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Deflation Is Not the Enemy, Bad Economics Is

Economics / Economic Theory Nov 01, 2010 - 02:36 AM GMT

By: Gerard_Jackson

Economics

Best Financial Markets Analysis ArticleAccording to Alan Blinder "the present danger is not inflation but deflation". His pal Bernanke has driven the Fed's funds rate down to zero while giving the US economy an unprecedented increase in its monetary base. Not satisfied with that he is now apparently preparing an astonishing $2 trillion monetary expansion -- and Blinder worries about deflation!


Like most of today's economists Blinder doesn't even know what deflation is. Regardless of what is taught in the economics faculties of universities a fall in general prices is not deflationary by definition. It is, in fact, an absolute fall in the quantity of money. That you can have falling prices along with an expanding money supply should have given these economists second thoughts.

The main error behind much of this thinking is rooted in a misreading of nineteenth century price movements. Many economic historians and economists noted that nineteenth century Britain experienced some 50 years of falling prices, even though living standards rose at an unprecedented rate. From about 1874 to 1895 wholesale prices fell by about 45 per cent while industrial output and real wages continued to rise.

If one has succumbed to the erroneous definition of deflation it is easy to therefore conclude -- based on the British experience -- that deflation is not a real danger. This would be a grave mistake. 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 stern opponent of deflation and a strong supporter of a stable price level. According to his thinking if recessions were to be avoided then the money supply would have to expand at a rate that maintained a constant purchasing power by preventing prices from falling. And yet he admitted that the historical evidence did not support him when he wrote:

[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).

Disregarding the evidence from his own study he stubbornly stuck to a stabilisation policy. The result is that America got both inflation and recessions. Perhaps he should have heeded D. H. Robertson's observation that

... a policy aiming at ultimate stability of the general price-level seems to be neither the "most natural" nor the "most effective" policy for the monetary authority to adopt. (D. H. Robertson, Banking Policy and the Price Level, Augustus M. Kelley, 1989, p. 32, first published 1926).

The older economists understood that productivity-induced price falls are a natural result of economic growth and should never be confused with a deflationary situation. They were fully aware of the fact that what really matters to the producer is not the absolute level of prices but price margins. Alfred Marshall explained this some 130 years ago:

...in the same way a manufacturer, though he has to pay for raw material and wages would not check his production on account of a fall in prices, if the fall affected all things equally, and were not likely to go further. If the price which he got for his goods had fallen by a quarter, and the prices which he had to pay for labour and raw material had also fallen by a quarter, the trade would be as profitable to him as before the fall. Three sovereigns would now do the work of four, he would use fewer counters in measuring off his receipts against his outgoings; but his receipts would stand in the same relation to his outgoings as before. His net profits would be the same per centage of his total business. The counters by which they are reckoned would be less by one quarter, but they would purchase as much of the necessaries,, comforts and luxuries of life as they did before. (Alfred Marshall and Mary Paley Marshall, Economics of Industry, C. J. Clay, M. A. & Son, 2nd edition, 1881, p. 156).

Much misery could have been averted if the Austrian insight that money is not neutral had not been completely disregarded by orthodox economists. (In fact, the idea that money was far from being neutral -- meaning that it did not influence individual prices -- was discussed in considerable detail 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).

Clearly, if the absolute quantity of money shrinks prices must inevitably 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 can have dangerous consequences.

It is still argued that to allow prices to fall indefinitely (as if price could fall to zero) would also 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 brings on a depression. I know which one I prefer.

By Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes' economics editor.

Copyright © 2010 Gerard Jackson

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