A Deflation Primer

Probably THE thing I’m most interested in in my hobby field of Economics at the moment is Deflation – which most economists think of as a general fall in prices (probably owing to waning demand), and which Austrian and Monetarist Economists think of as a drop in the money supply (the amount of money and available credit floating about). Obviously these two things are related, and in light of the current situation it’s interesting to compare the two definitions. By the standard definition, we’re definitely in a deflation. Prices are falling (the CPI is down 0.1%, and it almost never drops), and it seems to have to do with a drop in demand (people just aren’t spending as much). By the Austrian definition the situation is interesting because the Federal Reserve is trying desperately to cause inflation. Interest rates are as low as they’ve pretty much ever been, and of course the government is handing out money left and right.

There are two reasons I’m so interested in Deflation. The first is the sort of natural curiosity that everyone has for forbidden fruit. Deflation is the big bugbear of almost every school of Economics – to be avoided at nearly any cost. (Even for some Austrian economists it’s an evil – though no Austrian economist would advocate avoiding it “at any cost.”) The second is that it seems to me an inevitable consequence of a certain kind of gold standard. Imagine that there is a fixed amount of gold (or whatever commodity it is) in Fort Knox, and that’s just it – a frozen money supply. Dollars are defined at some fixed weight, and so there are only ever so many dollars floating about. It seems that in this kind of situation (which no one is advocating or will likely ever advocate) deflation would actually be an inevitable consequence of prosperity as competition and ever-increasing supply means there is always the same amount of money chasing ever greater quantities of goods and services. Prices in general would have to drop. Since I can imagine a situation in a totally alien economy where deflation would thus be a good thing, I’m curious whether anyone more knowledgable about these things than me has worked out all the implications.

So I was pleased to discover that the Mises Institute had made a copy of a book on the subject available as a free podcast download (also available in pdf form). The book is Jörg Guido Hülsmann’s Deflation and Liberty, and it tries to make the case that deflation is not only necessary but socially desireable. Since it’s so far from the standard script on the subject, I downloaded and listened to it this week.

The argument in a nutshell is that deflation and inflation are best understood in terms of the price of money, or else the size of the money supply. Inflation is when the amount of money “out there” grows relative to the amount of goods and services available. Deflation is when it shrinks. Hülsmann argues plausibly that for this reason inflation and deflation are best understood as redistributive mechanisms. Since that’s always the way I’ve thought about them too, it was nice to get some confirmation! To show how it works, let’s take an inflation example. This means that the money supply (the amount of paper dollars and available credit) grows relative to the number of goods and services. So you have the same total amount of “value out there” in the form of goods and services, what’s changed is that there’s more money available to exchange for these goods and services. OK – so clearly since the amount of value has not changed, what will have changed is who commands how much of that value. The people who get more of the new money obviously benefit from the redistribution, the people who didn’t get as much (or any) of the new money are harmed. What cannot be doubted, really, is that a redistribution of some kind has taken place. The interesting question is then who benefits and who is harmed, generally speaking? The answer seems to be that in general people who go into debt benefit from inflation and those who save are made worse off.

There are two ways to convince yourself of this. First, consider that inflation means that each dollar bill is worth a little bit less. Remember, there is exactly the same amount of value, what’s changed is that there are more dollars “out there” to spend on that value. So each dollar is a little bit weaker than it used to be. It’s sort of like if you’re measuring something in inches and are suddenly told to change to centimeters. The length of the thing that you’re measuring hasn’t changed, but it now takes more individual units of length to account for it. Second, consider that the consequence of more money being “out there” is that prices will have to rise. Since there’s more money to be had, people who make things will need more of it to maintain their position. Either way you think of it, it’s easy to see that inflation steals from people who save. Your money in the bank is now worth less than it was, whether you think of this in terms of it being a smaller portion of the overall money supply, or whether you think of it as buying less at the newly higher prices than it did before inflation. People who borrow do comparatively better, however. They buy things without having first saved for them, and if the inflation continues, they can work off their debts at inflated wages relative to the amount they borrowed, making it easier to pay off the accumulated debt.

It stands to reason, then, that deflation redistributes in favor of the savers. Money in the bank buys more than it did the day you put it in – whether you think of this in terms of it being a bigger part of a shrinking money pie, or in terms of the general price level decreasing. By contrast, people who are in debt are worse off, because they borrowed money when prices and wages were higher, and now they have to pay it off at lower wages, or by selling off things they own at lower prices.

I hadn’t ever thought of deflation in terms of helping savers, so this book really helped me see how that works. By the same token, I’d never really thought of deflation as a good thing for liberty. That’s a more complicated argument that I’ll leave it to the book to make – but the nutshell version is that since the people who print the inflated new money get to decide where it goes but don’t find it as easy to control things when they shrink the money supply, that inflation more than deflation is a tool for economic manipulation by the central bank/government.

The book was really useful to me for clearing up these issues, and so I recommend it. However, I had a few lingering questions.

  1. I’m frankly a little uncomfortable with the ATB praise for deflation in the current situation. I agree that a general deflation is necessary and therefore probably welcome. However, a freefall deflation seems a bit unfair given the extent to which people have been encouraged to go into debt. Taking myself as an example, I’ve accumulated some student loan debts here in graduate school, which seemed more rational than going to work for a year and postponing graduation. I’m fully willing to take responsibility for my choice, and I’m not therefore seeking to avoid my debts. Quite the contrary – I’ve been very careful to take out these loans only from private sources, at higher interest rates, so that I am not asking anyone I don’t know (i.e. the general taxpayers) to finance my education. I consider myself a responsible borrow responding to the incentives that were placed before me, and it seems a bit unfair for the amount of my debt to suddenly inflate should prices be allowed to go into freefall. Since most people are in much worse situations than I am (from housing loans, larger quantities of student loans, etc.), the problem only compounds. A lot of innocent people will be hurt by a general deflation.
  2. Related to the first reason, most people currently in debt simply won’t be able to pay under a general deflation. This will lead to lots of defaults and bankrupcies, which will dry up a lot of the capital stock for recovery. I suppose the answer to this question is that that’s to a large degree money that was never there to begin with (i.e. money the Fed pulled out of thin air), so no harm no foul. I buy that to a large extent – but surely there is some residual damage?
  3. I wonder if there is a sense in which inflation is a nature’s response to central bankers trying to game the system. I’m thinking in particular here of the labor unions. They negotiate their wages higher with government backing, which has the effect of causing more inflation. Which means that some of their gains then vanish as general price levels go higher. Push the economy, and it pushes back! Of course, I suppose the answer to this one is to point to all those other workers who aren’t union members and have to deal with higher prices even though their wages haven’t necessarily gone up – in which case the unions really do gain, even if not by as much as they planned.

At any rate, an interesting book. It won’t answer all your questions by a long shot, but as food for thought on deflation (which, at a manageable hour and fifteen minutes you can easily digest during commutes), it’s a good place to start.

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