Deflation is the real threat

Even a right-wing glibertarian economist at the AEI agrees. The money multiplier has taken a dramatic decrease -- indeed, has basically ceased to exist -- and the result is that, in reality, we're already in deflation.

Now, I hear you say, "but... but... prices haven't gone down!" But price stickiness is a typical trait of all deflationary regimes. The deal is that businesses will not voluntarily sell items for less than they paid to acquire / manufacture said item. If they manufactured a Woddle for $100 in pre-deflation dollars, intending to sell it for $110, they will *not* sell the Woddle for $90 in post-deflation dollars. Rather, they will accept a lower volume of business and price it at $101 or higher, and make up the difference by laying off the workers that they no longer need at the lower volume of business. Once the supply of Woddles manufactured at $100 is depleted, they can then begin manufacturing Woddles at $80 in deflated dollars and price them accordingly, but the point is that price declines lag actual deflation of the money supply -- thus "stickiness", which is more "sticky" for goods with many inputs, and less "sticky" for things like raw commodities with fewer inputs, but sticky nevertheless.

This reaction of economies to monetary deflation is a fact which greatly puzzled many economists during the Great Depression, who were baffled by both price and wage "stickiness" in the face of massive monetary deflation. They were baffled that businesses would preferentially reduce production and lay off workers rather than lower prices, when the classic economics theory of the time predicted that businesses would simply cut wages and prices to deal with monetary deflation. Both prices and wages did decrease during the Great Depression, but nowhere as much as simple monetarist observation of the money supply itself would have predicted. The difference was made up in lower economic output -- i.e., if the money supply declined by 20%, part of that would be made up via lower wages and prices, but the remainder would be made up by a decline in output due to price stickiness. This reality is why mainstream economics moved away from classical economics towards either Keynesianism or Friedmanism depending upon the political proclivities of the economist, both of whom have models which explain this actual observed reality (as vs. the imaginary reality where unicorns are real and a decline in the actual money supply results in an immediate decrease in wages and prices).

We are of course seeing that exact same scenario playing out again today, for the exact same reasons. We have models to explain this, thanks to both Keynes and Milton Friedman, yet the "conventional wisdom" still refuses to admit that deflation is a monetary rather than price phenomenon and continues to insist that we need to put the clamps onto the money supply now to prevent some mythical inflation that as has much reality as unicorns, despite the fact that both Keynes and Friedman's models were pretty darn specific that this is a time to start *printing* money, not *evaporate* it. Fascinating. In some neurotic, deranged way that usually involves people in white coats bearing restraint jackets use of the word "fascinating", that is...

-- Badtux the Economics Penguin