Deflation in the Eurozone is not good deflation


ASI Senior Fellow Anthony J. Evans has a very good new piece on the Cobden Centre blog. First he notes how Austrian economists have been able to say interesting things about deflation that others have missed:

As inflation rates continue to fall across the Eurozone one might expect Austrian economists to rejoice. After all, inflation reduces our purchasing power and acts as a hidden form of taxation. Failure to control inflation caused some of the greatest social and political disturbances of the twentieth century, and attempts to centrally plan the monetary system are destined to failure. George Selgin’s “Less than Zero” is the seminal account of how deflation can be beneficial, and why central banks should be willing to tolerate it.

But he goes on to point out that this 'good deflation' is typified by rising real incomes, as it has come through productivity improvements. If we don't see rising real incomes, then we're not seeing good deflation. If we are seeing bad deflation then we risk sustained recession and depression, as inflexible wages are forced to bear the burden of adjustment:

Austrians are loathe to advocate monetary activism and for good reason. But the goal of monetary policy is not inactivism, but neutrality. The issue comes down to the costs of adjustment. If aggregate demand remains at 1% then people will adjust their expectations, prices will adjust, and output will return to normal. During the Great Depression Hayek advocated this path, even though he recognised that prices take time to adjust, and whilst they do so unemployment would rise. His reasoning was that increasing the load on price adjustments will increase their flexibility. In a time of chronic wage and price inflexibility it was a moment to bust the unions. However he later came round to the idea that those costs were too high. The collateral damage of using a downturn to put more emphasis on nominal wage adjustments was unfair. For the mass unemployed, nominal wage rigidities isn’t their fault. So instead of placing the burden on wage adjustments, central banks have the option of maintaining a certain level of total income. This avoids the necessity of a nominal wage adjustment, in part because inflation allows real wages to adjust.

The whole piece is very good, and consonant with what I have been trying to say since the third dip of the ongoing Eurozone crisis.