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Consequences and Myths Concerning Deflation

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Book cover In Defense of Deflation

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

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Abstract

In order to understand the consequences of price deflation, many economists have focused on a macroeconomic aggregate: price levels. They have considered its declines and its relation to other aggregates like the gross domestic product (GDP). This procedure, however, obstructs the view of consequences apart from those aggregates that are more or less meaningful. In other words, the aggregates obstruct the view on individual human action. It is individual human actions in the first place that lead to exchanges of things and thus to exchange relationships, i.e. prices. Looking at the movements of a statistical price level obstructs the analysis of consequences of individual price changes on human action. To understand the consequences of price deflation one has to analyze the consequences of a decline of individual price changes. This is what price deflation really means: the fall of a significant portion of individual prices. Of course, prices are always the result of a complex market process. It is within this dynamic of human interactions that one can determine which prices fall first, which fall later, which fall faster, which fall slower and to which extent. Which companies or individuals make higher or lower profits in a price deflation depends on this dynamic.

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Notes

  1. 1.

    Salerno offers also an ethical argument in favor of a deliberate credit contraction induced by a central bank. He regards the fiduciary media issued by the banking system as “counterfeit property titles” (2003, p. 88). The destruction of those counterfeit property titles he regards as beneficial and an obligation of the central bank: “Similarly, in carrying out a contractionary monetary policy, the central bank is merely ceasing to violate its contractual obligation to maintain the integrity of its depositors’ titles to their stored money balances…” Salerno refers to the case of a commodity money. However, the argument can mutatis mutandis also be applied to a fiat money. He thinks, however, that a central bank in a fiat money regime would never adopt a contractionary policy. In a gold standard regime, Salerno (ibid.) also sees the contraction as a step in a transition process back to a 100 % commodity money.

  2. 2.

    See Hülsmann (1998).

  3. 3.

    See Rothbard (1991, p. 67).

  4. 4.

    See also Sect. 3.3.4 on this cumulative process.

  5. 5.

    See Huerta de Soto (2006a, b), Chaps. 1–4. See also Rothbard (1991, 1998) for a libertarian ethical theory that implies that fractional reserve banking is fraud.

  6. 6.

    See Huerta de Soto (2006a, p. 151). For a further discussion of the legal impossibility of a valid fractional reserve demand deposit contract see Bagus and Howden (2009, 2012a, 2013) and Bagus et al. (2013).

  7. 7.

    See Hülsmann (2003a, p. 58).

  8. 8.

    Hülsmann (2006, p. 66) speaks of an “creative destruction” reminiscence of Schumpeter.

  9. 9.

    See Hülsmann (2003a, p. 58).

  10. 10.

    Inflation allows the government to ignore fiscal resistance to its spending. This is especially important in times of war when governments hide the real costs of war by financing it via the printing press.

  11. 11.

    See, for instance, Carlson (2003).

  12. 12.

    See for instance Sect. 5.2 for the German bank credit deflation in the 1930s and the reduction of state expenditures like unemployment benefits, pension, state employee’s salaries, etc.

  13. 13.

    Hülsmann (2008, p. 16), therefore sates: “A frank and enthusiastic endorsement of deflation is, at any rate in our time, one of the most important requirements to safeguard the future of liberty.”

  14. 14.

    See Hülsmann (2006, pp. 175–181) for habits in price inflation.

  15. 15.

    Of course, a negative price premium could be factored into the interest rate. Nevertheless, debts become more unattractive when prices are expected to fall as it gets easier to finance through equity or retained earnings that keep increasing in purchasing power.

  16. 16.

    There are further implications of the lower debts. One can, for instance, maintain that, the higher the debt of a company, the higher the pressure on managers to work efficiently. One should keep in mind, though, that equity owners can control managers in different ways and provide them with incentives.

  17. 17.

    See also Sect. 2.5 on this.

  18. 18.

    See Svensson (2000, p. 31) or Bernanke (2002, p. 1).

  19. 19.

    See Meltzer (2000, p. 71) or Goodfriend (2001, p. 1).

  20. 20.

    Austrian economists, as well, diverge on the subject of deflation and some even propose an arsenal of interventions to fight it (Bagus 2003).

  21. 21.

    See Mises (1998, p. 10).

  22. 22.

    See also Borio and Filardo (2004, p. 7); also see Stamp who writes that “[deflation] brings about the worst type of redistribution of income” (1932, p. 5).

  23. 23.

    This has another implication. In an inflationary boom, the inequality in material wealth tends to increase, as some groups benefit at the cost of other groups. When those who profit in an inflationary boom suffer losses in a price deflation, the differences in material wealth are reduced.

  24. 24.

    For instance, Bernanke considers the problems for debtors who did not anticipate the deflation (2002).

  25. 25.

    See Hülsmann (2004, p. 45).

  26. 26.

    For a libertarian theory of ethics that considers all government interventions as unjust as they are based on the initiation of violence, see Rothbard (1998).

  27. 27.

    (Keynes [1931] 1963, p. 177; or King 1994, p. 422); Interestingly, Keynes, himself, summarizes here the liberating effects of deflation and admits that the financial system would be liquidated and “[i]ndividually many of us would be ‘ruined,’ even though collectively we were much as before.” ([1931], 1963, pp. 177–178).

  28. 28.

    Hicks (1946, p. 264) argues that the increased fear of bankruptcy in times of price deflation would have a negative output effect as debts are harder to pay back. Again, the money saved to be able to repay the increasing debt burdens might come from reducing consumption spending. Therefore, investment might actually increase relative to consumption spending. This would lead to a more capital intensive structure of production and a higher output.

  29. 29.

    See Delong (1999); For a similar view, see Keynes (1936).

  30. 30.

    An example is the information industry and computer industry in the last decades that were able make profits and thrive with falling selling prices.

  31. 31.

    Translation is from the German original (Mises 1931, p. 29).

  32. 32.

    See Rothbard (2000, p. 17).

  33. 33.

    It must be noted, that it is illusionary to measure the changes in the purchasing power of money. Every individual would need his own index, which would be constantly changing. For a critique of index numbers, see Mises (1998, pp. 221–224).

  34. 34.

    See Goodfriend (2001, p. 17); Cargill (2001, p. 116).

  35. 35.

    See Kent (1966, p. 458); On this point, also see, Bernanke (1981, p. 155).

  36. 36.

    On the subjective concepts of utility, value, costs, and benefits see Huerta de Soto (2001, pp. 41–50).

  37. 37.

    (1999, p. 961); Also, Bernanke states that “[a]ministrative and legal expenses in bankruptcy are substantial.” (1981, p. 155)

  38. 38.

    Governments actually did that before. See Hamburger (1933) for blanke measures during the German Great Depression.

  39. 39.

    It is true that the expansion of the legal sector bidding away factors of production from other ventures implies a reduction of other sectors. Real income in terms of goods and services other than legal services, therefore, falls slightly in the short-term. But this is not the end of the story. We should also keep in mind, that the medium and long-term growth prospects are greatly enhanced by these mass bankruptcies. People will be less willing to accept fiat money inflation and to incur in debts. The size of the state may be reduced significantly. There may even arise a free market monetary system.

  40. 40.

    Colander (1995, p. 519); See also Hahn (1956) for this argument.

  41. 41.

    For more intensive accounts of the Austrian business cycle theory, see: Rothbard (2001) and Rothbard (2000, Part I), and Mises (1998) and Huerta de Soto (2006b).

  42. 42.

    See Shiratsuka (2000, p. 16) or Dowd (1995, p. 722).

  43. 43.

    Hayek (1979, p. 15).

  44. 44.

    For a discussion of price stickininess as a justification of credit expansion by a fractional reserve banking system see Bagus and Howden (2011, 2012b).

  45. 45.

    It is also possible that a worker is still in the process of searching for better job opportunities.

  46. 46.

    Translation of the German original (Mises 1931, pp. 29–30).

  47. 47.

    This Keynesian reasoning is wrong, because an increase in the money supply through the loan market does not lead to more investments in form of real resources, but to malinvestments of these resources and higher nominal spending.

  48. 48.

    It might be added, that it is contradictory to add as the costs of deflation both unemployment induced by wage rigidity and a fall in investments due to increases in the real interest rate (See Borio and Filardo 2004, p. 8). Only when the deflation is unexpected, wages will be too high due to price deflation. And only if there are deflationary expectation, real interest rates increase above the nominal rate.

  49. 49.

    See Rothbard (2000, p. 40).

  50. 50.

    See also Svensson: “Fourth, and arguably equally important, the ineffectiveness of monetary policy removes all possibilities of using monetary policy for stabilization purposes” (2000, p. 29). It is hard to see why that would be bad, since “monetary policy for stabilization purposes” simply stands for interfering with market adjustments. And from the assumption that monetary policy making in times of deflation might be complicated, it does not follow that deflation is bad and must be prevented.

  51. 51.

    Most writers still see a way to expand credit and get out of the liquidity trap. Finding a way out of the liquidity trap is actually the task that most writers want to solve. See, for instance, Goodfriend (2001, p. 24) and Cargill (2001, p. 131).

  52. 52.

    It might be better to call the situation a illiquidity trap, since overindebted agents regard themselves as illiquid.

  53. 53.

    White (2005) describes the Federal Reserve System’s influence on monetary research. He shows, that in 2002 the great majority of articles on monetary policy were published in FED journals or are co-authored by FED staff economists.

  54. 54.

    It is irrelevant if the price deflation had been anticipated. Debtors (and creditors) lose (and win) relative to a situation where prices had not fallen. They oppose the price deflation even though they anticipated it, because they lose relative to a scenario with higher prices.

  55. 55.

    See Selgin (1997, p. 42).

  56. 56.

    See on this point also Hülsmann (2008, p. 27). Felix Somary (1959, p. 185) makes a similar argument comparing the visibility of the costs of inflation and default.

  57. 57.

    Public choice literature emphasizes the costs of organizing an interest group in order to seek wealth transfers through state intervention or to defend them against it. See Robert Ekelund, Jr. and Robert Tollison (2001). If the burden is spread on few shoulders it is easier to organize interest groups that seek wealth transfers because there is a higher incentive to do so. The protest against price deflation is also relatively easy to organize when, there is already an organized group, that is used for other purposes. See on this also the following section.

  58. 58.

    For the public choice literature on the question why some groups can easier organize for rent-seeking purposes and have a higher influence than others, see for instance, Gordon Tullock (1967) or Mancur Olson (1971).

  59. 59.

    See for instance Olson (1971, pp. 5–52).

  60. 60.

    Olson (1971, p. 132) explains that the free rider problem can be overcome in large groups if they offer as a “by-product” services from which non-members can be excluded. For farmers these services could be farming magazines, educational services etc.

  61. 61.

    See Olson (1971, p. 143).

  62. 62.

    Hülsmann (2012, p. 99) points to the fact that politicians of all parties independent of their ideology and notwithstanding their differences in other areas always coincide in their opposition to price deflation.

  63. 63.

    It is true that banks being creditors also on the winning side in a price deflation. However, when a home owner defaults on his mortgage and the bank has to take over the house it suffers normally losses, especially in an environment where housing prices are falling sharply. A higher real debt burden tends to coincide with losses on banks’ asset in a harsh price deflation caused by credit contraction.

  64. 64.

    Bordo et al. argue that possibly this was the case for the 1880s and 1890s (2004, p. 16).

  65. 65.

    This is not necessarily so in all deflation cases. In a growth deflation for instance, income in nominal terms might not fall for everyone as production is increased. Workers’ discounted marginal value productivity (DMVP) might be constant as physical productivity increases. On the concept of DMVP see Rothbard (2001, pp. 387–409).

  66. 66.

    See Stolper (1966, p. 137).

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    Philipp Bagus

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Bagus, P. (2015). Consequences and Myths Concerning 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_4

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