Economic Myths #12 - The Deflation Danger

[First published on Free Life.]

Politicians and mainstream economists are persistent in their warning of the so-called “deflation danger” – the idea that falling prices are calamitous for economic progress and that a perpetual, ceaseless price inflation is needed in order to bring us back to prosperity. Often, a deflation figure as small as 0.6% seems to be sufficient to trigger alarm – something of an hilarious travesty when, regardless of the merits of the deflation thesis, this figure amounts to little more than a rounding error.

The typical argument against deflation runs something like this: with continuous price deflation people expect prices to be lower tomorrow than they are today so that, as a result, they put off their purchases until a later date. This, in turn, causes prices to fall further and further and so we end up in an endless downward spiral of depression and impoverishment. Inflating prices, however, cause people to buy today so that they may insulate themselves from future price rises, thus bringing about economic prosperity and an increase in the standard of living.

The term “deflation” is used, quite confusingly, to refer to two different economic phenomena:

Although the two phenomena are related by the commonality of falling prices, the causes and effects of each are distinct and, as such, they must be treated separately. However, because of the bias of our current monetary system towards perpetual inflation it is usually the case that a general price deflation occurs only during monetary crises – i.e. the second cause of deflation. The supposedly negative effects of such deflations, which are often characterised by sharp, persistent falls in prices, are used, quite carelessly, to demonise the first type of price deflation as well so we end up with the notion that any prices falling for whatever reason are a bad thing.

The first type - secular deflation - occurs because an increase in the supply of goods relative to the supply of money causes the prices of those goods to fall gradually. It should be clear to everyone that such falling prices are the result of economic prosperity, permitting us to gradually buy more and more with the same amount of money. Hence, they are not an economic burden and any anti-deflationary thesis seeking to counteract these price falls is absurd.

The notion that people will suddenly “stop buying” during such a deflation in order to defer purchases to a later date when prices are expected to be lower is ridiculous. Every businessman will tell you that if you lower prices people will buy more whereas if you raise them people will buy less – precisely the opposite of the deflation thesis.

Goods are evaluated for the ends that they meet. The fulfilment of these ends, as a result of the logic of human action, cannot be put off indefinitely and each individual will have to consume at some point. Applying a reductio ad absurdum, the deflation thesis suggests that falling prices will cause people to starve because they will always be waiting for lower food prices in the future.

To give an actual example, although general, secular price deflation is highly unlikely under our present, paper money regimes, it can still be observed in specific industries – particularly in personal technology, such as computers and mobile phones, where productivity increases translate into price decreases in spaces of time short enough to counteract the general trend of price inflation. And yet these falling prices have not caused the collapse of this sector precisely because, however much you expect prices to fall, the value of owning a more expensive computer today is greater than that of waiting for a less expensive one in, say, three years. In other words, even if a person knows that a computer costs £1,000 today but will cost only half as much in three years, he will still spend £1,000 today if the benefit to be derived from the computer today is more valuable than saving £500 and waiting three years for that benefit.

Another daft argument is the idea that falling prices will cause business revenues, in turn, to fall, thus slashing profits and causing investment to slump. However, the success of a business – measured by its profit – depends not only upon the height of its revenue but also upon the height of its costs. The prices businesses are prepared to pay for their costs today is based upon what they expect the prices of their outputs to be tomorrow. Thus, gradually falling selling prices will transform into gradually falling costs and so profit margins will still exist.

It is, in fact, inflation that serves to damage (or at least falsify) profits at the expense of investment. The accounting practice of depreciating an asset over its useful life serves to set aside a portion of the revenue for eventual replacement of the asset. If depreciation charges are made at the old price of the asset while the replacement cost has, in the meantime, risen then this fund will clearly be inadequate. The opposite is true when prices fall – the fund will be able to afford more investment than a simple replacement of the worn out asset.

However, the bigger flaw in the theory of the deflation worriers is that it is based on the false, “consumptionist” view of economic progress – that the driver of prosperity is consumers spending increasing amounts of their money on more and more rubbish. As “Austrians”, however, we know that prosperity derives from the abstinence of consumption in favour of saving and investing, which, in turn, results from lower time preference rates. Yet that is precisely what happens if a person defers his consumption from today to tomorrow in order to take advantage of lower prices that are only available tomorrow. (Preferring the same quantity of goods in the future at a lower price is of the same ilk as preferring a higher quantity of goods in the future at the same price). Thus, there will be more resources available for investment in longer and more complex production processes resulting in a boost to economic progress. Inflating in order to make people consume more, however, will have the opposite effect.

The second type of deflation – that resulting from a monetary contraction – is of a somewhat different nature. Here, the problem is that a reduction in the supply of money will cause the prices of dollar quoted assets to fall while dollar denominated debts that have been taken on to fund those assets will remain at their previous value. Thus, there will be a cascade of defaults, bankruptcies, job losses, etc. that will, so it is alleged, cause endless destitution and misery. As we noted earlier, this nearly always happens at the start of the "bust" phase of the business cycle, when monetary inflation has stopped and higher interest rates have served to cut off cheap borrowing.

To anyone with even a rudimentary understanding of the “Austrian” theory of the business cycle, this anti-deflationism is clearly nothing more than a case of special pleading on behalf of the banks and businesses that borrowed cheap money in order to plough it into inflating assets (such as sub-prime mortgages) during the boom. They cry out for a vigorous re-inflation so that their particular firms do not have to suffer liquidation and their chief executives do not have to sell their mansions and yachts.

This type of deflation would not be a cause of a general economic malaise but would, in fact, serve to restructure the economy away from malinvestment by transferring the purchasing power of resources from those who borrowed and wasted during the boom to those who did not, the latter still holding a large quantity of steadily appreciating cash. Once that liquidation is complete the economy can proceed on a sound footing. This is precisely the argument of distinguished “Austrian” economist Jörg Guido Hülsmann in Deflation and Liberty.

Indeed, much of the deflation fear comes from the monetarist analysis of the Great Depression where there was, in fact, a real monetary contraction (although, as Murray Rothbard argues in America’s Great Depression, the lack of inflation did not result from want of trying, and that the actual cause of the contraction lay in factors that negated the inflationary responses of the government and the Federal Reserve). However, the stagnation during this era was not due to the deflation per se but because of the widespread attempt to keep wages and prices high in spite of the monetary contraction. Had prices been allowed to fall then recovery would have been much swifter.

Here we have, then, the real reason why we are supposed to be alarmed by the “deflation danger”. Deflation would cripple heavily indebted governments and banks who rely on a constant source of cheap money. The need for perpetual inflation is wholly unnecessary for economic prosperity and the wellbeing of the general public. Rather, it is necessitated by the asset-liability mix brought about by previous inflation which would threaten the existence of large, establishment institutions if it was to reverse. They need more cheap money, more theft of your purchasing power, in order to keep their phoney assets rising in value. The deflation myth, therefore, is nothing more than a part of the big, statist fraud, benefiting a select few at the expense of everybody else.