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George Reisman

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 The Anatomy of Deflation*
George Reisman

Fears of deflation, prominent a month or two ago, are now rapidly subsiding, and soon may disappear entirely. Nevertheless, deflation is still a subject about which it is important to have a correct understanding.

Deflation is usually thought to be a synonym for falling prices. There could be no more serious error in all of economics. Calling falling prices "deflation" results in a profound confusion between prosperity and depression. This is because the leading cause of falling prices is economic progress, whose essential feature is an increasing production and supply of goods and services, which, of course, operates to make prices fall.

Yet the term deflation is also closely associated with the phenomena of a plunge in business profits and a suddenly and substantially greater difficulty of repaying debts, with the consequence of widespread insolvencies and bankruptcies. The plunge in profits and sudden sharp increase in the burden of debt are, of course, leading symptoms of a depression.

Hence, the proximate cause of prosperity, namely, increasing production and supply, comes to be confused with depression and the widespread impoverishment that accompanies depressions. This, of course, is closely related to the absurdities of the overproduction doctrine, which claims that we are poor because we are rich.

What needs to be realized is that there are two distinct causes of generally falling prices. One is the increase in production and supply, which should never, never be confused with deflation, depression, or poverty. The other is a decrease in the quantity of money and or volume of spending in the economic system. Falling prices is the only effect that they have in common. They differ profoundly with respect to their other effects.[1]

The essential things that need to be understood are that falling prices caused by increased production do not serve to reduce the general or average rate of profit in the economic system and do not make debt repayment more difficult. Indeed, to the extent that such falling prices take place in the face of an increasing quantity of money and rising volume of spending, and result merely from the fact that the increase in production and supply outstrips the increase in money and spending, they are accompanied by a positive elevation of the rate of profit and a greater ease of repaying debts.

Precisely this would be the case under a gold standard, inasmuch as the supply of gold modestly grows from year to year as the result of continued and expanded gold mining operations, and the volume of spending in terms of gold grows commensurately. In such circumstances, the average seller in the economic system would be in the position of selling at lower prices and at the same time have a supply of goods to sell at those lower prices that was larger in greater degree than prices were lower.

For example, if falling prices result from the fact that while the quantity of money and volume of spending in the economic system are rising at a two percent annual rate, production and supply are rising at a three percent annual rate, the average seller in the economic system is in the position of having three percent more goods to sell at prices that are only one percent lower. His sales revenues will be two percent higher, and that is what counts for his nominal profits and his ability to repay debts. His profits will be higher and his ability to repay debt will be greater. There are lower prices here, but absolutely no deflation.

What wipes out profits and makes debt repayment more difficult is not falling prices but monetary contraction, i.e., the reduction in the quantity of money and or volume of spending in the economic system. This is what serves to reduce sales revenues, and, in the face of costs determined on the basis of prior outlays of money, causes a corresponding reduction in profits. It is also what makes debt payment more difficult, in that there is simply less money available to be earned and thus available to be used for the repayment of debts. It is monetary contraction, and monetary contraction alone, which should be called deflation.

Moreover, in the face of any given monetary contraction, the reduction in profits and increase in the burden of debt would in no way be diminished if prices did not fall. Indeed, these phenomena would not be alleviated even if prices rose. Prices would not fall if production and supply fell to the same extent that money and spending fell. They would actually rise if production and supply fell to a greater extent than the quantity of money and volume of spending. But irrespective of what might happen to production, supply, and prices, the same monetary contraction would cause the same reduction in sales revenues and, in the face of the same prior outlays of money showing up as costs, the same reduction in profits. And it would cause the same increase in the burden of repaying debt.

The point is that falling prices are simply not the cause of a plunge in profits and increase in the burden of debt. At most they can be the accompaniment of these things, when all three result from monetary contraction. But they need not even be an accompaniment. For the phenomena of plunging profits and a rising burden of debt, as I've just shown, can also be accompanied by rising prices—to the extent that a reduction in production and supply were to outstrip the reduction in money and spending.

What deserves special stress is the fact that even when falling prices are the result of monetary contraction, rather than increases in production and supply, and are accompanied by actual economic hardship rather than by general prosperity, their specific contribution to the situation is not only not that of cause, but of remedy. Falling prices in response to monetary contraction are precisely what enable a reduced quantity of money and volume of spending to buy as many goods and to employ as many workers as did the previously larger quantity of money and volume of spending. Preventing the fall in prices, including a fall in wage rates, serves only to prevent the restoration of production and employment.

Let me put it this way. Deflation is not falling prices. It is monetary contraction. Falling prices are necessary as a response to deflation, which is prior, and which exists whether prices do or do not fall, and can exist even if prices rise. Falling prices in response to deflation are economically beneficial, in that they enable a reduced quantity of money and volume of spending to buy as much as the previously larger quantity of money and volume of spending bought.

In other words, the effect of falling prices is always positive. They should not be confused with deflation or depression and are certainly not their cause. On the contrary, as we have seen, they are a remedy for the effects of deflation. And this is true even for debtors. It is not the level of prices that makes it difficult to repay a debt, but the amount of money one can earn in relation to the size of the debts one must pay. If the average member of the economic system can no longer earn as much money as he used to, and thus finds it more difficult to repay any given amount of money debt, then the fact that prices fall does not make him earn still less. Rather it enables his reduced spending power to buy more. His problem is in the relationship between the amount of money he can earn and the amount of money he must repay. His problem is not caused by a greater buying power of that money.

(And here one can see the macroeconomic absurdity of the New Deal measures in the Great Depression to achieve recovery by compelling the burning of potatoes, the plowing under of cotton, and the slaughter of piglets. Such measures had no power to increase sales revenues, profits, or the ability to repay debt in the economic system. At most, they could increase the sales revenues of selected groups, to the extent that the demand for their specific products was inelastic, and equivalently reduce sales revenues elsewhere in the economic system. Their effect on sales revenues was comparable to that of the so-called "oil shock" of the early 1970s, in which the sales revenues of the oil and other energy-producing industries rose, but at the expense of the sales revenues of the rest of the economic system, which correspondingly suffered. They had no overall, economy-wide effect on sales revenues, profits, or the ability to repay debts. All they served to accomplish on net balance was to make prices higher and reduce the buying power of the funds available—in other words, just to make life more difficult.)

Nor should the prospect of a fall in prices in and of itself be taken as the cause of an increase in the desire to save, still less of an increase in the demand for money for holding and thus of a monetary contraction. To the extent that falling prices are the accompaniment of greater prosperity, the prospect of falling prices is accompanied by the prospect of greater prosperity. The prospect of greater prosperity in the future provides an inducement to greater consumption in the present.

It should be understood as operating in the same way on present consumption as the prospect of coming into an inheritance. It means that one's future is better provided for and thus that one can afford to increase one's consumption and enjoyment in the present. This offsets the fact that every dollar withheld from present consumption will have greater buying power in the future. In other words, the effect of falling prices caused by increased production on the degree of saving and provision for the future should be assumed to be neutral, because the prospect of greater future buying power of the monetary unit is offset by the prospect of greater future prosperity. In such circumstances, the prospect of falling prices does not provide a basis for a rise in the demand for money for holding.

The case is different when the need for the fall in prices is caused by monetary contraction. In this case, the failure of prices to fall, in the face of the anticipation that they will fall, to the extent necessary to clear the market of unsold supplies of goods and labor, leads to a speculative postponement of purchases, which increases the pressure on prices to fall.[2] Once prices do fall to the necessary extent, that is the end of the contraction. Indeed, given the existence of a speculative withholding of purchases in anticipation of prices and wages falling to some necessary level, once that level is achieved, the speculative withholding of purchases comes to an end and there is an increase in the volume of spending. In other words, the response to the necessary fall in prices and wages is economic recovery.

Provided the quantity of money in the economic system does not decrease, a rise in the demand for money for holding can have the very beneficial effect of increasing the degree of financial liquidity in the economic system, a valuable point which Rothbard made.[3] It serves to improve such vital measures of financial health as the cash balances businesses hold relative to their current liabilities. It accomplishes this to the extent that it serves to bring down wage rates and prices and thus the dollar amount of current liabilities, which fall as the result of smaller outlays being made and thus smaller bills having to be paid.

  The higher is the degree of such financial liquidity, the less is the danger of insolvencies and bankruptcies and thus the greater is the security against any need for further increases in such cash holdings. The implication of this is that increases in the demand for money for holding are self-limiting, and that the demand for money for holding tends to stabilize at the higher level. There is no process of its feeding on itself and endlessly increasing.[4]

Indeed, what creates the need for a sudden, substantial increase in the demand for money for holding is the preceding artificial decrease in the demand for money for holding brought about by credit expansion. Credit expansion leads businessmen to believe that they can substitute for the holding of actual cash the prospect of easily and profitably borrowing the funds they might require. It also encourages a reduction in the demand for money for holding by means of the seeming ease with which inventories can be profitably sold in the face of the rising sales revenues it fuels, which makes it appear better to hold more inventory and less cash. The rise in interest rates that credit expansion serves to bring about in the course of its further progress, as rising sales revenues raise nominal profits and thus the demand for loanable funds, also serves to reduce the demand for money for holding. This is because the higher interest rates serve to make it worthwhile to lend out sums available for short periods of time that it would not have been worthwhile to lend out at lower interest rates. To these factors must be added the influence of any prospect of rising prices that credit expansion may create. And finally, the loss of capital that credit expansion engenders, as the result of the extensive malinvestment that it causes, serves to make credit less available and thus to create a still further demand for money for holding.[5]

Avoid inflation and credit expansion, let the demand for money for holding be high, let prices and wages be adjusted to that fact, and the economic system will be secure from sudden increases in the demand for money for holding thereafter.

Similarly, the best reason in favor of an actual decrease in the quantity of money is that suffering it may serve to avoid a greater, more severe decrease later on. This would be the case under a fractional-reserve gold standard that had not departed too radically from a one-hundred-percent-gold reserve. In such circumstances, a reduction in the quantity of money in the form of fiduciary media[6] could bring the quantity of money down to the supply of actual monetary gold and thus both retain the gold standard and avoid the need for a more severe and potentially catastrophic reduction in the quantity of money later on—the kind of reduction that occurred from 1929 to 1933, after decades of expanding the supply of fiduciary media relative to the supply of gold.

Deflation, which, it cannot be repeated too often, means monetary contraction, not falling prices, is at best in the category of a pain to be endured only in order to avoid greater pain later on. It should never be, and virtually never is, regarded as any kind of positive in its own right. Indeed, opposition to credit expansion, and to the fractional-reserve banking system that makes credit expansion possible, rests for the most part precisely on the fact they are responsible for deflation, which would not exist in their absence.

The most important point I have made, namely, that falling prices caused by increased production are not deflation and should never be confused with deflation, is illustrated by the following table, which can be taken as a summary of this article.





[1] This is something I've explained at length in my book Capitalism: A Treatise on Economics, pp. 544–46, 557–59, 573–80, 809–20 and in an article "The Goal of Monetary Reform," The Quarterly Journal of Austrian Economics, Fall 2000, vol. 3, no. 3, pp. 3–18.

[2] Concerning this point, see Ludwig von Mises, Human Action 3rd ed. rev.  (Chicago: Henry Regnery Company, 1966),  pp. 568–70; Murray N. Rothbard,  Man, Economy, and State (Princeton, New Jersey: D. Van Nostrand Company, Inc., 1962), pp. 112–14, 673–75.

[3] Murray N. Rothbard, What Has Government Done to Our Money? (Novato, California: Libertarian Publishers, 1964), pp. 14–16.

[4] See Rothbard, Man, Economy, and State, p. 675.

[5] On this last point, see Mises, op. cit., pp. 550–66, p. 568.

[6] Fiduciary media are transferable claims to standard money, in this case gold, that are payable on demand by the issuer and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists.

[7] This table is taken from my article "The Goal of Monetary Reform," The Quarterly Journal of Austrian Economics, Fall 2000, vol. 3., no. 3, p. 14.

This article originally appeared on web site of the Ludwig von Mises Institute on August 22, 2003.

*Copyright © 200? by George Reisman. All rights reserved.

**George Reisman, Ph.D., is professor of Economics at Pepperdine University’s Graziadio School of Business and Management and is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). 

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