postage stamp. German savers who kept their money in marks were completely wiped out.

No cloud, it is said, is without a silver lining. While some were wiped out by the German hyperinflation, others were made much richer. In fact, hyperinflation works to wipe out all debts. The Bible writes of jubilee years when all debts are forgiven: Then you shall cause the trumpet of the Jubilee to sound... And you shall consecrate the fiftieth year, and proclaim liberty throughout all the land to all its inhabitants. In a Jubilee year, all debts are forgiven.

Hyperinflation is an effective jubilee. For example, during German hyperinflation the total value of all German mortgages as measured in U.S. currency declined from $10 billion to under one U.S. penny.11 Debtors were able to pay off their debts with the wheelbarrows full of nearly worthless marks. Thus, one important effect of inflation is to hurt savers and help debtors (more on how to profit from this later). This could be considered good or bad, depending on whether one favors the savers or the spenders.

While the erasing of debts helps some and hurts others, a second effect of high inflation is simply bad. Because of the uncertain value of currency, many people simply stop accepting money. Thus, the economy returns to barter with all the consequent inefficiencies of simultaneous exchange.

So an economy like that of 1920s Germany can go in a full circle. Before the creation of money, all exchanges are done by barter. Then commodity money replaces barter with gold, and then with paper money. If the paper money loses value because of high inflation, the economy returns to barter with its inherent inefficiencies.

Goldilocks and Inflation That Is Just Right

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.

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.

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 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. Hormels 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 Hormels 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 managements offer).

The Hormel strikers were unwilling to take a small wage cut even though the economic conditions were severe. The unwillingness to accept managements 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