverage, with 4 million already unemployed, would not be very intelligent. Its tendency would be to increase unemployment among the very groups it is ostensibly designed to help unless, of course, the purchasing power of the higher money wage rates were reduced by another dose of inflation.

What Congress and the Federal Reserve are in effect saying is that no recession is ever to be corrected by individual wage or price adjustments, but only by further doses of inflation to boost the whole price level. In fact, instead of there being any correction of uneconomically high wage rates in a recession, wage rates are to be hiked still higher.

It remains to be seen whether present inflationary policies will have their intended economic and political effects. They will surely do nothing to restore our export markets, to correct our adverse balance of payments, or to increase foreign confidence in the dollar. They are more likely to induce a further drain on gold stocks already slightly exceeded by our short-term liabilities to foreigners.

The recent actions by the Federal Reserve authorities not only seem unwise, they raise once more the whole question of whether monetary managers can be trusted, in the long run, to use wide discretionary powers wisely or whether restoration of a full gold standard, governed by strict and quasi-automatic rules, would not be preferable after all.