EXCERPT:
During the Great Depression, what should have just been a Bad deflation became an Ugly one. This deflation was unlike earlier ones for two reasons. First, the scale of the deflation was unmatched. The U.S. money supply fell over 30 percent between 1929 and 1933, a period in which the demand for money was actually rising as a consequence of the stock market crash and the bank failures that followed it. The combined effect was a massive downward pressure on prices....
The second difference from earlier recessions was that policymakers adopted the view that the key to recovery was to “maintain” prices and wages at their pre-deflation levels. Both Presidents Hoover and Roosevelt strong-armed business leaders into keeping prices and wages up and pushed laws that directly or indirectly did the same.
The effects of these misguided attempts at price and wage maintenance were devastating. Firms continued to pay unjustifiably high wages, while watching sales slacken because prices also stayed high; they covered their losses out of their profits, causing some firms to fail and others to see severe declines in their stock prices. This contributed to the low levels of private investment that prolonged the depression since firms did not have profits to recycle back into their own activities. More brutally, keeping wages so high led to the horrific unemployment rates of the Great Depression, which peaked at around 25 percent in 1933. Only by around 1934 did prices and wages fall enough to start bringing unemployment rates back down. However, unemployment remained at historic highs because even with the declines in prices and wages, private investors were hesitant to take risks in light of the policymakers’ earlier mistakes and the constantly shifting political environment. During the Great Depression, unemployment stayed above 14 percent from 1931 through 1940.
Current observers are quite right to point to the Great Depression as an example of what can go wrong from deflation. There is no doubt that the very large monetary deflation of the early 1930s made the recession that began in the summer of 1929 much deeper and more severe than it would have been otherwise. But even so, had prices and wages been allowed to adjust, that recession would have been Very Bad, but not Ugly. Attempting to keep prices and wages high during the monetary deflation prevented the cleansing price adjustments from taking place and forced sellers to make “quantity” adjustments in the form of reduced production and historic levels of unemployment....
