George Selgin: hen fear of falling prices becomes a self-fulfilling prophecy
... Yes, deflation again. But this isn't the bad deflation of the 1930s. It comes not from consumers having less money to spend but from them being confronted with more to spend it on."Bad" deflation happens when demand shrinks;"good" deflation happens when supply expands.p The difference between the two sorts of deflation couldn't be more basic. Most people grasp it without a hitch. Unfortunately, economists seem to be the exception, perhaps because of their obsession with the Great Depression and zeal to avoid repeating it. Nor has their understanding been aided by the fact that none of them has ever actually witnessed the good sort of deflation.
Yet good deflation isn't just hypothetical. For much of the 19th century, when the gold standard prevented central banks from printing money willy-nilly, prices fell more often than they rose, and people considered that tendency to be perfectly natural. After all, technology was improving, so goods cost less to produce. Why shouldn't prices reflect that reality? From 1873-96, for instance, prices in most gold-standard countries fell at an average rate of about 2 percent a year, while real output grew at correspondingly healthy rates of between 2 and 3 percent, thanks largely to productivity gains. That isn't to say that there weren't occasional crises—there were, and some involved a dose of bad deflation, driven by temporary lulls in lending and spending. But the general trend of spending was up, while the downward trend of prices remained within the bounds of underlying productivity gains and was for that reason perfectly benign: businesses could afford to sell their products for less as long as it was costing less to make them.
Of course technological improvements didn't come to a halt, much less give way to technological backsliding, after the 1930s. On the contrary, the post-Depression era has been witness to some of the U.S. economy's most dramatic productivity gains. Yet the Consumer Price Index, instead of falling along with those gains, has risen dramatically and with scarcely a break. Even 2008 saw a slight rise in the CPI, despite the last several months' deflation, and if 2009 turns out to be a deflationary year, it will be the first since 1954. Whatever else is driving price movements, it's no longer underlying changes in real unit production costs.
The complete disconnection of price movements from underlying real cost changes in modern times is a measure of contemporary monetary authorities' laxness when it comes to preventing inflation, combined with their refusal to acknowledge the theoretical possibility of a benign deflation. That denial rests on sloppy economics that insist on conflating the consequences of good, supply-driven deflation with those of its bad, demand-driven counterpart....