Salerno on the Benign Effects of Deflation

During his testimony last week before the House Committee on Financial Services, Joseph Salerno noted that a primary reason current Federal Reserve policy is so biased toward inflation is that they are deflation-phobes. I've blogged about this a few times already, but Salerno's brief, but profound explanation why a fear of falling prices has "no rational basis in theory or history" is worth quoting in full:

Let me explain. As technology advances and saving increases in a progressing economy, entrepreneurs and business firms are given the means and the incentive to invest in new methods of production, which in turn enables them to lower their costs and expand their profit margins. In a given market, the natural result is an increase in the supply of the good and more intense competition among its suppliers. Assuming no change in the money supply and continuing technological innovation, this competitive process will drive the production costs and price of the good ever downward. Consumers will benefit from the falling price because their real wages will continually increase as each dollar of income commands an increasing quantity of the good in exchange.

This is not merely abstract theoretical speculation but is precisely the process that occurred in the past four decades with respect to the products of the consumer electronics and high-tech industries, such as hand calculators, video game systems, personal computers, HDTVs, and medical lasers. Thus, for example, a mainframe computer sold for $4.7 million in 1970, while today one can purchase a PC that is 20 times faster for less than $1,000. The first hand calculator was introduced in 1971 and was priced at $240, which is $1,400 in terms of today’s inflated dollar. By 1980, similar hand calculators were selling for $10 despite the fact that the 1970s was the most inflationary decade in U.S. history. The first HDTV was introduced in 1990 and sold for $36,000. When HDTVs began to be sold widely in the United States in 2003 their prices ranged between $3,000 and $5000. Today you can purchase one of much higher quality for as little as $500. In the medical field, the price of Lasik eye surgery dropped from $4000 per eye in 1998, when it was first approved by the FDA, to as little as $300 per eye today.

Now no one, not even a Keynesian economist, would claim that the spectacular price deflation in these industries has been a bad thing for the U.S. economy. Indeed the falling prices reflect a greater abundance of goods which enhances the welfare of American consumers. Nor has price deflation in these or other industries diminished profits, production and employment. In fact, their growth has been just as spectacular as decline in the prices of their products and has been caused by it. But if deflation is a benign development for both consumers and businesses in individual markets and industries than why should we fear a fall in the general price level, which of course is nothing but an average of the prices of individual goods? The answer given by theory and history is that a falling price level is the natural outcome of a dynamic market economy operating with a sound money like gold.

Once you think about it, the idea that lower prices for some goods is good for individual households while lower prices on all goods is a disaster is absurd.

I encourage you to read Salerno's entire written testimony. For a more detailed discussion on the economic consequences of various forms of deflation I recommend his article, "An Austrian Taxonomy of Deflation," published in the Winter 2003, Vol. 6, No. 4, issue of the Quarterly Journal of Austrian Economics.