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Ben Bernanke, chairman of the Board of Governors of the Federal Reserve System, made his academic reputation as an advocate of “inflation targeting.” Monetary policy, he and other Fed governors have argued, should attempt to maintain a long-run annual rate of price inflation of around two percent. The target cannot be a rate of zero price inflation, they say, because the Federal Reserve needs leeway to prevent price deflation. But what is so bad about falling prices?
First, it needs to be remembered that even a two percent rate of price inflation will reduce the purchasing power of the dollar by half in one generation. In other words, what costs $100 today would cost $150 in only twenty years. Second, there is no reason to fear price deflation when prices in general are falling due to technological innovations and cost-efficiencies that enable more goods to be produced and then sold at lower prices. Indeed, standards of living go up when people can now buy more at lower prices, even if their money incomes stay the same. The post-Civil War period in American history is a very good historical example of this. The decades between 1865 and 1900 were the years of America’s industrial revolution. Before this time, America had an economy of primarily light industry and farming. By the beginning of the 20th century, however, the United States had surpassed all of the European nations in manufacturing, including Great Britain and Imperial Germany, the industrial giants of the time. Mass immigration from Europe, huge capital investments, and technological improvements provided the means for America’s growth and rising standards of living that soon became the envy of the rest of the world. During the years after 1865 prices in general slowly fell from their Civil War highs. A Consumer Price Index that stood at 100 in 1865 had declined to 57 by 1900, or a 43 percent decrease in prices over a 35 year period. On average prices went down around 1.2 percent each year over three and a half decades. At the same time, indices of money wages in agricultural and manufacturing employment both rose during this period as labor was becoming more productive due to capital investments, even with a rising population resulting from millions of immigrants joining the American work force. The index of money wages in agriculture rose by almost 40 percent between 1866 and 1900, while money wages in manufacturing went up 20 percent during this period. Thus, on average, money wages in general increased by about 30 percent for workers as a whole. In combination with the productivity gains and the capital investments that resulted in the 43 percent decrease in the price level, this meant that in the last 35 years of the19th century the real standard of living of the American people increased by almost 75 percent as measured by the positive change in the average American’s buying power in the market place. There is no reason, therefore, for America’s central bank to burden the people of the United States with a planned “target” of a positive rate of price inflation. Milton Friedman insightfully pointed out after studying the American economy in the late 19th century: “Economic growth was entirely consistent with falling prices.” Prosperity and price deflation easily can go hand-in-hand.
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