Defeating Deflation - Option 1, Reducing Wages

One point that I failed to mention in my previous post that I think is an important one is that the financial sector meltdown: AIG, Merrill Lynch and so forth were not, in and of themselves, responsible for the economic crisis that started in 2008.  Just like the stock market crash in 1929 was not the root cause of the Great Depression.  Both events were the manifestation of poor monetary and fiscal policy, and the first sign that there was a large problem coming home to roost. 

Now, this post is about the first of the two options I specified previously for how the government fights periods of deflation, a reduction in real wages.  The reason that died in the wool republicans favor this solution is that it is truly the market solution, leaving markets to move production back to equilibrium demand and reducing employment or wages as required to do so.  The option to let wages self correct in the marketplace doesn't mean that every business calls a meeting with their employees and says, "Well guys, we're in a bit of a pickle here.  We're not selling as many widgets, so I need to cut your pay by 10% each."  What that business owner actually has to do is make fewer widgets: open the doors later, close earlier and that requires fewer employees.  Reducing their workforce by 10% increases the pool of available workers.  You've now increased the supply of workers, in a weak job market demand scenario.  Those companies that do hire, can now offer lower wages, after all, someone will take the job making less because...hell, that beats no job at all.

2009 is playing out this way.  Unemployment is still fairly high, in some areas it is still increasing, and those being offered jobs are being paid substantially less than when they last worked in 2007.  The market wage has been in correction mode, even though GDP growth has returned in the latest quarter.  This method of letting deflation correct itself via a correction in real wages is a painful exercise in Capitalism.  Does it work?  Sure.  Is it quick?  Hell no.  Let's try to list the pros and cons of letting the market play itself out:

PRO:

• Government avoids running deficits
  

CON:

• One consequence is that in the long run, this creates labor and social unrest in an economy.  That social unrest and the political uncertainty that it creates can dog stock market and economic recovery.
• While wages fluctuate in a market, debt remains fixed.  The ability to repay debts is severely compromised when policy makers choose to let the market put downward pressure on wages and people's ability to pay down debt.  This pressure is not just on individual consumers, but on the business owner who has borrowed for capital improvements.

Keynes had much to say about this approach to dealing with deflation, and often he was accused of being in favor of inflation, which during the 1930's was a very serious accusation.  The common economic thinking of the day was to control inflation at all costs, even if that meant deflation.  The label of pro-inflation was not accurate, but given a choice of inflation or deflation, Keynes would accept inflation much more readily, because the issue was much easier to address.

From The Economic Consequences of the Peace, Keynes wrote:

Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

If that's not a denouncement of using inflation as policy, I don't know what it.  So it wasn't with a light heart that Keynes encouraged the second option we'll look at for addressing deflation: stimulus spending and the running of deficits...