Crying Wolf over Deflation

by Jehu

larry-summersProSyn has a post today about why deflation poses such a mortal risk for the fascists. The post is written by Jean Pisani-Ferry, a French economist and public policy expert according to the Wikipedia. Being a public policy expert Pisani-Ferry has decided that a fall in the prices of commodities is bad for “the public” for several reasons:

“The first problem with deflation is that it tends to raise the real (inflation-adjusted) interest rate above its equilibrium level. As there is a zero lower bound to the nominal interest rate, the central bank may well find itself unable to drive the interest rate/inflation differential to a low enough level, which may result in a slump and even a downward spiral …

“The second problem with deflation is that it makes economic rebalancing within the eurozone much more painful. From October 2012 to October 2013, inflation was negative in Greece and Ireland, and zero in Spain and Portugal. But these countries still need to gain competitiveness by lowering the relative price of their export goods, because they need to sustain external surpluses to correct accumulated imbalances. …

“Last but not least, deflation increases the burden of past debt. Unlike equity, a debt security is a nominal claim whose value does not vary depending on the inflation rate. With deflation leading to negative income growth, the weight of debt relative to income increases, potentially becoming unbearable for borrowers – and thus increasing the risk of sovereign- and private-debt crises.”

Everyone likes a bargain. In an environment of falling prices, even wages that are nominally unchanged can buy more because the purchasing power of currency is rising. A deflation rate of five percent a year is the same as getting a five percent pay raise, without all of the futzing around with labor strikes. Personally, I don’t know anyone who would not agree that lower prices — deflation — is better than rising prices for necessities. That is, everyone likes falling prices for necessities except Jean Pisani-Ferry, it seems. For Pisani-Ferry, the benefits of lower prices is offset by the impact these lower prices have on interest rates, trade imbalances and the burden of public and private debt service.

For most of the past fifteen years, we have been treated to this sort of propaganda regarding the dangers posed by deflation. The very same people who, in the 1970s, explained to us that inflation was an unsustainable burden to society, now tell us deflation is bad. But they offer little more than the above examples of the negative impact of the malady: it makes life difficult for creditors, debtors and countries running a trade imbalance.

According to Pisani-Ferry, since monetary authorities cannot bring policy interest rates below zero, central banks are unable to respond to a deflation. The real interest rate is the nominal interest rate minus the rate of inflation: e.g., 3% nominal minus 3% inflation equal 0% real interest. If the economy is in deflation, the deflation adds to the real interest rate, e.g., 3% nominal minus -3% inflation equal 6% real interest. At the zero lower bound on policy rates, the monetary authority still faces real interest rates equal to the rate of deflation. If the deflation was 2%, real interest rates (interest rates after inflation) would be 2%.

The question is why Pisani-Ferry thinks this is a problem for the rest of us?

In a deflation the purchasing power of currency is rising, so while borrowing becomes more difficult, clearly there is less need to borrow because real wages are rising. Assuming wages were constant, if prices are falling by five percent each year, real wages would be rising by five percent per year. Even if nominal wages were absolutely unchanged, real wages would be increasing, i.e., the nominal wage could buy more real stuff.

However this direct benefit of deflation to the consumption power working class appears nowhere in Pisani-Ferry’s argument. Instead, he focuses our attention on that fact that the Federal Reserve and other central banks would lose control of the economy. They would be unable to drive the real interest rates to a low enough level, which may result in an “economic slump” and even a downward spiral. However it is altogether unclear in Pisani-Ferry’s argument why there would be “a slump and even a downward spiral” in a deflation when real income is rising. If real wages are increasing by  5% each year, why would this lead to a slump or even a downward spiral?

Of course, Pisani-Ferry is not talking about a slump or downward spiral of real wages, but a slump or downward spiral of profits. Deflation poses a risk for central banks because they are not concerned with an increase in real wages — they only care about profits. Leaving aside the cost of raw materials, the price of a good consists in the wages paid to the laborer and the profit of the capitalist. If the price of the commodity is falling and the real wage is rising, the portion falling to the capitalist — his profit — must be falling.

All good, right?

But here is the thing: the operation of the capitalist mode of production is determined by profit, not wages. If the prices of commodities are falling, wages must fall together with prices. Why would this be true? In labor theory, wages are the price of the commodity labor power. In the case of a real deflation, therefore, falling prices for commodities implies that wages — the price of labor power — must be falling as well. Since we are abstracting from the raw materials going into the commodity in this discussion, we can reduce deflation to a simple definition: Deflation is a fall in the price of labor power, i.e., a fall in wages.

We now appear to have a clear paradox: On the one hand, deflation leads to the rise in the real wage, yet, on the other hand, it also leads to a fall in the real wage. It would appears that the two propositions cannot both be correct.

In fact, all the contradictory results of labor theory tells us is that analyzing the problem of deflation itself is a dead end. We now must move on to the problem posed by the prices themselves: to an investigation of the role prices play in the mode of production.

Howard Nicholas has a very interesting take on this question in his book, “Marx’s Theory of Price and its Modern Rivals”. If I understand Nicholas correctly, prices serve a function within the mode of production by determining the structure of material reproduction. The value or socially necessary labor time of any commodity is the labor time required for its production. The price of the commodity, however, is determined by how much of the commodity is materially required by society for reproduction.

To give a simple example: Suppose society produces 100 widgets and the labor time required for this is 100 hours. If then the price the widgets fetch is only equal to 90 hours, society is telling producers only 90 widgets are necessary for reproduction to meet material social needs. Nicholas explain that if the labor time necessary for production is given, society tells the producer how much labor time is needed to reproduce itself though the mechanism of prices. His simple explanation demonstrates why prices of commodities fluctuate and can never be equal to their values: Values are determined by the material requirement of production, while prices are determined by the material requirement of society for the commodities being produced.

Going back to the problem of deflation, Nicholas allows us to examine it in a new light.

If the prices of commodities generally are falling, society is stating through the price mechanism that the need for labor in the form of labor power is falling. Since, in our example, all prices have now been reduced to real wages — the price of labor power — society is stating less labor is necessary. If, before, it took the labor time expended to produce 100 labor powers to satisfy the needs of society, now these needs can be met with only the equivalent of 90 labor powers.

What then explains the rise in the purchasing power of money wages despite the declining need for labor power?

This is a paradoxical effect that cannot be explained simply on the above premises. Although the need for the labor powers is falling, the price of the labor powers is rising, leading to an increase in the real wage. This paradoxical result itself results from the fact that the mode of production is not just the production of value, but the production of surplus value, i.e., production for profit.

The answer is that the rise in the real wage is a rise of wages generally at the expense of profits. The the production of wage goods, i.e., its expansion or contraction, is determined by the rate of surplus value, not the wages of the existing employed workers. To actually reduce the reproduction of labor power to the real needs of society, the rate of surplus value must fall. The puzzle posed by deflation is that the necessity to reduce hours of labor is imposed on capital through the movement of prices. But the movement of prices must affect the rate of profit, since the operation of the mode of production is determined by profit.

Deflation, which is simply a signal to reduce production, must, therefore, first and foremost reduce profits while leaving wages essentially unchanged. This is because the rate of surplus value is the rate at which the material requirements for additional labor powers (wage goods) is produced. To slow the production of additional wage goods, the rate of surplus value must fall or even go negative. Which is to say, the expansion of the total capital must slow or even reverse, leading to its contraction.

Now here is the thing: if the rate of surplus value is negative, the real rate of interest must also be negative. Since the mass of interest cannot be greater than the mass of profits, a contraction of the total capital means interest rates are negative. This presents central banks with a peculiar problem: monetary policy loses its effectiveness at the zero lower bound. If the real interest rate is now negative, holding policy rates at the zero lower bound — no matter for how long — won’t work. This is the meaning of Larry Summers’ comments that reverberated throughout the simpleton economist blogosphere last month.

In that speech Summers made this ominous statement:

“we may well need, in the years ahead, to think about how we manage an economy in which the zero nominal interest rate is a chronic and  systemic inhibitor of economic activity, holding our economies back below their potential.”

Summers is saying that even an interest rate set to zero may be too high at present for the mode of production. This poses a problem because “extraordinary measures” like quantitative easing likely cannot continue indefinitely — although it may still be needed for an indefinite period, perhaps forever.

Fascist state management has encountered its material limit and this is what frightens the simpletons.