There is this widespread myth that deflation – particularly price deflation – is bad for the economy.  It is a result of bad economics and a misunderstanding of history.

In the 19th century, there was price deflation in the United States.  Generally speaking, there was a gradual decline in prices.  There were periods where this didn’t hold true, such as the Civil War.  But this exception just helps make the case, because war is marked by inflation and a reduction in living standards, especially when the war is on your own soil.

Throughout most of the 1800s, it was generally a time of peace.  There was something of a gold and silver standard, although admittedly not pure.  It was not a purely free market in terms of money, but it was a lot closer than what we have now.

As technology improved and capital investment and savings built up, production of goods and services increased at a substantial pace.  It was really probably the greatest increase in growth in recorded history.  Since the money supply was generally stable, at least compared to now, people’s purchasing power increased.  When you have the same amount of money chasing an increasing supply of goods and services, then the prices of those goods and services fall.

The one event that causes a lot of confusion is the Great Depression.  It was the worst economy in the history of the country.  This is in relative terms.  I’m sure someone living in 1833 would have gladly traded places with someone living 1933.

That is similar to today’s story.  Our economy is bad in relative terms as compared to the 1950s, but I don’t think a lot of people would trade in their smartphones, microwave ovens, and high-speed computers for an era of the 1950s.

The Great Depression is linked with deflation.  While the central bank was not deflating the money supply, there was a widespread failure of banks.  This reversed the fractional reserve lending process.  This is the equivalent of deflating the money supply available in the economy.

Of course, it was the monetary inflation of the 1920s that was partially responsible for setting up this problem in the first place.  And again, the banking system was far from being a free system, even back then.

The problem with linking depression and deflation is that it is confusing cause and effect.  When it rains, you get wet sidewalks.  But you don’t make it stop raining by drying the sidewalks.

You don’t stop a depression by ending the deflation.

A price deflationary scenario is a necessary correction process of the previously misallocated resources.  In today’s world of the FDIC, this is especially true.  We know we are not experiencing price deflation or a lack of price inflation because of bank failures.  Most depositors are made whole, and the biggest of the banks are not allowed to fail.

A lack of price inflation today can be the result of a lack of bank lending, and to some extent this is the case.  Since 2008, much of the increase in the money supply went into excess reserves with the banks.  This new money has not multiplied through the system.  But given some semblance of a free market, there is generally a reason why banks are not lending.  It is because it is too risky or because people don’t want to borrow.

Price deflation, or a lack of price inflation, can also be the result of an increased demand for money.  I believe this is the case now in the U.S., as well as places such as Japan and Western Europe.

When there is fear in the economy, people want to save some money for a rainy day.  If they fear a job loss, or even a reduction in income, it makes sense to take on less debt and put away some money for savings.  This has a deflationary effect.  It is a reduction of velocity.  Money is changing hands less frequently, which means prices are not bid up.

But this increase in money demand is necessary.  It is an attempt to correct for past errors.  It is an attempt by market forces to reallocate resources in accordance with consumer demand.  It is generally the prior monetary inflation that caused these misallocations in the first place.

There is not general price deflation in the U.S. right now.  Anyone who pays for health insurance and shops for groceries probably knows this.  There may be some mild price deflation in some sectors, such as the computer industry.  The price deflation would likely be greater if not for the Fed’s massive monetary inflation from 2008 to 2014.

The Fed says it wants 2% price inflation, but there is nothing magical about this number.  It just means a decrease in purchasing power.  Wages will eventually adjust, but they tend to lag behind.  You will already be paying higher prices at the store before you see a wage increase, at least in most cases.  This may not be true if you are one of the lucky few who is one of the first receivers of the new money.

The U.S. economy – while seemingly better than Japan and Western Europe – needs a major correction.  This means a widespread adjustment in prices.  If the Fed were to allow it to happen, which it should, it would likely mean lower prices for most things.

While a major correction would be painful for the American people, it will be even more painful in the future if the misallocations are allowed to continue.  While a major correction would be painful in terms of short-term unemployment, it would also provide a huge relief in lowering prices, especially for those things that are considered basic needs.

If the Fed and the government did not significantly interfere, then the pain should be short term.  Once everything adjusted, it would lay the foundation for an actual recovery based on savings and investment, and not some artificial recovery based on government spending and monetary inflation.

This is what our economy needs.  Price deflation may be associated with a bad economy, but the deflation is actually part of the medicine.  This is what we need to get back on a path of sustainable growth.  The central bank and the government need to allow it to happen without trying to produce positive price inflation.

If deflation is bad, it is only because of the prior inflation from the central bank.  But the price deflation is only trying to correct the previous errors.  Don’t blame the wet sidewalk for the rain pouring down.