Following the recession in 2008, Mark Thornton of the Austrian School of economics coined the term apoplithorismosphobia to refer to the “fear of deflation” prevalent among economists. He then proceeds with a half-assed, one-sided economic analysis to justify the laissez-faire approach of the Austrian School. Thornton points out that low interest rates and easy credit encouraged malinvestments during the boom and that deflation is part of the market correction process. Furthermore, he suggests that the average consumer ought to be delighted to see lower prices. He says,
“As malinvestments from the bubble are liquidated, the economy begins the correction process. The value of the malinvestments plummets. The values of loans backing these investments falls, and the money supply contracts as banks reduce lending. The price of capital and labor falls, and entrepreneurs discover new profit opportunities to redeploy the capital and labor that had been misdirected by the Federal Reserve's boom or bubble. As the price of goods falls, potential consumers become actual buyers.”(Mark Thornton, Bernanke's Apoplithorismosphobia
Well, I would say that Mr. Thornton would do well to recall Frédéric Bastiat’s lesson on “that which is seen, and that which is not seen.” In Thornton’s analysis, that which is seen is a fall in prices. That which is not seen is that contracting money supply means “too many hands chasing too few dollar bills,” as Milton Friedman used to say. Well, Mr. Thornton even alludes to the problems that he seems to overlook in the grand scheme of things. He points out (1) that the money supply contracts and (2) that the price of labor falls. This basically negates his ultimate conclusion. He assumes that the reduced prices of goods will encourage people to consume more, thereby stimulating the economy. What he is overlooking is the fact that there is less money available for consumption.
During a recession, the reality is that deflation results in less money being available for consumption. Either wages will drop or unemployment will increase. This means that people will have less money to spend. Yes, the prices of consumer goods will drop, but many would-be consumers won’t be able to buy those goods with their lower wages or lack of wages. Consequently, many businesses will end up failing and going under. As businesses start to fail, the people that were employed by those businesses become unemployed. Consequently, unemployment increases more and consumption falls as even less money is available in the hands of consumers in the aggregate. Left alone, this tends to drag on for long periods of time. This is what John Maynard Keynes called a “deflationary spiral.”
The conventional way of dealing with this problem is to stimulate the economy and offset the deflation with inflationary policies. This can be done by lowering interest rates and creating easy credit. The problem with this approach is that (1) it doesn’t always work because interest rates can’t be reduced below zero [although the idea of a negative interest rate has been thrown around] and (2) it only temporarily relieves the symptoms of the economic illness by re-inflating the bubble, putting the crisis off for a little while longer. Alternatively, the government can inflate the money supply and stimulate the economy through spending. The government can bailout failing industries either directly or indirectly, or some combination of both. For instance, when the auto industry was failing, they directly bailed out the industry by giving money to the auto companies, but they also indirectly bailed them out with the Cash for Clunkers program, which essentially gave people money to buy new cars with.
There are two better approaches. First, there is Hyman Minsky’s job guarantee approach. According to Minsky, when jobs in the private sector start to be eliminated, the public sector should step up and ensure that everyone who wants to work can find work. The government can either employ these people directly or indirectly. It makes little difference whether they are directly on the government payroll or if they are employed by private contractors in the private sector who are paid by the government for their services. On the one hand, this approach is very capitalistic, by which I mean it basically assumes that wage-labor ought to be the norm. On the other hand, this approach can be seen as socialistic, at least insofar as it bears a certain resemblance to Louis Blanc’s proposals in The Organization of Work. This just demonstrates the failure of language.
Alternatively, there is the citizen’s dividend or universal basic income approach. When the economy goes bust and the money supply starts to contract, the government can simply give everyone some money. People will then be able to spend that money for consumption. If you make this policy standard, regardless of the state of the economy, it guarantees that deflationary spirals cannot occur and lessens the likelihood of serious recessions occurring. The basic income provided by government would be sufficient for survival only, but not sufficient to allow one to enjoy all the luxuries that we demand in modern society. Since the basic income will encourage consumption, there will be jobs on the other end. Producers and retailers will need to employ people and people will need jobs in order to buy luxury items (phones, televisions, computers, etc.). This approach can also be seen as both capitalistic and socialistic, again demonstrating the failure of language.