The New York Times / December 17, 2008
Economic Scene: Finding Good News in Falling Prices
By DAVID LEONHARDT
Very few Americans alive today can remember a time when prices across the economy were falling. But they're falling now.
The cost of fruits, vegetables, clothing and vehicles are all dropping. Housing prices have been falling for more than two years, and a barrel of oil costs about $45, down from $145 in July.
The inflation report released by the government on Tuesday showed that the Consumer Price Index was 3 percent lower last month than it had been three months earlier. It was the steepest such drop since 1933.
Note that most of the prices that are falling are "commodity" prices that are inelastically supplied and demanded (like those of gasoline, fruits, veggies, etc.) The economist Michal Kalecki (who developed a lot of Keynesian economics before Keynes) called this the "demand-determined price" sector. We should expect falling demand to hit this sector hardest.
In general, significantly falling prices have not spread to the manufacturing or service sector (where prices are mostly determined by costs), with the obvious exception of autos.
By the way, falling housing prices do not show up in a big way in the usual measures of the "cost of living," which only cover newly-produced goods and services. The falling house prices that Leonhardt points to are like falling stock prices in that they refer only to assets, not newly-produced items. So they don't show up in the CPI or similar measures.
The cost of living measures do not assume that each person buys a house each year (or some period like that). Instead, they measure what the statisticians believe people would pay if they rented the houses. Thus, as house prices fall, that might affect the rental cost of housing and the cost of living. But actual rents did not rise as much as the asset price of housing in the late bubble, so they're not likely to fall as much either. Most workers -- who are mostly renters -- won't benefit much.
In any event, falling house prices will not be a benefit to those of us who are strapped for cash due to lay-offs or stagnant income and have a really hard time borrowing. Mostly, they will hurt those who (partially) own houses, pushing them in the direction of being "upside down" (having negative equity in the house). Many have already achieved that fate. This encourages the recession by depressing consumer spending further.
These [price] declines have raised fears of a deflationary spiral — fears that help explain the Federal Reserve's surprisingly large interest rate reduction on Tuesday. And there is good reason to fear deflation. Once prices start to fall, many consumers may decide to reduce their spending even more than they already have. Why buy a minivan today, after all, if it's going to be cheaper in a few months? Multiplied by millions, such decisions weaken the economy further, forcing companies to reduce prices even more.
This "expectations effect" is only one reason why deflation is a bad thing. In addition, deflation raises the real value of the debts of the debtors. It's true that it also raises the real value of the assets of the creditors. But debtors are usually the bigger spenders, so the net effect is to depress demand. Further, as the debtors are squeezed, more and more of them go bankrupt. This undermines the real value of the winnings of the creditors, further depressing demand.
In simple terms, if you borrowed a bunch of money last year and your money income falls now, then you discover very quickly that your interest and principal payments have not fallen, pushing you to the wall.
One rule is that the more debt people and companies have accumulated in the past, the more they and the economy suffer due to deflation. We in the US have just ended a monumental debt-powered splurge, at least among consumers. So avoiding deflation is especially important.
In passing, it's interesting to note that the very orthodox economist Irving Fisher developed his "debt-deflation theory of great depressions" back during the last serious deflation (the early 1930s). Somehow, the role of debt has been elided.
But a truly destructive cycle of deflation is still not the most likely outcome. For one thing, the price of oil cannot fall by another $100 in the next few months. For another, the federal government will soon, finally, be fully engaged in trying to stimulate the economy.
In mechanical terms, the Fed's rate cut is actually a decision to pump more money into the economy (which will cause short-term interest rates to fall). Starting next year, the Obama administration is planning to spend hundreds of billions of dollars on public works and other programs.
It should be mentioned that the Federal Reserve has just run out of interest rate ammunition to stimulate the economy. Maybe "Helicopter Ben" can do something just by printing a lot of money, but we'll see how effective that is. On the other hand, Obama's stimulus plan will not happen for months... Who knows what will happen in the meantime or how large the deficit hawks will allow the stimulus to be.
All else being equal, more money sloshing around an economy causes prices to rise. In this case, it will probably keep them from falling as much as they otherwise would have.
So amid all the legitimate worries about deflation, it's worth considering what may be the one silver lining in the incredibly bad run of recent economic news: The cost of living is falling.
Jobs are disappearing, bonuses are shrinking and raises will be hard to come by. But the drop in prices, which isn't over yet, will make life easier on millions of people. It's possible, in fact, that the current recession will do less harm to the typical family's income than it does to many other parts of the economy.
There's a lot of truth to this (Leonhardt's main point). My grandparents used to tell me about how they (who weren't hurt by the 1929 Crash or the 1929-33 Collapse) were able to get real bargains because of the deflation then, even buying luxury goods that they normally couldn't afford.
But a lot of other people suffered big time. My research has found that the amount of nutrition received fell significantly. Per capita food energy per day fell about 5% between 1929 and 1933.
The reason is something called the sticky-wage theory. Economists have long been puzzled by the fact that most businesses simply will not cut their workers' pay, even in a downturn. Businesses routinely lay off 10 percent of their workers to cut costs. They almost never cut pay by 10 percent across the board.
The Post-Keynesian economist Paul Davidson also praises the sticky money (nominal) wage as a nominal anchor that prevents deflation.
The stickiness of money wages is crucial, because without it, falling prices could start a downward wage-price spiral, with wages falling due to falling prices and prices falling due to falling wages. It's this spiral which represents true deflation, the kind of deflation that's been so destructive in the past. A merely temporary fall in prices does not have this kind of negative effect.
Traditional economic theory doesn't do a good job of explaining this [wage stickiness]. During a recession, the price of hamburgers, shirts, cars and airline tickets falls. But the price of labor does not. It's sticky.
In the 1990s, a Yale economist named Truman Bewley set out to solve this riddle by interviewing hundreds of executives, union officials and consultants. He emerged believing there was only one good explanation.
"Reducing the pay of existing employees was nearly unthinkable because of the impact of worker attitudes," he wrote in his book "Why Wages Don't Fall During a Recession," summarizing the view of a typical executive he interviewed. "The advantage of layoffs over pay reduction was that they 'get the misery out the door.' "
This makes a lot of sense. I hope that orthodox economists are going to follow this lead and return to the 1930s fashion of actually talking to businesscritters and workers as a way of finding out the nature of economic behavior, to supplement the standard abstract/deductive or statistical techniques.
However, it's not true that "Traditional economic theory doesn't do a good job of explaining" downwardly sticky wages. The problem instead is that the dominant schools of economists ignore a very traditional reason why workers resist or resent money-wage cuts (perhaps because of an obsession with "representative agent" models). It's a version of the prisoners' dilemma.
The standard story is that if workers accept a nominal wage cut, it will lead to falling prices, ceteris paribus. Thus, real wages won't fall much, but they will fall a bit, raising employment. The problem with this story is that each group of workers fear that no other groups of workers will take wage cuts. If one group takes a money-wage cut and others don't, prices won't fall much and the group will suffer real wage declines. There won't be a significant increase in employment (especially given the aggregate demand failure). Fearing this fate, most groups of workers resist nominal wage cuts. This means that the only price decreases are in the commodity sector (gasoline, food, etc.) and assets (houses, stocks, etc.)
If money wages in the manufacturing and service sectors don't fall, but the demand for products is falling, then employers will employ lay-offs because their profits will be squeezed. They will also refrain from expanding their operations (as they're doing right now). This encourages further falls in employment.
Lay-offs mean that the average money wage of the entire labor force (employed and unemployed) may fall even though that of employed workers does not. Falling asset prices will also hurt those workers who own houses or other assets, discouraging consumer spending. This encourages further production cut-backs and lay-offs. A downward spiral can occur even though money wages don't fall.
Wage stickiness, by the way, is likely less important in the U.S. economy than it was a generation ago. That's because of the "neoliberal policy revolution" of the 1980s and after (starting with the resistable rise of Paul Volcker to power in August 1979). This revolution has meant that more and more workers are treated as commodities. Fewer and fewer of them belong to labor unions (outside of the government sector). So it's more and more likely that nominal wages will fall during the current recession.
It's just possible the neoliberal policy revolution, which aimed at returning the economy to its pre-1929 state, has brought back the deflationary disaster of the 1930s. Of course, we won't know until it happens. If the reflation efforts of the Fed and the federal government succeed, any undermining of the sticky wages phenomenon is irrelevant in practice.
If the anti-government rhetoric of the neoliberals is to be taken seriously, it's ironic that its policies have put so much responsibility has been put in the Fed's and federal government's hands.
Companies resort to cutting jobs and giving only meager pay increases, increases that are even smaller than the low rate of inflation that's typical during a recession. This recession may well be the worst in a generation — but thanks to the stickiness of wages, the pay drop for most families may not be much worse than that of a typical recession.
The forecasting firm IHS Global Insight predicts that prices will fall by an additional 1 percent in 2009. That would bring the total drop, from the summer of 2008 to the end of 2009, to roughly 4 percent. But you can be sure that most executives will not force their workers to take a 4 percent cut in their paychecks. The fears about morale will be too great.
Should we rely on this forecast? I doubt it. The accuracy of economic forecasts has dived even lower in recent years. Forecasts seem better measures of what people expect than of what might actually happen in the world.
Strange as it sounds, the drop in prices will keep real incomes — inflation-adjusted incomes — from dropping too much.
I don't mean to make things sound better than they are. The economy is bad and getting worse. A deflationary spiral remains a real threat, even if it's not the most likely result. No matter what, unemployment is headed much higher.
People who keep their jobs, meanwhile, will suffer through some stealth pay cuts — higher health insurance premiums, for instance. Raises will also remain meager in 2010, even if prices start rising again. Like every other recent recession, this one will force families to take an effective pay cut, and a significant one.
Alas, "stealth pay cuts" are not really stealthy: they hit people directly in the pocketbook, having the same effect as non-stealthy pay cuts. Higher health insurance premia reduce the amount of income left over for other purposes. And they're hard or impossible to avoid, just like a payroll tax increase. They encourage resentment -- and cut-backs in consumer spending -- just like non-stealthy pay cuts.
But the drop in prices will still soften the blow. And at this point, American families can use any bit of economic help that they can get.
Copyright 2008 The New York Times Company
True, but methinks that Leonhard is a tad too optimistic.