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
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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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.
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
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.
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
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 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.
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.
Murray N. Rothbard, What Has
Government Done to Our Money? (Novato, California:
Libertarian Publishers, 1964), pp. 14–16.
See Rothbard, Man, Economy, and
State, p. 675.
On this last point, see Mises, op.
cit., pp. 550–66, p. 568.
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.
This table is taken from my article
Goal of Monetary Reform," The Quarterly Journal of
Austrian Economics, Fall 2000, vol. 3., no. 3, p. 14.