Consider a deflationary environment in which stagnant wages and zero
interest rates can still have a - negative or positive - inflationary
effect. In real terms, in deflation, both wages and interest rates
increase relentlessly even if they stay put. Yet it is hard to
incorporate this "downward stickiness" in present-day inflation
measures.
The methodology of computing inflation obscures many of the "quantum
effects" in the borderline between inflation and deflation. Thus, as
pointed out by George Akerloff, William Dickens, and George Perry in
"The Macroeconomics of Low Inflation" (Brookings Papers on Economic
Activity, 1996), inflation allows employers to cut real wages.
Workers may agree to a 2 percent pay rise in an economy with 3 percent
inflation. They are unlikely to accept a pay cut even when inflation is
zero or less. This is called the "money illusion". Admittedly, it is
less pronounced when compensation is linked to performance. Thus,
according to "The Economist", Japanese wages - with a backdrop of
rampant deflation - shrank 5.6 percent in the year to July as company
bonuses were brutally slashed.
Economists in a November 2000 conference organized by the ECB argued
that a continent-wide inflation rate of 0-2 percent would increase
structural unemployment in Europe's arthritic labor markets by a
staggering 2-4 percentage points.
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