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.) (Kalecki called this the demand-determined
price sector.) 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. Falling house prices are like
falling stock prices in that they refer only to assets, not
newly-produced items. 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.
[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 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.
[The 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 the 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 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
[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.]
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
[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.
[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. Note
in passing that money wages are typically seen as sticky downward but
[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
"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 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
[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.]
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.]
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.
[True, but methinks that Leonhardt is a tad too optimistic.]
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