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Deflation is No Mystery Except to Most Economists

Economics / Deflation Jun 11, 2007 - 11:31 AM GMT

By: Gerard_Jackson

Economics That the great body of economists think that a fall in general prices is deflationary by definition and a clear indicator of an impending recession tells us how much this phenomenon is misunderstood. On the basis of this understanding central banks have implemented price stabilisation policies which in themselves carry the seeds of future recessions. The situation is so bad in the economics profession that I am inclined to go so far as to suggest that only a handful of economists actually know what deflation really means. (Classical economists had no such difficulty).

The basic problem is that deflation has been associated with a general fall in prices to the extent that today's economists unthinkingly link falling prices to recessions. (Up to the early 1930s depressions were always accompanied by falling prices. Today, Keynesian economics has managed to give us rising prices with recessions).

The main error behind much of this thinking is rooted in a misreading of nineteenth century price movements. Many in the economics profession have noted that nineteenth century Britain experienced 50 years of falling prices, even though living standards rose at an unprecedented rate. From 1875 to 1895 wholesale prices fell by about 45 per cent while industrial output and real wages continued to rise.

Presto! conclude some financial advisers, deflation is not a real danger. Unfortunately for them they are not describing deflation. Prices fell in nineteenth century Britain because productivity outstripped the money supply. Because prices were flexible and price changes fairly slow wages and costs adjusted themselves easily to the monetary situation. This meant that as output grew faster than the money supply prices not only fell but the benefits of increasing productivity were more evenly spread.

Milton Friedman was a very persuasive supporter of the apparent need for central banks to stabilise the purchasing power of the currency through the use of the price rule concept. (Expanding the money supply at a rate that is supposed to maintain a constant purchasing power by preventing prices from falling). According to Friedman this monetary policy was necessary to prevent recessions from emerging. Yet the very same Friedman could write that

[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United states to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible. (Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867-1960 , Princeton, N.J.: Princeton University Press, 1971, p. 15).

The Austrian insight that money is not neutral was completely disregarded. (In fact, the idea that money was far from being neutral -- meaning that it did not influence individual prices -- was discussed by the participants in the bullion controversy). During the 1920s qualitative economists like Benjamin M. Anderson, Ludwig von Mises and Frederich von Hayek pointed out that the Fed's attempt to stabilise the so-called price level was concealing enormous "imbalances" created by excess credit, and that these "imbalances" would eventually have to be liquidated once the economy went into an unavoidable recession. Keynes, however, strongly disagreed, stating that the Federal Reserve Board's monetary management was a "triumph". It was pointed out later on in the depression that the current

...difficulties are viewed largely as the inevitable aftermath of the world's greatest experiment with a "managed currency" within the gold standard, and, incidentally, should provide interesting material for consideration by those advocates of a managed currency which lacks the saving checks of a gold standard to bring to light excesses of zeal and errors of judgment. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle , Macmillan and Company 1937, p. 56).

On the other hand, deflation occurs where the absolute quantity of money shrinks. This means that prices must now fall if the number of transactions is not to contract. Of course, true deflations are always accompanied by depressions because what is contracting is not notes or coins, i.e., cash, but fictitious bank deposits, the product of credit expansion produced by a fractional reserve banking system.

These expansions sparked off a boom and misdirected production. Eventually the boom went bust, credit contracted and the economy fell into depression. Hence falling prices caused by deflation are money induced; falling prices caused by productivity outstripping the money supply are goods induced. Confusing these two phenomena could have dangerous consequences.

It has been argued that to allow prices to fall indefinitely would cause interest to fall close to zero and thus make it impossible for a government to use interest rate cuts to stimulate economic activity. This is just pure nonsense. Interest is a product of time preference. For it to fall to zero people would literally have to give up every kind of current consumption in favour of distant consumption. Not a very practical thing to do. If, for example, the social rate of time preference remained unchanged, falling prices would lead to a nominal fall in interest rates while the real rate would remain unchanged. This means that if time preference brings about a 5 per cent interest rate then a an annual 2 per cent price fall would create a nominal 3 per cent interest rate.

In any case, falling prices would eventually see the market respond by expanding the money supply as it did in the nineteenth century. What our commentators also overlook is that falling prices raise the price/value of money. The nineteenth century fall in prices raised the value of gold, stimulating gold prospecting and the means to extract gold from low-grade ores. Falling prices caused by rising productivity are to be welcomed. Falling prices caused by deflation is the fruit of a badly mismanaged monetary policy that brought on a depression. I know which one I prefer.

Gerard Jackson

Gerard Jackson is Brookes economics editor.

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