Monday, February 02, 2009

Our friend, inflation

Harold Cole and Lee Ohanian have an op-ed in today's Wall Street Journal which carries forward one of the most stubborn conservative talking points about the current economic crisis: that FDR's New Deal, often cited as an inspiration for radical action now, made the Great Depression worse.

The op-ed is a tough read because it's relying on technical research which the professors are trying to communicate in non-technical language. But in doing so, they are sidestepping the controversies that surround the interpretation of this research. One of these controversies is revealed by one economic variable that they don't discuss: inflation.

Their story (which has a supply side philosophy) lays the blame for the Depression in excessively high wages and prices, at least in industries which benefitted from New Deal protections. But there's always been a simple alternative explanation for the Depression: that it was due to chronic deflation i.e. falling prices and expectations of falling prices which made people reluctant to spend, a cycle that was only decisively broken by World War II and the subsequent monetary arrangements, which were completely different from those of the early 1930s.

The chart above is part of the evidence. It's the level of consumer prices 1930-1950. Read the 15 line across (which represents an average price 15% of early 1980s prices). Prices plunge below it in the early 1930s, creep upwards, with bumps, for a decade, but only get back above it during the war. After the war, the price level takes off for good -- which happened to kick off the greatest prosperity the world has ever known.

But their theory of the Depression is that prices were too high. You'd think that problem would merit some discussion. Bringing it up would be, from their perspective, a can of worms. Sometimes, sometimes, inflation solves a lot of problems.

UPDATE 16 FEBRUARY: Paul Krugman spells out the role of inflation very clearly.

FINAL UPDATE 4 APRIL: Consider the above chart in light of this nugget from the Council on Foreign Relations New Deal conference --

Richard K. Vedder, an economist at Ohio University... By artificially keeping prices and wages high, he argued, both Hoover and Roosevelt prevented the economy from adjusting, which is why unemployment remained in double digits until the United States entered the war.

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