Stable Prices Are No Cure-All

By Christopher Farrell For the past quarter century, central bankers have preached the virtues of price stability -- the elusive, long hoped-for goal, an economic equivalent of the holy grail. Economists of all stripes -- liberal, conservative, Keynesians, neo-Keynesians, monetarist, neoclassical, and Austrian, to name just a handful of the major schools -- believe the economy works better if the value of money is stable.

The more consumers, savers, investors, and entrepreneurs trust that a dollar today will be worth a dollar tomorrow or 10 years from now, the easier it is for everyone to make sensible decisions with their money, especially risk-seeking capitalists. Price stability, says Federal Reserve Board Chairman Alan Greenspan, is when "expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household decisions."

Well, America has reached economic nirvana. That's according to Fed Governor Ben S. Bernanke, who recently remarked that "something remarkable happened -- the goal was achieved!" The main inflation measures, excluding the prices of volatile food and energy, now range between 1% and 2% a year. Inflation is likely running at or close to zero, since a respected body of economic research suggests the major indexes overstate price changes by as much as a percentage point.

NO CAUSE FOR CELEBRATION. Then why does everybody feel so bad? Why aren't newspaper and magazine editorials hailing price stability? Why aren't public radio and major broadcasters gathering the best and brightest at roundtable discussions to dissect the achievement?

For one thing, hardly anyone is enjoying the payoff from price stability that central bankers have promised in speech after speech over the years. Zero inflation has been accompanied by a recession and an anemic recovery, a long bear market in stocks, and rising unemployment.

And the mood remains somewhat sour because the prospect of deflation has heightened fears of an economic depression. The world economy is stagnant to weak, and deflation could be a precursor to tougher times ahead. But deflation and depression aren't synonymous. For instance, during the 1880 to 1896 period, when prices fell nearly 2% a year on average, real incomes increased 85%, almost 5% annually, according to the Federal Reserve Bank of Cleveland.

RISK COMPENSATION. The odds of a depression may be very small, but the far bigger risk in a world of stable prices is slow, disappointing growth. Unemployment stays high, investment anemic, entrepreneurial dreams unfulfilled, and politics rancorous. Price stability is here to stay because the global capital markets won't allow for a reprise of systemic inflation.

Yet the bond-market vigilantes are wary of the fiscal profligacy shown by the Bush Administration and Congress. No one is too worried about deficits right now, with the economy weak. But as the recovery takes hold, bond investors may drive rates higher than would be otherwise to compensate for the risk that the budget deficit is inflationary.

What's more, many people still worry about rising costs. Here's a simple test: Ask a handful of colleagues at work whether they're more concerned about rising or falling prices next year. Do the same thing during a get-together with some neighbors. My guess is that most people will fret about higher prices, especially if they're in the market for a house, about to write some college tuition checks, or heading to the hospital for some minor surgery.

An e-mail I got from a listener of my nationally syndicated public radio show captured the skepticism: "My health-insurance premiums went up 40% this year. And housing prices have almost doubled in this area in the past five years. Deflation?"

FAMILY VALUES. True, the difference between the change in average prices as represented by inflation, deflation, or stability, and shifts in the relative prices of goods and services is big. Average prices can be "stable" even as the price of steel soars and that of computers plunges, or cable-TV companies hike fees and fast-food hamburger chains slash the price of a meal.

Bernanke is right that the overall price level is flat. But that doesn't mean many of the things families truly value, like education and health care, aren't getting more costly.

Central bankers and other opinion leaders seem shaken, since price stability means the odds of falling into deflation could be as great as, if not greater than, the chance of an inflation outburst. Yet the risk of deflation shouldn't have come as a surprise.

REMINDER NEEDED. From 1776 to 1965, America was a hard-money country. The overall price level was essentially flat to down for much of the nation's economic history, especially during the long deflation in the latter part of the 19th century. From 1880 to 1896, the wholesale price level in the U.S. fell 30%, nearly 2% a year. Inflation was largely an economic phenomena associated with major wars, a price eruption that quickly reversed during peacetime.

In today's world, price stability coupled with sound fiscal finances is still a recipe for a healthy economy. But the White House and Congress must be reminded that price stability combined with fiscal irresponsibility is a formula for slow growth and high unemployment. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

Steve Ballmer, Power Forward
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