The old argument has recently come back into vogue that moderate inflation is desirable to prevent the far greater evil of deflation. What used to be roundly condemned as "creeping inflation" in the 1950s by Fed officials and mainstream economists alike is today given the scientific-sounding name "inflation-targeting" and hailed as the proper goal of monetary policy.1 In the past decade, this view has been promoted by many mainstream economists, most notably former Fed Chairman Greenspan and current Fed chairman Bernanke. But this view is based on a fundamental confusion. It conflates deflation and depression, which are two very different phenomena. Falling prices are, under most circumstances, absolutely benign and the natural outcome of a prosperous and growing economy. The fear of falling prices is thus a phobia – I call it a "deflation-phobia" – which has no rational basis in economic theory or history.
Let me explain. As technology advances and saving increases in a progressing economy, entrepreneurs and business firms are given the means and the incentive to invest in new methods of production, which in turn enables them to lower their costs and expand their profit margins. For a given good, the natural result is an increase in the supply of the good and more intense competition among its suppliers. Assuming no change in the money supply and continuing technological innovation, this competitive process will drive the unit production costs and price of the good ever downward. Consumers will benefit from the falling price because their real wages will continually increase as each dollar of income commands an increasing quantity of the good in exchange.
This is not merely abstract theoretical speculation; it is precisely the process that occurred in the past four decades with respect to the products of the consumer electronics and high-tech industries. Thus, for example, a mainframe computer sold for $4.7 million in 1970, while today one can purchase a PC that is 20 times faster for less than $1,000. The first hand calculator was introduced in 1971 and was priced at $240 (which is roughly $1,400 in terms of today’s inflated dollar). By 1980, similar hand calculators were selling for $10 despite the fact that the 1970s was the most inflationary peacetime decade in U.S. history. The first HDTV was introduced in 1990 and sold for $36,000. When HDTVs began to be sold widely in the United States in 2003 their prices ranged between $3,000 and $5,000. Today you can purchase one of much higher quality for as little as $500. In the medical field, the price of Lasik eye surgery dropped from $4,000 per eye in 1998, when it was first approved by the FDA, to as little as $300 per eye today.
Now, no one – not even a Keynesian economist – would claim that the spectacular price deflation in these industries has been a bad thing for the U.S. economy. Indeed the falling prices reflect a greater abundance of goods which enhances the welfare of American consumers. Nor has price deflation in these industries diminished profits, production, and employment. In fact, the growth of these industries has been just as spectacular as the decline in the prices of their products. But if deflation is a benign development for both consumers and businesses in individual markets and industries then why should we fear a fall in the general price level, which of course is nothing but an average of the prices of individual goods? The answer given by theory and history is that a falling price level is the natural outcome of a dynamic market economy operating with a sound money like gold.