Goldilocks entered the house of three bears. In the kitchen, there were three bowls of porridge. Goldilocks was hungry. She tasted the porridge from the first bowl. "This porridge is too hot!" she exclaimed. So, she tasted the porridge from the second bowl. "This porridge is too cold," she said. So, she tasted the last bowl of porridge. "Ahhh, this porridge is just right," she said happily and she ate it all up.

Robert Kiyosaki - Rich Dad, Poor Dad

Just as Goldilocks liked porridge that was neither too hot nor too cold, economists think that the optimal level of inflation is neither too high nor too low. While high inflation has obvious costs, falling prices also have their "costs." During a recent visit to Japan , my wife Barbara and I were discussing Tokyo rents with a friend. Our host told us that every year she meets with her landlord to discuss the magnitude of the rent decrease for the following year. Over recent years, prices of land have fallen dramatically, and consequently landlords have found it necessary to cut rents.

Rent reductions may sound delicious, but the broader consequences can be quite negative. It turns out that falling prices can cause trouble. In fact, the Japanese economy has suffered from deflation since the bursting of its financial bubble in the late 1980s.

Jim Cramers Real Money Sane Investing In An Insane World

An obvious problem with deflation is that it rewards frugality—to an extent that can harm the economy. My friend Jane, for example, never wants to buy a computer because she knows that she can buy it for a lot less next year. In a deflation, all sorts of prices are falling and this can create a destructive cycle. Falling prices encourage people to wait to buy, and this in turn reduces demand, which causes prices to fall even further. This is precisely the opposite of the effects of hyperinflation that encourage people to spend money in the bank minutes after they are paid.

A second problem with deflation is that people really hate taking pay cuts. While this seems obvious, the amount of hatred can be surprising, and the consequences severe. One striking example involves the labor negotiations between the workers and the management of Hormel Foods in the early 1980s. Hormel's products include the meat product Spam, which inspired the name for junk e-mail. We teach this example in our negotiations class at the Harvard Business School , and the saga is recorded in the excellent documentary American Dream.

In the early 1980s, the areas surrounding Hormel's plant in the mid- western United States were hit by a severe recession. Accordingly, Hormel plant workers agreed to temporary wage cuts. In the next contract negotiation, the workers and management met to reach a more per­manent labor agreement. After some intense and protracted negotiation, management offered $10/hour, an offer that was less than a dollar below that contained in the pre-recession contract. The workers insisted that the new wage be at least as high as the wage in the previous contract.

With pennies per hour separating the two sides, the union went on strike. The results were devastating. The strikers were fired. Many of the fired strikers were forced to move out of the area. The company found plenty of replacement workers (the prevailing wage for similar jobs in the area was around half of management's offer).

The Hormel strikers were unwilling to take a small wage cut even though the economic conditions were severe. The unwillingness to accept management's offer led to severe disruptions in the workers' lives.

What does this have to do with money and inflation? The relationship between inflation and the Hormel strike is as follows: Imagine that the workers were given back their old wages but that inflation has eroded the value of their wages to the level offered by management. Would the workers have gone on strike, lost their jobs, and moved out of state to prevent inflation from reducing their pay by less than a dollar per hour? No one can know the answer, but evidence suggests that the Hormel workers would have not gone on strike to prevent a few cents' worth of inflation.

If inflation changes a decision, it is labeled "money illusion." In most economic theory, workers are expected to react identically to a pay cut by management, and the same effective pay cut due to inflation. If, however, workers treat the two situations differently, mainstream economists say that they are acting irrationally. (Behavioral economists suggest they are acting like normal people.)

In real world situations, one can never be sure of the causes. So per­haps there was more to the Hormel story than worker stubbornness. In laboratory experiments, however, economists can create artificial inflations and deflations. The result from recent experiments by the team of professors Ernst Fehr and Jean-Robert Tyran indicate that people do exhibit money illusion. 12

A more mundane version of money illusion is the tendency for people to set watches and clocks a few minutes fast. The clock on my computer has been six minutes fast for years. If I were completely rational, I would immediately know the real time. Even after years, however, my lizard brain is still fooled by my fast clock. While I can rapidly calculate the correct time, my first glance takes the clock at face value. Consequently, I get out the door a little sooner than I would with a clock with the right time.

Money illusion is one reason economists believe that some inflation is good. Inflation allows the adjustment of prices without triggering anyone's emotional stand against getting a worse deal. For example, increased competition from China might cause the "appropriate" wage for U.S. textile workers to go down. This real-wage drop can occur either through an actual pay cut (which is likely to be resisted) or through a wage increase that is less than the rate of inflation. The true economic impact is the same in both cases, but one is more palatable.

Wage rigidity appears to hold outside the laboratory as well, and some believe it was an important source of the extremely high unemployment rate during the Great Depression. 13 Because of money illusion and defla­tion, some scholars argue that Depression wages did not fall to levels low enough to induce employers to hire more workers.

This Goldilocks view of inflation has been studied extensively by a large number of economists. 14 In 1996, Larry Summers gave a talk on his views on the optimal inflation rate. Larry Summers is currently the president of Harvard University , and although still quite young, was a tenured economics professor at Harvard before holding a variety of nonacademic positions, including Secretary of the Treasury. In his discussion, he summarizes this sticky wage situation as follows: "You can't get real-wage reductions without nominal wage cuts, making it harder to get the needed labor market adjustments." For this and other reasons, Professor Summers concludes that an inflation rate of 1 to 3% "looks about right.