So one of sect of conservative economists has made a great deal of noise about the idea that the Great Depression was prolonged by various policies. These policies, implemented by Hoover and FDR, were intended to support prices and wages on the theory that this would support income and spending. The policies relaxed antitrust law and provided, for the first time in our history, a legal environment that supported union organization.

These ideas can be read in detail here if the reader wants to pay $10 per day for the privilege. Wonks Anonymous took a pass on that, having limited time and funds. A more intrepid reader might get back to Wonks Anonymous on where they get their productivity estimates but let this pass.

So what would price cuts do in our current situation?

First remember that this is not one market. We are not saying that somehow the price of strawberries or union auto workers or whatever is too high. The claim here is that all prices are somehow too high.

Now in the freshwater world of Lake Michigan the overall price level is defined by a simple equation: Mv=pQ. M is the supply of money, determined by the FED. v is the velocity of money, the number of transactions that can be supported by one dollar over a period of time. Most often this is assumed to be fixed. Q is the quantity of goods and services produced by the economy. It is determined by the real economy which works in mysterious ways. p, the average price of goods, is discussed in the previous post. It is usually determined by M.

Why do prices and wages need to fall? The supply of money has not really decreased, thanks to Mr Bernanke and friends. A massive increase in productivity could raise Q and, other things equal, this could be seen as demanding a deflation to restore the economy. Of course the FED could also just increase the supply of money, as it has over the past year.

In the Chicago framework the market for money/goods has changed because the velocity of money has dropped. The number of transactions made by each dollar in a given period of time has dropped. It has dropped because many dollars languish idle in bank accounts. They have been transformed from transaction fuel to stores of value, that would be savings or claims on future output.

As noted in the previous post the market that might transform our idle money balances into demand for goods and services - the market for loans - is frozen because with zero interest rates we would just as soon hold money as lend to potential deadbeats. We want to hold our wealth as money.

Not only do we want to hold our wealth as money, we also want to accumulate more wealth than we currently have. The financial crisis destroyed the value of assets that we had been accumulating.

Wonks Anonymous tries not to worry about the drop in the value of his IRA but suppose this for the sake of example:

If the money value of your assets dropped by 20%. Prices would need to drop by roughly 20% in order to get you back to where you were, in real terms.

Wonks Anonymous believes that we can all agree that during this period of price decline, however needed and laudable, we can kiss off and prospects for increases in the prices of houses, stocks, bonds and other assets.

Wonks Anonymous would submit that people who wax eloquent about the perils of 10% inflation should have at least a little fear of a 20% deflation. Plenty of distortions here folks.

And specific problems would come. The money value of a great many assets is based on the price of goods so drops in asset values would trend to wipe out increases in purchasing power caused by price drops.

At the same time a great many of us have outstanding loans. These are agreements to pay money. As wages and prices drop it becomes harder for us to earn the money to make payments. If our creditors are lucky we cut back on our demand for goods and services to accumulate money balances to pay the loans. If our creditors are not lucky we go bankrupt which takes the value of their loans to zero. They need to accumulate more money to make up for the drop in their worth.

Meanwhile dropping prices only encourage us to hold money. If you know that a new care will cost 5% less next year then why not drive the old one and wait. Even if you leave it in your mattress your money buys 5% more real stuff next year.

All of these circumstance would tend to require further drops in wages and prices. Can we really be sure that there would be an end?

Now Wonks Anonymous supposes that we could try an experiment. We could repeal all regulations and labor laws that keep the creative forces of the market from bringing prices to their natural level. Wonks Anonymous does not really believe that the results would be as imagined by the more fervent devotees of the cult of free markets.

He is not convinced by a hypothetical replay of history even if it was executed on a very fine computer system.