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<font color="#002864" size="1" face="Verdana">http://www.mises.org/fullstory.asp?control=1254</font>
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<font face="Verdana" size="2"><font color="#002864" size="5"><strong>Deflation: The Biggest Myths</strong></font>
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<font size="4">by J.G. Hülsmann</font>
<h1>&nbsp;</h1>
<p align="left"><font size="2">[Posted June 13, 2003]</font>


<p align="left"><font size="2">[img][/img] The
prospect of deflation haunts the political and economic establishment in our
western democracies. Their fears are understandable, at any rate from an
economic point of view. Consider the following three basic propositions of
monetary economics:</font>


<p align="left"><font size="2">According to the first proposition, both the
quantity of money and the price level are irrelevant for the wealth of a
nation. Firms and households can successfully produce any quantities of
consumers’ goods at any price level and with any nominal quantity of money.
The ultimate springs of human wellbeing are savings, technology, and
entrepreneurship - not money supplies and price levels.</font>


<p align="left"><font size="2">According to the second proposition, while
changes in the money supply do not affect the wealth of a nation in the
aggregate, they change the distribution of resources among the members of
society. In the case of an increasing money supply, for example, the first
owners of the additional quantities of money benefit at the expense of all
other money owners. Notice that these redistribution effects result not only
from changes in the quantity of money, but from any changes in the supply of
any good. There is a significant difference between money and all other goods
only in a fiat money regime. This brings us to our third proposition:</font>


<p align="left"><font size="2">A fiat money regime considerably facilitates
the re-distribution of resources within society. It allows the owners of the
printing press and their political and economic allies to enrich themselves
far quicker and at much lower cost than any other producer in any other field.
This explains why governments have for centuries sought to establish a paper
currency. And it explains why, after they had achieved this goal in the 20^th
century, governments and their business allies set off on an exponential
growth path. The welfare state has exploded in the 20^th century,
and Wall Street and the banking sector grew quicker than almost any other
sector of the economy.</font>


<p align="left"><font size="2">This would not have been possible on a free
currency market, because nobody would accept banknotes the purchasing power of
which depends on the whim of its producer. And indeed paper money has never
existed in a truly free currency market.</font><a title href="http://www.mises.org/fullstory.asp?control=1254#_ftn1" name="_ftnref1"><font size="2">[1]</font></a><font size="2">
It is essentially fiat money - money that the government imposes on
its citizens. Paper money is protected through “legal tender” laws, which
means that you and I can be forced to accept it as payment, even if we have
contractually stipulated payment in other commodities. Moreover, in many
countries paper money is shielded against its main competitors such as coins
made out of precious metals through the tax code - sales taxes and capital
gains taxes apply to these metals, but not to paper money. In short, paper
money is monopoly money; it enriches the happy few at the expense of all
others.</font>


<p align="left"><font size="2">The deflation-phobia of our elites is therefore
the rational reaction of those who profit from the privileges that our present
inflationist regime bestows on them, and who stand to lose more than any other
group if this regime is ever reversed in a deflationary coup. Perennial
inflation is based on monopoly. Deflation brings in the fresh winds of the
free market. True elites would welcome deflation for precisely this reason,
because they owe their leadership positions exclusively to the voluntary
support of other members of society. They have nothing to fear from deflation
- a shrinking money supply - because their leadership is grounded on the
useful entrepreneurial services they provide to their fellow citizens -
services that would subsist through any changes in the money supply or in the
price level.</font>


<p align="left"><font size="2">But large parts of our present-day elites are
“false elites” or “political entrepreneurs.” These men and women owe a
more or less great amount of their income and decision-making power to legal
privileges that protect them from competition and which enrich them at the
expense of all other people. The fortunes of many political entrepreneurs are
directly or indirectly attributable to the money monopoly of the Federal
Reserve System. It is only because of this monopoly that the Fed could create
a near boundless expansion of the money supply. And it is this inflation that
in turn has financed a near boundless expansion of the activities of the
federal and state governments, and of those who rely essentially on their
lobbying effort with the Fed, rather than on the quality of their products, to
reach and maintain leadership positions.</font>


<p align="left"><font size="2">Political entrepreneurs are thus&nbsp;right to
fear&nbsp;deflation. For deflation takes away the source of their illegitimate
income and puts them finally back on equal footing with all other members of
society, whose incomes are based on efforts and services provided in a
competitive environment.</font>


<p align="left"><font size="2">But these privileges can only survive because
of widespread ignorance about the true character of deflation.</font><a title href="http://www.mises.org/fullstory.asp?control=1254#_ftn2" name="_ftnref2"><font size="2">[2]</font></a><font size="2">
A closer look reveals that the case against deflation squarely rests on a
litany of inflationist myths. To these we now turn.</font>


<h2 align="left"><font size="2">Myth #1: You cannot earn a living and make
profits when the price level falls</font></h2>
<p align="left"><font size="2">Most of our analysis will deal with deflation
in the sense of a shrinking money supply. This case is most interesting from a
political point of view, because few economists and laymen are ready to
concede any benefits to deflation in this sense. But before we turn to this
case, let us briefly examine the character of deflation in a somewhat
different connotation, namely, in the sense of a decrease of the general price
level. This type of deflation draws much less criticism than the other type,
but it might be useful to deal with it first as a warm-up for out subsequent
discussion.</font>


<p align="left"><font size="2">Thus, is it true that one cannot earn a living
and make profits when the price level falls? The answer is in the negative.
Successful business does not at all depend on the level of prices, but
on price spreads or, more precisely, on spreads between selling
receipts and cost expenditure. But such spreads can exist and do exist at any
level of prices, and they can exist and do exist even when there is a secular
decline of prices. The essential reason is that entrepreneurs can anticipate
declining prices, just as they can anticipate increasing prices. If they
anticipate a future decline of their selling proceeds, they will bid
down present prices of factors of production, thus assuring profitable
production and paid employment for everyone willing to work. This is exactly
what happened in the few periods of modern history in which deflation was not
prevented through inflationist counter-measures.</font>


<p align="left"><font size="2">For example, both the U.S. and Germany enjoyed
very solid growth rates at the end of the 19^th century, when the
price level fell in both countries during more than two decades. In that
period, money wage rates remained by and large stable, but incomes
effectively increased in real terms because the same amount of money
could buy ever more consumers’ goods. So beneficial was this deflationary
period for the broad masses that it came to the first great crisis of
socialist theory, which had predicted the exact opposite outcome of unbridled
capitalism. Eduard Bernstein and other revisionists appeared and made the case
for a modified socialism. Today we are in dire need of some revisionism too
- deflation revisionism that is.</font>


<h2 align="left"><font size="2">Myth #2: While falling prices are good,
lacking aggregate demand is bad</font></h2>
<p align="left"><font size="2">This is a variant of myth #1. While the
advocates of this myth concede the point that lower prices are advantageous
from the point of view of consumers, they claim that there are manifest
disadvantages from the point of view of producers. In particular, there would
be few incentives to invest into any sort of business in an environment of
shrinking prices. We have already rebutted this view by pointing out that the
absolute future price level is irrelevant for profitable enterprise. The
relevant factor is the possibility to realise a spread between selling
proceeds and cost expenditure, and this possibility exists irrespective of the
movement of the price level.</font>


<p align="left"><font size="2">Now our anti-deflationist might come up with
the following objection: profitable enterprise in times of falling prices
presupposes that businessmen can bid down factors of production in
anticipation of the event. If they are unable to bid factor prices down, they
will not invest at all. QED.</font>


<p align="left"><font size="2">But this argument overlooks that all resources
are invested into some use at any point of time. Why are our farsighted
entrepreneurs unable to bid the factor prices down? Clearly this is so either
because the factor owners are not ready to sell them at the lower prices, or
because other entrepreneurs offered slightly higher prices. In the latter case,
there is clearly no lack of investment and productive activity. The factors in
question are bought and sold - albeit at lower prices than would have been
offered in inflationary times. And even in the former case, the factors are
invested - they are invested in the “reserve stock” of the owner of
these factors, and such a reservation demand fulfils a useful social function
just as any other form of demand.</font>


<h2 align="left"><font size="2">Myth #3: You cannot earn a living and make
profits when the money supply shrinks</font></h2>
<p align="left"><font size="2">Human beings are able not only to anticipate a
falling price level, but also the consequences of a shrinking money supply.
Such anticipations will usually accelerate the deflationary process and make
it reach the “rock bottom” of a stable money supply very quickly. Two
cases need to be distinguished: A) the case of a fractional-reserve banking
system operating on the basis of a commodity money such as gold or silver and
B) the case of a paper money.</font>


<p align="left"><font size="2">In case A, the supply of physical gold or
silver can obviously not just vanish in thin air, and thus it remains to
provide rock bottom in case of a deflation of fractional-reserve notes. Such a
deflation usually starts when more and more people refuse to accepts these
notes as payment, and it usually ends in a bank run, when even the present
holders of the notes no longer wish to own them and rush to the issuing bank
to redeem them in gold or silver. After the run, the money supply has often
considerably shrunken because all fractional-reserve notes have disappeared
from circulation. But the stock of metallic money remains and provides a rock
bottom, below which the money supply cannot sink. There is no reason why this
deflationary process should not be finished in a few hours or days. When it
has ended, many banks will be bankrupt and many entrepreneurs will be bankrupt
too, to the extent that they have financed their firms with debt rather than
with equity. This explains of course why the present debt-financed
establishment ferociously resists deflation. But it does not mean that
production could not go on without them - in fact it can go on and will go
on under new ownership.</font>


<p align="left"><font size="2">In case B, there is no rock bottom to provide a
stopping point to the deflationary process reducing the supply of a paper
money. When people no longer wish to own a paper money and start selling it at
any price, the result will be an ever declining purchasing power of this money,
which in turn might convince even those who had bought that they better get
rid of it, and the sooner the better. The result is a deflationary spiral:
less willing owners - less purchasing power - less willing owners - less
purchasing power and so on, until the paper money has completely vanished from
circulation. Notice that this does not mean that the economy will necessarily
be thrown back into a state of barter. What usually happens in such cases is
that people start using other monies such as gold and silver coins, or
foreign paper monies. The deflationary spiral therefore has the healthy effect
of replacing an inferior sort of money - inferior from the point of view of
the money users - with superior money. Again, there is no reason why this
process should not be completed in a few days. And there is therefore no
reason to expect that production will not resume very quickly under new
ownership.</font>


<h2 align="left"><font size="2">Myth #4: Deflation entails slower economic
growth than inflation</font></h2>
<p align="left"><font size="2">Some champions of inflation concede that
production can go on after a deflation, and possibly even in the midst of a
deflation. But they claim that economic growth will be seriously curtailed by
the necessary adjustments, to the point that it would have been preferable to
avoid the deflation through inflation - or as they say, reflation.</font>


<p align="left"><font size="2">It is difficult to discuss such claims in the
absence of a commonly agreed-upon definition of economic growth. But the
following consideration nevertheless applies: The problem of adjusting to
deflation in the sense of a shrinking money supply is inherently a short-run
problem. It is a problem of identifying those investment projects that are
most profitable (and thus most socially beneficial) under the new conditions
that deflation has brought into being. In particular, deflation in the worst
of all circumstance induces businessmen and factor owners to hold back with
their assets to avoid wasting them in any fancy venture. Deflation is
therefore inherently sober, prudent, and financially conservative.</font>


<p align="left"><font size="2">By contrast, inflation constantly lures capital
into investment projects that do not find the spontaneous support of other
members of society - capitalists, workers, and customers - but which are
feasible only because they are financed, directly or indirectly, with money
from the printing press. The most glaring example is the welfare state, which
can be financed, not because there is any prospect of future returns, and not
because it attracts a sufficient amount of voluntary donations, but solely
because it is backed up with an ever-increasing amount of debts, which one day
will be paid with new money from the printing press. This consideration
applies quite apart from the fact, stressed by the Austrian economists, that
inflation can induce inter-temporal misallocations of capital.</font>


<p align="left"><font size="2">Given the enormous waste that goes in hand with
inflation, it is not farfetched to assume that deflation will spur economic
growth both in the long run and in the immediate run, by any definition of
growth that emphasises the value scales of the individual members of society,
rather than some arbitrary criterion of social justice.</font>


<h2 align="left"><font size="2">Myth #5: Deflation is particularly burdensome
for lower-income groups</font></h2>
<p align="left"><font size="2">The main asset of relatively poor people is
their labour, and labour is a relatively non-specific asset, which means that
it can be used in many branches of industry. If a worker can no longer be
employed in his present position, it is therefore always possible for him to
find new employment elsewhere, even though at a lower market price. By
contrast, relatively rich people typically derive a larger part of their
income from financial assets. Ultimately these assets relate to the ownership
of capital goods, which in turn are highly specific assets - they can very
often be used only in exactly the way in which they are presently used. If
this use is no longer profitable, there will be a more or less dramatic drop
of their market price, often to scrap value.</font>


<p align="left"><font size="2">It follows that deflation affects lower-income
groups less than higher-income groups.</font>


<h2 align="left"><font size="2">Myth #6: Deflation destroys the credit of the
state</font></h2>
<p align="left"><font size="2">It is true that deflation - especially
deflation in the sense of a contraction of the money supply - will make it
impossible for a government to ever pay back public debts. And it is also true
that it will then for some time be impossible for the government to obtain new
credits.</font>


<p align="left"><font size="2">But it is a myth to believe that we have to
wait for deflation to bring about this result. Public debts are on an
exponential growth path and no official even talks about paying them back.
Fact is that our western governments are already on a slippery slope that will
inevitably end up either in hyperinflation or in state bankruptcy. It is just
a question of time until they will have destroyed their credibility all on
their own - deflation would merely speed up this process.</font>


<p align="left"><font size="2">Let us also notice that there are potentially
beneficial effects associated with state bankruptcy. In particular,
governments would again be dependent on obtaining revenue mainly through
taxation, and that puts a healthy break on their expansion path.</font>


<h2 align="left"><font size="2">Myth #7: Deflation creates unemployment</font></h2>
<p align="left"><font size="2">Unemployment of a factor of production comes
about only in two cases: A) if the owner of the factor is not willing to rent
it out at the price offered to him, or B) if the law prevents him from doing
so. It is therefore not true that declining wage rates bring about
unemployment by any sort of inner necessity. People are not just unemployed.
They choose not to work for an employer under the (pecuniary and non-pecuniary)
conditions offered to them. Now it is clear that no sane person will accept to
work for somebody else if the wage rate does not allow him to survive anyway.
But this is not the case in a deflation. Remember that here all prices fall,
and thus the decline of wage rates is compensated by a parallel decline of the
prices for consumers’ goods. It is true that there might not be in all cases
an exact parallel between wage rates and the prices of consumers’ goods, but
any deviations will be temporary only and can easily be bridged for some time
with the assistance of family, friends, and charitable institutions.</font>


<p align="left"><font size="2">Involuntary unemployment might arise in a
deflation only if the latter is combined with minimum wage laws, which prevent
the worker from offering his services at lower rates. But clearly this
unemployment does not result from deflation, but from the minimum-wage laws,
which infringe on the freedom of association.</font>


<h2 align="left"><font size="2">Myth #8: Deflation entails unequal and
arbitrary burdens for the citizens</font></h2>
<p align="left"><font size="2">It is true that deflation involves heavy
burdens for many individuals. Just consider the fact that today the great
majority of U.S. household have incurred considerable liabilities, usually in
the form of real estate mortgages. If a contraction of the money supply sets
in, household incomes will decline and it will be impossible to pay back these
liabilities. It will then be necessary o renegotiate debts, and some
individuals will have to file bankruptcy. It is also true that deflation has
unequal consequences for the individual citizens. Some will prosper in a
deflationary environment more than they would have prospered in the present
inflationary regime, and others will fare worse. Finally it is true that these
re-distributions are often difficult to square with one’s notions of what is
just and unjust.</font>


<p align="left"><font size="2">So where is the myth? The myth consists in the
belief that only deflation entails unequal and arbitrary burdens for
the citizens. The truth is that the present inflationist regime is no less
re-distributive and arbitrary than any deflation could possibly be. Inflation
constantly re-distributes income from people who offer genuine services to
people who happen to enjoy political alliances with the masters of the
printing press.</font>


<p align="left"><font size="2">Even if inflation is used “only” to prevent
an impending deflation, these arbitrary and unequal redistribution effects
cannot be avoided. The very least thing we could say, therefore, is that
deflation is certainly not more unjust than inflation. But as well shall see
further down, there are in fact very tangible benefits to be derived from
deflation that make it actually preferable to continued inflation. But before
we come to discussing this point, let us briefly deal with another issue:</font>


<h2 align="left"><font size="2">Myth #9: It will take decades to settle
deflation-induced legal disputes</font></h2>
<p align="left"><font size="2">Have we not been too over-optimistic in
assuming that deflation might be a matter of a few hours or days? Is it not
rather likely that deflation will upset a great number of long-term contracts,
from mortgage contracts over industrial bonds to real estate leases? And is it
not rather likely that it will take the courts some twenty years or so to sort
out all the different claims and counter-claims?</font>


<p align="left"><font size="2">It is true that, while the adjustment of the
price structure to the new deflation-created conditions might take just a few
hours or days (but could take much longer if government interventions hamper
the adjustment process), the settlement of legal disputes could involve much
longer times periods. But based on the empirical evidence it is certainly
exaggerated to assume that more than a few months would be needed.</font>


<p align="left"><font size="2">Consider the German deflation that set in after
the bankruptcy of the Darmstädter Bank on July 13, 1931, and which lasted
some two years. The crisis very quickly jeopardised the liquidity, not only of
the banking sector, but also of virtually all other branches of German
industry. Contractual relations were upset on a large scale, and thus it not
only came to bankruptcies on an unprecedented scale, but also to a great
number of revisions of previous contracts, both inside and outside of the
courts, and to payment moratoria. Unemployment rose to almost 7 million,
production stopped in many firms, salaries and wages plummeted, as did all
other prices. The radical drop of real estate prices jeopardised the mortgage
business, as well as financial titles backed up with mortgage claims.</font>


<p align="left"><font size="2">How were these problems handled? Well, the
unemployment problem was not handled at all, because government had created
the conditions under which unemployment was inevitable: unemployment insurance
and minimum wage laws. The result was social upheaval and twelve years of
National Socialism.</font>


<p align="left"><font size="2">But the problems relating to claims resolution
were handled rather quickly and efficiently, partly because the German courts
had, in the wake of the hyperinflation of 1923, gained some experience in
dealing with dramatic changes in the purchasing power of money. In a great
number of cases, the disputes never made it into the state courts, but were
settled in private arbitration. The remainder was settled in the state courts
or dealt with in a series of four emergency laws, the last of which was voted
in parliament on December 8, 1931. Thus, a few months after the deflation had
set in, all essential legal tools and institutions were in place and operated
fairly efficiently.</font>


<p align="left"><font size="2">There is no reason to assume that things would
be handled less efficiently in the present-day United States, especially if
legal scholars turn their energies into analysing the problems that are here
at stake.</font><a title href="http://www.mises.org/fullstory.asp?control=1254#_ftn3" name="_ftnref3"><font size="2">[3]</font></a>


<h2 align="left"><font size="2">Myth #10: Deflation confers no positive net
benefit</font></h2>
<p align="left"><font size="2">Granted that a heavy contraction of the money
supply is merely on equal footing with increases of the money supply when it
comes to the distribution of burdens among the citizens. But is it not the
case that we have pretty well adjusted out behaviour to the present
inflationary environment, where as letting deflation happen would impose on us
a re-adjustment? Even if this adjustment is only a temporary affair, still it
involves costs for all members of society. So what are the benefits of
deflation that could prompt a responsible citizen to endorse it, apart from
the uncertain prospect of being on the winners’ side in the short-run
zero-sum redistribution process that deflation entails? Here the following
consideration comes into play.</font>


<p align="left"><font size="2">First of all, deflation is a very efficient
mechanism to speed up adjustment to new circumstances in the wake of a major
financial crisis. The reason is, as we have noticed above, that deflation
affects the prices of factors more than it affects the prices of consumers’
goods. As a consequence, deflation increases the spread between selling
receipts and cost expenditure - in other words, the interest rate - and
thus creates powerful incentives for increased savings and investments.</font>


<p align="left"><font size="2">Second, and equally importantly, deflation is a
one-time process that however has the potential to destroy the very
institutions that produce inflation on a perennial basis, in particular,
fractional-reserve banks and fiat money producers (“central banks”). The
destruction of these institutions eliminates the “advantage at the margin”
enjoyed by liability finance as compared to auto-finance. In other words,
economic and social power is taken away from the Fed and the banks, and
returned into the hands of individual citizens. Firms will operate on a far
higher equity basis than before, and households will, in more cases than
before, first save and then buy a home. Furthermore, the destruction of the
inflation machine will destroy the main financial engine of the welfare state.
Governments will henceforth have to obtain their resources exclusively through
taxation, which is subject to far greater social control than the unworthy
stealth method of gaining resources by inflating the money supply.</font>


<h2 align="left"><font size="2">Myth #11: Letting deflation happen is
“passivism”</font></h2>
<p align="left"><font size="2">In the light of our foregoing discussion, it is
clear that letting deflation happen must not be simply equated to an apathetic
resignation before the power of mysterious forces and blind market mechanisms.
Deflation can fulfil extremely useful social functions and those who cherish
individual liberty and the sanctity of private property are on good grounds in
consciously striving to let deflation run its course. If anything, it is letting
inflation happen&nbsp;that amounts to apathetic resignation -
resignation that is before the power of a money monopoly that thrives on
ignorance, and which benefits political networks at the expense of
capitalistic civil society.</font>


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<hr align="left" width="33%" SIZE="1">
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<div id="ftn1">


<font size="2">Jörg Guido Hülsmann is senior fellow of the Mises
Institute. jgh@mises.org. See his Daily
Article Archive and his
vita and other links. &nbsp;He is lecturing
at the Mises Institute this summer. His latest lecture on
deflation is available on Mises.org audio.</font>


<hr align="left" width="33%" SIZE="1">


<a title href="http://www.mises.org/fullstory.asp?control=1254#_ftnref1" name="_ftn1"><font size="2">[1]</font></a><font size="2">&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;One
might object that the banknotes of the Bank of England that circulated
from 1797 to 1821 were an exception, because they were not legal tender.
But these notes were not paper money, but credit money. During the entire
period of this “paper pound,” the market participants expected a
resumption of specie payments of the Bank of England in the near future.
For the distinction between commodity money, credit money, and fiat money
(in most cases: paper money), see Mises, Theory of Money and Credit,
part one, chap. 3, sect. 3.</font>


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<div id="ftn2">


<a title href="http://www.mises.org/fullstory.asp?control=1254#_ftnref2" name="_ftn2"><font size="2">[2]</font></a><font size="2">&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;Of
course we mean to defend only free-market deflation. Confiscatory
deflation is in-defendable. See Rothbard in Making
Economic Sense, and Salerno, “Taxonomy
of Deflation.”</font>


</div>
<div id="ftn3">


<a title href="http://www.mises.org/fullstory.asp?control=1254#_ftnref3" name="_ftn3"><font size="2">[3]</font></a><font size="2">&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;One
of the most interesting present-day problems for libertarian legal
scholarship is the development of a legal theory of deflation.


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