Another Possible Lesson from the Roaring 20's

I recall a short time, when Alan Greenspan was chairmen of the Federal Reserve, when there was talk of achieving an inflation rate of zero.  This meant disallowing any wage increases on the grounds that they were inflationary.  Fortunately, this did not get very far.  I think there were two reasons for it.  One was that productivity was growing very fast at the time, an it was becoming apparent that only wage increases in excess of productivity growth are inflationary.  But even granting that real wages should grow with productivity, why should real wage growth take the form of nominal wage growth?  Why not keep nominal wages steady and let real wages grow by falling consumer prices?  The answer, so far as I can tell, is that the Fed eventually came to realize that sooner or later, recession always strikes, and when it does, inflation falls. A little inflation in good times is therefore necessary as a buffer against deflation in the next recession.

And deflation is harmful for several reasons.  For one thing, prices and especially wages are sticky and tend to resist falling, so downward pressure on them introduces distortions into the system.  For another, deflation is an inflation of debt and makes the debt burden more onerous.  Borrowing and investment also become onerous, as real interest rates are necessarily higher than nominal interest rates.  And finally, deflation means that holding onto cash effectively pays interest, so people are more likely to hold onto cash and less likely to invest it.

Which leads me to the 1920's.  I had previously heard the Austrian theory that the Great Depression was the result of the horrendous inflation that occurred during the 1920's boom.  That leaves the slightly awkward question of how there could have been such terrible inflation in the 1920's if the consumer price index was, in fact, falling.  Their usual answer is that although the CPI fell, it did not fall as much as it would have if their favored policies had been implemented.  But that raises other awkward questions, such why did other economic booms (before and since) have higher rates of inflation without being followed by such a severe depression.

Indeed, the 1920's have been described as "the only deflationary expansion of the entire 20th century."  Others see the price decline in the 1920's boom as the beginning of the deflation that would prove so ruinous.

Speaking for myself, I am reluctant to consider the late 1920's as a time of deflation because, although the consumer price index was falling, wages and property values continued to rise.  It might instead be seen as a time of very low (even negative) inflation, in which productivity growth was passed onto into real wage growth as much in the form of falling prices as rising nominal wages.

In other words, is it possible that the 1920's should really be seen as a warning about the dangers of very low inflation during good times?  Was the deflation of the 1930's perhaps so devastating because there was no inflationary cushion whatever to soften the impact of downward pressure?  I have not seen any economist proposing this theory.  But perhaps it needs some investigation.