Editor’s Note: This is Part I of a two-part series. Part II is now up and you can see it here.
The media and blogosphere are buzzing with panic about an imminent “deflationary spiral” — a lengthy, self-reinforcing, and intractable decline in prices that will usher in pain not seen since the Great Depression.
The fear is that if declining demand for goods and services forces companies to charge less, they will fire workers or reduce wages, thus forcing a further reduction of economy-wide demand. Demand for goods is further reduced because while wages are dropping, the amount of debts owed remains the same, so people have to spend a higher proportion of their wages on debt service. Along the way, the thinking goes, consumers will see that prices are dropping and accordingly delay their purchases, putting yet more downward pressure on prices. The result is an ever-growing spiral of decreasing economic activity and falling prices.
There is something to this line of thinking, but it ignores a major piece of the puzzle: prices are denominated in dollars. And today’s dollar differs from the currency that kept score during the Depression of the 1930s in two very important ways: that our government can create as many new dollars as it sees fit, and that it sees fit to create an awful lot of them.
While this state of affairs offers many reasons for concern, the risk of a protracted deflationary spiral shouldn’t be one of them.
Mainstream economics’ big takeaway from the Depression is that deflation must be prevented at all costs. Our fiscal and monetary leaders have fully embraced this view. And unlike their Depression-era predecessors, they can carry this goal out by virtue of their ability to push up dollar-denominated prices by creating literally endless amounts of new money from nothing.