Secondary deflation and the wisdom of Fed intervention(Read article summary)
There's a strong case to be made for battling secondary deflation – the fall in prices that can occur when people try to liquidate too much debt.
A reader asks about the issue of "secondary deflation":
"What do you think about secondary deflation? Austrian economists are
divided about this. For example Hayek in his Prices and Production (1933)
argue that FED should do nothing and let deflation run its course. But later
he changed his opinion. In 1975 he wrote that FED should have done something
to prevent secondary deflation:
“More generally, intervention by the monetary authorities could bring
advantages ‘in the later stages of a depression’ when ‘deliberate attempts
to maintain the money stream’ would be justified to counter the ‘cumulative
process of secondary deflation’ - Hayek(1975)
“I agree with Milton Friedman that once the Crash had occurred, the Federal
Reserve System pursued a silly deflationary policy. I am not only against
inflation but I am also against deflation. So, once again, a badly
programmed monetary policy prolonged the depression.” - Hayek(1979)
Later Hayek proposed that central bank should stabilize MV money stream.
How can central bank stabilize MV money stream?
What should have Bernanke done as a response to 2008 crash. Nothing?
Or should he has done "something" (rates cuts, QE...). What is your opinion about this?"
Well, first of all. "Secondary deflation" is indeed bad for the economy. While some Austrians likes to blame the Great Depression entirely on the preceding boom as well as the bad policies implemented by Herbert Hoover (tax increases, protectionism and prevention of wage cuts), that is not the entire story.
While the inflationary excesses of the 1920s and the disastrous Hoover policies certainly both contributed significantly to the problems, they are not the entire story. The fact that there was 10% annualized deflation, causing real interest rates to rise above 10%, also contributed to the severity of the downturn. The above 10% real interest rates didn't reflect time preferences, they reflected the fact that nominal interest rates can't fall below zero, while there was massive deflation.
Murray Rotbard once argued that this deflation would liquidate malinvestments faster. And it probably will, but the problem is that it will to an even more significant extent also liquidate a lot of fundamentally sound businesses.
So, yes, there is a strong case for preventing "secondary deflation".
Another thing to remember that in the absence of fractional reserve banking, "secondary deflation" would be impossible. Unless that is abolished this means that at some times active interventions from a central banks will be needed to prevent that outcome.
Short of the politically impossible goal of abolishing fractional reserve banking, what should be done then? Well, I don't know of any flawless solutions, but keeping interest rates near zero if (with emphasis on "if") there is a danger of "secondary deflation" seems like one of the least bad. Preventing banks from going under is also effective, but that is associated with the downside of "moral hazard".
The Christian Science Monitor has assembled a diverse group of the best economy-related bloggers out there. Our guest bloggers are not employed or directed by the Monitor and the views expressed are the bloggers' own, as is responsibility for the content of their blogs. To contact us about a blogger, click here. This post originally ran on stefanmikarlsson.blogspot.com.