Revolution and Deflation

A few nights ago I posted a short essay on why the post Civil War era was not a good comparison with today. Robert Prather of the Mind of Man commented that another factor in the deflationary environment after the War Between the States was an overcapacity on the part of the railroads, which was true and a factor that I had overlooked. He drew comparisons to the bandwidth glut that we have today and seems to be implying (I might be wrong here) that overcapacity in bandwidth could allow for deflation today without there necessarily being the terrible effects normally associated it.

Now, as I see it there are really four points in history that we need to look at here. The first is, obviously, the immediate post Civil War era. Next is the period around the Great Depression. Third are the boom years after WWII. And finally we want to look at the boom that began early in the Reagan years.

Mr. Prather is mostly correct in his assertation that there was significant overcapacity in the railroads right after the Civil War. Much of the industry was wracked by bankruptcies and liquidations. And in most markets it did take nearly 30 years for the overcapacity to be soaked up. There was one significant exception though.

Through portions of the Rust Belt - Pennsylvania, Ohio, Western New York - the railroads were actually had capacity constraints. The two railroads best positioned, the Pennsylvania and the New York Central, were rapidly expanding their route structure and their cargo carrying capacity. They were the exceptions, but they were significant ones. They served the area that was being most affected by the booming Industrial Revolution.

Now the immediate post Civil War era wasn't the only one to see a significant overcapacity in the railroads. In the 1930s, a time when rail was still king, there was also a massive overcapacity. Like the late nineteenth century, there were bankruptcies all around in the industry. But there was no downward pressure on shipping rates. Oversupply was eliminated by getting rid of capacity as measured by freight cars and locomotives.

Why the difference? Government regulation.

In 1887 Congress created the Interstate Commerce Commission. In the immediate post Civil War era, shipping rates had significant downward pressure as the brutal free market competition kept pressure on the rates the railroads could charge. Even the Pennsy and the NYC had keep rates under control, otherwise a more nimble competitor might gain inroads into their territory. So natural market competition, along with massive increase in shipping efficiency brought about by the railroads, put shipping costs into a good deflationary (defined by me as falling prices in a growing economy) cycle. And with shipping being such a significant component of a product's cost at the time, it helped to create a good deflationary pressure in the general marketplace.

In the 1930s, by contrast, government regulation prevented the railroads from dropping unprofitable branch lines or from lowering rates to encourage business. Instead, it pressed onerous regulation and rate increases onto the railroads, which were suffering not so much from competition from each other as they were from competition in the short haul markets from trucks. It's interesting to note that most of the railroad bankruptcies from the 1920s on started in the roads that had heavy reliance on short haul routes. The rate inflexibility caused by the ICC led to a massive shift of business from rail to highway - one that was never reversed in many cases.

So overcapacity in a transport industry isn't, by itself, a root cause of good deflation. But I had mentioned the integration of the former slave population into the economy as another factor in the unique situation of the post Civil War economy.

As the slaves were integrated as functioning members of the economy, they would have provided a substantial boost to its growth. They now had to acquire their own goods and services (more spending) and they also contributed a boost to the supply side of the economy as they finally had their efforts recognized separately from those of their former masters. The contributions of the former slave population cannot be overstated.

There has been one other time in our history when a "new" population was permanently integrated into the economy. During WWII and the immediate post war era, women were fully integrated into the economy for the first time. No longer were they just happy homemakers. They were out working, earning, and spending. The addition of women to the workforce allowed an expansion of the economy that was in excess of what the pre-war workforce would have allowed. The boom created by women joining the workforce lasted, also for nearly thirty years - from about 1940 until the end of the 1960s. But the addition of women to the workforce, even for a significant a change as it was, didn't lead to deflation.

So what was it that allowed a good deflationary environment in the post-Civil War era, but hasn't been seen since?

The overcapacity in transportation and the integration of new segment of the workforce were both important in and of themselves. But they, even combined, wouldn't have been enough to create a growth and deflation environment.

It was the Industrial Revolution that was the final kicker to bring about the good deflation of the post-Civil War era. The quantum leap in productivity and economic efficiency was what really put the economy over the top into a "perfect case" scenario.

It was the confluence of two revolutionary events and an unregulated rail industry that helped to create the special circumstances. In the other instances where some of the factors were in place, widespread deflation didn't occur.

But as we look at the early years of the Reagan era, we see the first great revolution in efficiency since the Industrial Revolution. The Computer Revolution (for lack of a better name. It was extremely important and revolutionary, but not Revolutionary. To be explained in a few minutes) brought about a whole new level of productivity.

But it wasn't supported by other significant changes, like the integration of the slaves or women into the workforce. The Computer Revolution helped to pull us out of stagflation. It brought deflation to information-based industries. It helped to create a massive economic boom.

But there wasn't economy wide deflationary pressure. The Computer Revolution marked a major turning point in our economic history, but it proved that even a Revolution alone isn't enough to create the "perfect case" needed for simultaneous deflation and economic growth.

So what about the current situation with bandwidth?

History points towards it being significant in certain industries, but not across the entire economy. We are already seeing it change the face of media distribution. Software that at one time would have been purchased on physical media is now downloaded - at a fraction of the distribution cost. Old line media companies, particularly the music companies, fear the change. They are realizing that the Internet will completely change the face of their industry. As bandwidth gets cheaper and faster, the pressures on the record companies will increase and increase. Only those who figure out how to adapt and compete in this new order will survive.

Deflation of prices in music, movies, literature and any other media will be substantial. But it will be primarily concentrated in those industries.

The bandwidth overcapacity, like the Computer Revolution before it, will cause significant upheaval in some sectors of the economy, but will barely register in other sectors. They were great leaps forward, but in terms of the overall economy, they weren't revolutions of the scale of the Industrial Revolution.

True economic revolutions are based in massive productivity gains in every sector of the economy. The Industrial Revolution achieved that. The Computer Revolution, while being far-reaching and important, has not created the sudden, immediate, and permanent jump in productivity of the Industrial Revolution.

This isn't to minimize the significance of either the Computer Revolution or of the overcapacity in bandwidth. They will be two of the factors most likely to help us to avoid a deflationary environment right now. We are not in a strong economic position at the moment. There isn't a far-reaching Revolution like the Industrial Revolution on the immediate horizon right now. The Information Revolution (the Computer Revolution and the bandwidth growth, combined with other factors) has been producing at best 5-10% productivity growth. That is great and points to the long term strength and viability of our economy, but it isn't the multi-hundred percent growth needed to create a deflationary growth economy.

The author of the original NY Times article was correct in his assertation that it is possible for growth and deflation to co-exist. But the post Civil War environment was an aberration in our economic history. The most powerful Revolution we have ever known really came into its own as two other major economic shifts came into play at the same time.

We don't have that some historic confluence of events happening right now. That's why we need to avoid deflation. We are not in a position to suffer a bout of "bad" deflation. Bandwidth and industry specific deflation along with the boost provided by a weak dollar will help to ward off the specter of an economywide deflation in a weak economic environment.

Let's just hope it's enough.