Productivity and Deflation

What happens when productivity grows faster than production?

We produce more with less work and that means unemployment, right? Initially, the answer is yes, but looking at history we can see that the answer is more encouraging than that. Productivity growth eventually transitions into falling prices. And these days, it should happen even faster. Here’s why:

Competition and consumer choice, especially now that information flows so freely, has led to much more efficient markets in terms of pricing. Improving productivity is rarely unique to a particular company… in other words, if one company benefits from a new technology, then others follow, competition drives prices down, and consumers ultimately benefit.

Are falling prices always good?

Falling prices is called deflation, and deflation is an ugly beast; it exaggerates the disparity in the distribution of wealth and creates an artificial investment hurdle. Deflation increases the buying power of wealth. It makes money more powerful. Those who have money can buy more with it, and people in debt fall deeper in debt. This makes the “real” distribution of wealth even more concentrated. Similarly, deflation means that your cash grows in value; if your cash grows in value, then your investments will have to appear very strong before you will be willing to make them.

The solution to these problems is a low stable inflation rate. Low stable inflation helps to maintain investment by discouraging holding cash, slowly eroding stagnant concentrations of old wealth unless it is invested.

In order to achieve a low stable inflation rate, the deflationary pressure of productivity growth should be balanced by growth in the money supply and a low FED Funds rate. The faster productivity grows (and it appears to be accelerating over the decades), the more aggressive the Federal Reserve may have to be in order to avoid deflation.