As declining prices and costs offer a potential boost to the U.S. economy, it's clear that this trend fits in the category of 'a mild tailwind would help, anything more is not welcome.'

As most investors know, the U.S. economy is suffering from a lack of demand, due in large part to the loss of more than 6.5 million jobs since the recession started in December 2007. Also, the long-term trend of globalization has further weakened that demand, as hundreds of thousands of jobs continue to be transferred to lower-cost production and commerce centers around the world.

Further, in addition to weak demand, these trends have led to stagnant - and in some cases declining - wages in many job segments. If allowed to continue, this will lead to a host of problems, including economic stagnation, soft revenue and earnings growth, and rising poverty rates -- along with all of the social costs associated with the latter.

Costs start to moderate

However, as economist Peter Dawson recently noted, there is a way, at least in theory, that wage stagnation/declines will not necessarily lead to a decline in U.S. living standards. If prices and costs fall in a sustained or permanent way, the downward trend could ameliorate the gap caused by falling wages.

So far, that appears to be happening. Most investors -- and certainly home owners -- are aware of the large decline in housing prices, with S&P Case-Shiller Home Price Index data showing an 18.1 percent drop in 20 large U.S. cities (pdf) over the course of the past year. Likewise, the consumer price index has fallen 1.3 percent in the 12 months.

At the retail level, most businesses have been reluctant to raise prices in the face of weak demand and intense competition. And now, prices of commodities - led by a price decline in the world's most important commodity, oil - have started to moderate. There had been some concern about a second surge in commodity prices on U.S./global economic growth in 2010. However, for many key commodities, a lack of demand amid ample supplies appears to have prevailed.

Meanwhile, Dawson noted that, while most states increased taxes last year to address budget shortfalls created by the recession, many are also limiting spending gains. This trend, in turn, should limit future tax increases. Also, some states' fiscal conditions have been so altered by the recession that they are cutting spending again this year. As they weed out non-essential programs to pay for necessities, tax increases should appear less and less necessary.

California – a fiscal harbinger?

Dawson cited the state of California's fiscal situation as a potential harbinger regarding state taxes and costs. As Bloomberg News reported Monday, California Governor Arnold Schwarzenegger and state legislators continue to negotiate on their latest round of spending cuts to close an estimate $26 billion deficit.

"If California's budget situation is indicative, and I believe it is, the bulk of future deficit reduction by the states will come from spending cuts, or labor-agreement concessions, which bodes well for prices and costs," Dawson said. "And that trend, if sustained, will support living standards by reducing pricing and costs in-line with stagnant or declining wages. It will stimulate the U.S. economy mildly."

Economic Analysis: While Dawson noted that moderating prices and costs amid a time of stagnant wages helps support U.S. living standards, he also emphasized that the nation does not want to see pervasive, protracted declines in prices and wages. Such a trend would signal the dreaded deflationary spiral that elongated the Great Depression.

According to Dawson, the ideal would be a gradual, proportionate decline in costs that would be consistent with a U.S. economy undergoing structural changes; on the other hand, large, sudden declines in prices and wages would imply that negative spiral that deepens recessions and that requires public policy action to counteract. And you can bet the U.S. Federal Reserve is watching prices and wages for tell-tale signs of the latter.

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