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Economic Theories of Deflation

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In Defense of Deflation

Part of the book series: Financial and Monetary Policy Studies ((FMPS,volume 41))

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Abstract

Many economists have written about deflation or touched upon the subject in passing while focusing on their development of related monetary theories. My aim in this chapter is not to comment on every reference concerning the subject of falling prices. This endeavor would be virtually impossible. Rather, I provide an overview of the main currents and changes in economic theories of deflation. This overview aids in explaining how and when theories of deflation in economic thought were formed and why views on deflation have changed. To explain why certain theories of deflation and deflation phobia have emerged, I place special emphasis on the circumstances and backgrounds of these deflation theorists. My exposition of the theories of deflation proceeds mainly in chronological order; however, at times I will group theorists with similar views together, though they may not be contemporaries of each other.

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Notes

  1. 1.

    For example, John Locke argued that the money supply was irrelevant as any amount of money would be sufficient for the needs of trade (Locke [1691] 1824, p. 48).

  2. 2.

    Viner ([1937] 1975, p. 6).

  3. 3.

    See Viner ([1937] 1975, pp. 36–37). These two authors, not surprisingly, were also advocates of paper money. Concerning two strands of mercantilists, see p. 40; See Rothbard concerning Law (2006a, p. 330) and concerning Potter’s opposition to hoarding and of Potter as proposing one of the most odd theories of price deflation (p. 328). In one of the most curious lines of reasoning in the history of economic thought, Potter claimed that an increase in the amount of money could stimulate production to an extent that prices would fall. He obviously, did not see any problems in a price deflation stemming from monetary inflation.

  4. 4.

    Manley (1669, p. 53).

  5. 5.

    (Viner [1937] 1975, pp. 45–46); Later, when mercantilism was already in retreat, David Hume would still condemn state hoarding as “a practice which we should all exclaim against as destructive, namely, the gathering of large sums into a public treasure, locking them up, and absolutely preventing their circulation” ([1752] 1826b, p. 361).

  6. 6.

    (Viner [1937] 1975, pp. 8–9, 23–24, 26, 49); Even though neither were mercantilists, both Richard Cantillon and Jacob Vanderlint advised the king to hoard money in order to keep prices low and competitive. See Rothbard (2006a, pp. 333–334).

  7. 7.

    “The doctrine of thrift also led to emphasis on the importance of a favorable balance of trade through another chain of reasoning” (Viner 1975, p. 30) Viner explains that “[t]he disparagement of consumption and the exaltation of frugality and thrift were common doctrines of the period, not wholly dependent upon economic reasoning but deriving much of their vitality from moral and religious principles and class prejudices. The Puritans disapproved of luxury…” (p. 26).

  8. 8.

    (Cantillon [1755] 1959, pp. 159–199); Cantillon wrote his treatise around 1730, but it was not published until 1755.

  9. 9.

    Hume ([1752] 1826a, pp. 326–327).

  10. 10.

    Hume ([1752] 1826a, p. 329).

  11. 11.

    (Hume [1752] 1826b, p. 351); Hume’s reasoning that prices would fall proportionately must be criticized. Even though all individuals would lose nominal money proportionately they might react quite differently to that incident. He does not concentrate on the dynamic processes that are caused by reductions or injections of money in the real world but only on the long run price equilibria.

  12. 12.

    Hume ([1752] 1826a, p. 324).

  13. 13.

    Hume ([1752] 1826a, pp. 324–325).

  14. 14.

    See Rothbard (2006b, p. 218).

  15. 15.

    See Rothbard (2006b, p. 219).

  16. 16.

    This is, of course, not necessarily so, but might be valid as a historical judgment for many individual cases.

  17. 17.

    See Humpfrey (2004, p. 17).

  18. 18.

    Smith ([1776] 1976), Book I Ch. I.

  19. 19.

    Smith ([1776] 1976), Book II, Introduction.

  20. 20.

    Smith ([1776] 1976, p. 356).

  21. 21.

    Ricardo ([1817] 1973), Chap. VII.

  22. 22.

    Ricardo [1817] 1973), Chap. XXI.

  23. 23.

    Ricardo ([1817] 1973), Chap. XXXI.

  24. 24.

    Ricardo ([1817] 1973), Chap. XXX, XXXI.

  25. 25.

    See Rothbard (2006b, pp. 203–205).

  26. 26.

    See Rothbard (2006b, p. 204).

  27. 27.

    See Rothbard (2006b, p. 205).

  28. 28.

    Bankers fear price deflation because it may lead to defaults of their clients on loans and, thereby, losses.

  29. 29.

    See Rothbard (2006b, p. 205).

  30. 30.

    See Fetter (1964, p. Viii).

  31. 31.

    David Laidler (2000, p. 17) comes to a similar conclusion and explains the deflation aversion by Thomas Attwood and interest groups with ties to steel and agriculture as follows: “Agriculture was faced with foreign competition again [after the end of the Napoleonic Wars], while small arms manufacturing and the metal working trades associated with it saw a precipitous decline in demand for their output. In view of this, it was perhaps to be expected that the representatives of agricultural interests in Parliament were sometimes found attempting to obstruct the restoration of convertibility and the deflation that had to accompany it. Nor, since metal working was concentrated around Birmingham, is it surprising that this important city became the centre of a dissenting and, for its time, quite radical body of economic thought. The principal, and certainly the most able spokesman of so-called Birmingham School at this time was the banker Thomas Attwood.” (Italics in the original)

  32. 32.

    Again, Attwood is speaking here in his own economic interest as he was himself a debtor. As Fetter, states: “As early as 1836, when the elder Matthias Attwood died, not only did the Attwoods have no net capital in the bank, but they were heavily in debt to it” (1964, Xxvii).

  33. 33.

    Quoted in Viner (1975, p. 186); italics in the original.

  34. 34.

    See Humpfrey (2004, p. 28).

  35. 35.

    See Viner (1975, p. 187).

  36. 36.

    Similar sticky price arguments are employed by C.C. Western, George Julius Poulett Scrope (1797–1876), Thomas R. Malthus (1766–1834) and Henry Thornton (1769–1815). For the first three, see Viner (1975, p. 187), fn. 3. See also Thornton ([1802] 1978, p. 119).

  37. 37.

    See Fetter (1942, pp. 358, 361).

  38. 38.

    Wheatley (1816), A Letter to Lord Grenville on the Distress of the Country, p. 29 as quoted in Fetter (1942, p. 374).

  39. 39.

    See Humpfrey (2004, pp. 20–22).

  40. 40.

    See Rothbard (2006b, p. 175). In the famous Bullion Report, Thornton also argues for a devaluation of the pound to prevent a price deflation. See Rothbard (2006b, p. 195).

  41. 41.

    George Julius Poulett Scrope, a son of a merchant, also married into an aristocratic family.

  42. 42.

    See Rothbard (2006b, p. 209).

  43. 43.

    As indicated above, Ricardo, in his theoretical long-term analysis, is not deflation-phobic. Only when it comes to practical policies in his time, does he become somewhat deflation-phobic.

  44. 44.

    See Rothbard (2006b, p. 207).

  45. 45.

    Ricardo ([1821] 2004, p. 73).

  46. 46.

    Also, Jean-Baptiste Say opposed the return to the old parity. He uses a legal argument, stating that debtors had to pay more than they owed if they had to pay back with the old parity. See Rist (1966, p. 184).

  47. 47.

    See Humphrey (2004, pp. 23–24).

  48. 48.

    Concerning manufacturing and agricultural interest groups, see Rothbard (2006b, p. 206). For instance, the landed aristocrat, the Earl of Carnavon denounced the Resumption Act of 1819, as well as lower farming prices, calling for monetary expansion and fiscal policies as a remedy.

  49. 49.

    See Humphrey (2004, pp. 38–39).

  50. 50.

    Mill ([1848] 1965), Book I, Chap. VIII.

  51. 51.

    Mill ([1848] 1965), Book I, Chap. IX.

  52. 52.

    Mill ([1848] 1965), Book IV, Chap. II.

  53. 53.

    Marshall (1920), Book VI, Chaps. XII and XIII.

  54. 54.

    Concerning Wicksell’s treatment of deflation, see Bioanovsky (1998).

  55. 55.

    An announced deflation cannot be gradual according to Gustav Cassel who argued that when a central bank would announce such a policy, demand would immediately contract and accelerate the fall in prices. The central bank would lose the control of the pace of the process. See Bioanovsky (1998, p. 248).

  56. 56.

    See Boianovsky (1998).

  57. 57.

    See Selgin (1995, p. 707).

  58. 58.

    This implies that the productivity norm goes back to times of classical economics. It is discussed in this paragraph because in neoclassical economics, the productivity norm still plays a prominent role.

  59. 59.

    See Selgin (1995, pp. 708–709).

  60. 60.

    See Selgin (1995).

  61. 61.

    See Selgin (1995, pp. 714–715).

  62. 62.

    See Selgin (1995, p. 717).

  63. 63.

    Pigou plays another important role in respect to deflation theories as the “Pigou-effect” is named after him. In a 1943 article “The Classical Stationary State,” Pigou argues that if the price level falls, real wealth, defined as government bonds and money supply divided by the price level, increases. Feeling richer (“wealth effect”), economic agents would increase consumption and thereby stimulating output and employment. The Pigou-effect was intended as a critique of Keynes’ General Theory. Through price deflation and the “wealth effect” an economy would be self-correcting when aggregate demand falls.

  64. 64.

    See the second edition of Prices and Production (von Hayek 1939, p. 124). Concerning the evolution of Hayek on this point from a proponent of a constant money supply to a proponent of policies which advocate adjusting the money supply to changes in the velocity of money, see Selgin (1999).

  65. 65.

    See Selgin (1995). The list given by Selgin must be considered with caution. It is true that the mentioned authors saw no problems in a price deflation caused by economic growth. However, not all of them explicitly follow Selgin in his view that changes in the demand for money must be necessarily counteracted by monetary policy. As one example, see Hayek in his earlier works.

  66. 66.

    See Selgin (1995, p. 705). According to Hülsmann (2006, p. 72), St. Thomas Aquinas was the first philosopher who postulated a stable purchasing power of money.

  67. 67.

    See Selgin (1995, pp. 706–707) and Dowd (1995).

  68. 68.

    Josiah Stamp is such a case (Stamp 1932).

  69. 69.

    See Rothbard (2002, pp. 453–456).

  70. 70.

    Another case is Clark Warburton. See Cargill (1979, pp. 439–440). Warburton argues that prices are sticky in the short run, especially wages. A decrease in the money supply or a failure to adopt the money supply to decreases in the velocity of circulation means a decrease in spending. Due to sticky wages, this leads to a decrease in business profits and, thus, to a further fall in total spending.

  71. 71.

    The concept of the liquidity trap was formalized in Hicks’ (1937) classic article “Mr. Keynes and the ‘Classics:’ A Suggested Interpretation.” The term liquidity trap, however, was first coined by Dennis Robertson, although in a different context. See Boianovsky (2004, p. 92).

  72. 72.

    (Keynes [1923] 2000, p. 143); Italics are in the original.

  73. 73.

    (Keynes [1923] 2000, p. 39); Italics are in the original.

  74. 74.

    See Keynes ([1923] (2000, p. 143); See also Keynes ([1925] 1963, p. 247).

  75. 75.

    See Keynes ([1923] 2000, p. 40); Italics are in the original. See also p. 4.

  76. 76.

    Keynes ([1936] 1964, p. 271, 291).

  77. 77.

    See Skidelsky (2002, p. 99).

  78. 78.

    See Keynes (1964, pp. 344–345).

  79. 79.

    See Keynes (1964, p. 30).

  80. 80.

    See Keynes (1964, p. 207). Later this concept became famously known or described as the liquidity trap. For Keynes, the liquidity preference and propensity to hoard are essentially the same thing (1964, p. 208).

  81. 81.

    See Friedman (1968, p. 3) or Friedman and Schwartz (1971, p. 407).

  82. 82.

    This is the difference of Selgin’s position as compared to the view of the zero inflationists who advocate reducing any change in the general price level no matter what its cause is.

  83. 83.

    For a book of selected essays that stand in this tradition, see Burdekin and Siklos (2004a). Good deflation is caused by a positive supply shock and bad deflation by a negative demand shock. In particular, see the Burdekin and Siklos (2004b) and Bordo and Redish (2004).

  84. 84.

    See Kumar and colleagues (2003, p. 5 or p. 9). On p. 12, these authors state that temporary price declines due to economic growth may not entail significant costs. This seems to imply that even with a positive supply shock, significant costs might exist.

  85. 85.

    See Kumar et al. (2003, p. 13); Krugman (1998, p. 137).

  86. 86.

    See Krugman (1998), Goodfriend (2000), Svensson (2003), and Leigh (2004).

  87. 87.

    Svensson (2003, p. 147); It should be pointed out that by criticizing the negative consequences of deflation, Svensson takes a stand against all kinds of deflation. For instance, a positive supply shock, or more specifically, continuous economic growth, might cause a prolonged price deflation also.

  88. 88.

    For example, Svensson (2000, p. 30), justifies an inflation targeting of 2 % instead of 0 % by the allegedly negative effects of price deflation. Krugman (1998, p. 161), even argues that when an economy is in a liquidity trap, it is stuck there, because the “economy needs inflation.” He, p. 181, suggests a price inflation rate of 4 % for 15 years for Japan.

  89. 89.

    See Bordo et al. (2004, p. 15). This is the main difference between the two groups. The liquidity trap group does not differentiate between causes of price deflation, but, in contrast, states that “[d]eflation is, in almost all cases, a side effect of a collapse of aggregate demand—a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers” (Bernanke 2002, p. 2).

  90. 90.

    Rational expectation theorists like Sargent and Wallace (1976, p. 175) argue that fully anticipated price changes would not have any effect on the real economic activity. This implies that a fully anticipated price deflation would have no adverse effect on economic activity. The public’s expectations are “rational” if they “are formed using the appropriate data and objective probability distributions” (p. 175). The view that an expected deflation would be “neutral” to the economic progress is widely held today.

  91. 91.

    See Bordo and Filardo (2004, p. 7); and (2005, p. 1).

  92. 92.

    See Sect. 5.1.7.

  93. 93.

    See also Bordo and Filardo (2005, p. 811).

  94. 94.

    Those economists regard price stability as dangerous for monetary policy due to the liquidity trap problematic. They argue for a positive inflation rate. See Goodfriend (2000, p. 1007).

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    Philipp Bagus

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Bagus, P. (2015). Economic Theories of Deflation. In: In Defense of Deflation. Financial and Monetary Policy Studies, vol 41. Springer, Cham. https://doi.org/10.1007/978-3-319-13428-4_2

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