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24.09.2002, 17:57

The Imaginary Evils of Deflation / Artikel mises.org, engl.

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The Imaginary Evils of Deflation
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by Christopher Mayer

[Posted September 11, 2002]

[img][/img] Deflation
is popularly defined as a general fall in prices; it is the opposite of what
most people generally think of as inflation. It is most commonly associated
with the Depression and with the recent economic woes in Japan. 

Perhaps as a result of this common association, or perhaps
as a result of a more general weakness in the clarity of economic thought,
deflation is often seen as something that brings calamitous consequences and
as something that must be prevented.

One of the more surprising recent business best-sellers is a
book titled Conquer the Crash, by Robert Prechter.  It is
surprising because the public does not often take to being told that disaster
is around the corner. Optimism is the far sweeter fruit, more often
indulged upon whether the facts justify it or not.  Be that as it may,
Prechter’s book calls for a deflationary depression and paints a rather dire
picture of financial distress.

Deflation worries are gathering more and more attention. The
Wall Street Journal recently ran a piece titled “Deflation Fears
Make a Comeback,” in which it noted the fall in prices of selected goods but
warned that “if deflation spreads into other segments of the economy, it
could turn into a major problem.” Assuming a connection, the article
mentioned financial hardships during the Great Depression and in Japan.

Not only is deflation seen as something that is harmful, but
it is also viewed as something that must be prevented. Naturally, the Fed
is envisioned as the institution that should do the job. A recent Fed
paper titled “Preventing Deflation: Lessons from Japan’s Experience in the
1990s” takes it for granted that the Fed ought to take measures to avoid
deflation.

There is something about monetary phenomena that make them a
particularly misunderstood aspect of economic life.  Deflation is no
exception. There seems to be little understanding as to what it is, what
causes it, and whether or not it is something that should be prevented.

Professor Joseph Salerno has done us all a favor with a
well-written paper titled “An Austrian Taxonomy of Deflation” that makes
it much easier to answer these questions and cut through the muddle of media
hype and distortion.

The effects of deflation, like the quality of drinking water,
cannot be considered without regard to its source. According to
Salerno’s taxonomy, there are four basic causes of deflation.

The first is growth deflation, which stems from
increases in efficiency and productivity. Assuming the supply and demand for
dollars is unchanged, an increase in the quantity of goods produced will
result in falling prices. In other words, the same amount of dollars can
now purchase more goods. The common example of this deflation is to look
at the falling prices for technological goods. The computing power a
consumer can purchase for a dollar today is much greater than what could be
purchased even a few years ago.

Growth deflation should be the prevailing trend in a healthy
progressing economy. It is only because of years of rampant money supply
growth, endemic under a fiat currency system, that inflation has become the
accepted norm. As Salerno notes, “throughout the nineteenth century and
up until the First World War, a mild deflationary trend prevailed in the
industrialized nations as rapid growth in the supplies of goods outpaced the
gradual growth in money supply that occurred under the classical gold standard.”

Growth deflation, then, is by no means harmful. It is
the natural product of voluntary exchanges and the ever-increasing
productivity that has become the hallmark of market economics even among it
detractors. 

The second type of deflation under Salerno’s taxonomy is cash-building
deflation, which occurs when the demand for money increases. All other
things being equal, an increase in the demand for cash will raise the price
(i.e., the purchasing power) of the currency. Increased purchasing power
implies a fall in prices. 

Hence, this deflation, too, is a result of that action taken
by free individuals to meet certain needs--the need for the additional
security gained by holding more cash, for example. If one remembers that
the ultimate basis for economic action is to satisfy human wants and needs, it
is hard to imagine why cash-building deflation (called “hoarding” by its
critics) is thought to be malign. From the perspective of the consumer doing
the cash-holding, it is obviously not a bad thing. Clearly, a want or
need is being satisfied.

Then there is bank credit deflation, which comes
from the contraction of the money supply. Salerno writes that “the most
familiar is a decline in the supply of money that results from a collapse or
contraction of fractional-reserve banks that are called upon by their
depositors en masse to redeem their notes and demand deposits in cash during
financial crises.” The effect of such a collapse, holding other factors
constant, is to increase the purchasing power of money.

Bank credit deflation, Salerno asserts, “has a salutary
effect on the economy and enhances the welfare of market participants….Bank
credit deflation is a benign and purgative market adjustment process.”
Obviously, you cannot have a bank credit deflation without first having bank
credit inflation. It is the inflation that creates all the malinvestments and
excesses of the boom. Bank credit deflation is a force that works to
correct those errors so the economy can profitably grow again. Despite
the beneficial effect of bank runs and credit deflation in helping to check
credit inflation, it is hard to imagine any widespread bank failures given the
hyper-interventionist government we live with today and the ease with which
money can be created.

While the money supply did contract during the Great
Depression, Salerno notes that the stabilization policies of the Hoover and
Roosevelt administrations “prevented the deflationary adjustment process
from operating to effect the reallocation of resources demanded by property
owners.” These attempts only hindered the recovery and worsened the
depression.

Finally, there is confiscatory deflation, which is the only
kind of deflation that is unequivocally bad for market participants. It
is also the kind of deflation that is usually overlooked. Confiscatory
deflation is forced deflation brought on by the exercise of political power.

The most recent example of this is the debacle that occurred
in Argentina, when the government attempted to prop up the ailing peso (a
victim of soaring money supply growth) by preventing or limiting the ability
of Argentines to make withdrawals on their bank accounts. By preventing
withdrawals, it was hoped that the bankrupt banking system could be saved--at
the expense of millions of Argentines’ savings! 

The events that followed are still fresh in our memory:
riots, loss of life, property damage, the forced resignation of Argentina’s
president--in short, chaos. Confiscatory deflation, in addition to being an
act of outright thievery by a government, also is tremendously harmful to the
market’s participants. It blocks them from meeting their wants and
needs.

Given this framework for understanding deflation, how likely
is it that the U.S. economy will experience the sort of widespread deflation
that worries so many observers? Salerno believes that there is little
chance of that. Given the slow growth or recession expected in 2002,
there would seem to be little risk of growth deflation for a while. Salerno
cites some evidence of cash-building deflation, but this, he says, tends to be
a short-term phenomenon. Looking at the money supply, there is the
expansionary monetary policy of the Fed, coupled with the fact that “there
is no evidence that Americans are losing confidence in the banking system.”
Again, given the hyper-interventionist government of today, it is hard to
imagine widespread bank failure, however beneficial the effects of such
failures might be.

Salerno concludes that “an existing or imminent deflation
in the U.S. is chimera conjured up by those unfamiliar with sound, Austrian
monetary theory.” Whether or not a widespread deflation does hit the U.S.
economy, given the analysis summarized here and assuming it is not of the
confiscatory variety, it is certainly not something to fear or prevent.

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Christopher Mayer is a commercial lender for Provident Bank
in the suburbs of Washington, D.C.  Send him MAIL and
see his Mises.org Articles
Archive.