Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Silver Bull Market Update - 7th Aug 20
This Inflation-Adjusted Silver Chart Tells An Interesting Story - 7th Aug 20
The Great American Housing Boom Has Begun - 7th Aug 20
NATURAL GAS BEGINS UPSIDE BREAKOUT MOVE - 7th Aug 20
Know About Lotteries With The Best Odds Of Winning - 7th Aug 20
Could Gold Price Reach $7,000 by 2030? - 6th Aug 20
Bananas for All! Keep Dancing… FOMC - 6th Aug 20
How to Do Bets During This Time - 6th Aug 20
How to develop your stock trading strategy - 6th Aug 20
Stock Investors What to do if Trump Bans TikTok - 5th Aug 20
Gold Trifecta of Key Signals for Gold Mining Stocks - 5th Aug 20
ARE YOU LOVING YOUR SERVITUDE? - 5th Aug 20
Stock Market Uptrend Continues? - 4th Aug 20
The Dimensions of Covid-19: The Hong Kong Flu Redux - 4th Aug 20
High Yield Junk Bonds Are Hot Again -- Despite Warning Signs - 4th Aug 20
Gold Stocks Autumn Rally - 4th Aug 20
“Government Sachs” Is Worried About the Federal Reserve Note - 4th Aug 20
Gold Miners Still Pushing That Cart of Rocks Up Hill - 4th Aug 20
UK Government to Cancel Christmas - Crazy Covid Eid 2020! - 4th Aug 20
Covid-19 Exposes NHS Institutional Racism Against Black and Asian Staff and Patients - 4th Aug 20
How Sony Is Fueling the Computer Vision Boom - 3rd Aug 20
Computer Gaming System Rig Top Tips For 6 Years Future Proofing Build Spec - 3rd Aug 20
Cornwwall Bude Caravan Park Holidays 2020 - Look Inside Holiday Resort Caravan - 3rd Aug 20
UK Caravan Park Holidays 2020 Review - Hoseasons Cayton Bay North East England - 3rd Aug 20
Best Travel Bags for 2020 Summer Holidays , Back Sling packs, water proof, money belt and tactical - 3rd Aug 20
Precious Metals Warn Of Increased Volatility Ahead - 2nd Aug 20
The Key USDX Sign for Gold and Silver - 2nd Aug 20
Corona Crisis Will Have Lasting Impact on Gold Market - 2nd Aug 20
Gold & Silver: Two Pictures - 1st Aug 20
The Bullish Case for Stocks Isn't Over Yet - 1st Aug 20
Is Gold Price Action Warning Of Imminent Monetary Collapse - Part 2? - 1st Aug 20
Will America Accept the World's Worst Pandemic Response Government - 1st Aug 20
Stock Market Technical Patterns, Future Expectations and More – Part II - 1st Aug 20
Trump White House Accelerating Toward a US Dollar Crisis - 31st Jul 20
Why US Commercial Real Estate is Set to Get Slammed - 31st Jul 20
Gold Price Blows Through Upside Resistance - The Chase Is On - 31st Jul 20
Is Crude Oil Price Setting Up for a Waterfall Decline? - 31st Jul 20
Stock Market Technical Patterns, Future Expectations and More - 30th Jul 20
Why Big Money Is Already Pouring Into Edge Computing Tech Stocks - 30th Jul 20
Economic and Geopolitical Worries Fuel Gold’s Rally - 30th Jul 20
How to Finance an Investment Property - 30th Jul 20
I Hate Banks - Including Goldman Sachs - 29th Jul 20
NASDAQ Stock Market Double Top & Price Channels Suggest Pending Price Correction - 29th Jul 20
Silver Price Surge Leaves Naysayers in the Dust - 29th Jul 20
UK Supermarket Covid-19 Shop - Few Masks, Lack of Social Distancing (Tesco) - 29th Jul 20
Budgie Clipped Wings, How Long Before it Can Fly Again? - 29th Jul 20
How To Take Advantage Of Tesla's 400% Stock Surge - 29th Jul 20
Gold Makes Record High and Targets $6,000 in New Bull Cycle - 28th Jul 20
Gold Strong Signal For A Secular Bull Market - 28th Jul 20
Anatomy of a Gold and Silver Precious Metals Bull Market - 28th Jul 20
Shopify Is Seizing an $80 Billion Pot of Gold - 28th Jul 20
Stock Market Minor Correction Underway - 28th Jul 20
Why College Is Never Coming Back - 27th Jul 20
Stocks Disconnect from Economy, Gold Responds - 27th Jul 20
Silver Begins Big Upside Rally Attempt - 27th Jul 20
The Gold and Silver Markets Have Changed… What About You? - 27th Jul 20
Google, Apple And Amazon Are Leading A $30 Trillion Assault On Wall Street - 27th Jul 20
This Stock Market Indicator Reaches "Lowest Level in Nearly 20 Years" - 26th Jul 20
New Wave of Economic Stimulus Lifts Gold Price - 26th Jul 20
Stock Market Slow Grind Higher Above the Early June Stock Highs - 26th Jul 20
How High Will Silver Go? - 25th Jul 20
If You Own Gold, Look Out Below - 25th Jul 20
Crude Oil and Energy Sets Up Near Major Resistance – Breakdown Pending - 25th Jul 20
FREE Access to Premium Market Forecasts by Elliott Wave International - 25th Jul 20
The Promise of Silver as August Approaches: Accumulation and Conversation - 25th Jul 20
The Silver Bull Gateway is at Hand - 24th Jul 20
The Prospects of S&P 500 Above the Early June Highs - 24th Jul 20
How Silver Could Surpass Its All-Time High - 24th Jul 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

Deflation is No Mystery Except to Most Economists

Economics / Deflation Jun 11, 2007 - 11:31 AM GMT

By: Gerard_Jackson

Economics That the great body of economists think that a fall in general prices is deflationary by definition and a clear indicator of an impending recession tells us how much this phenomenon is misunderstood. On the basis of this understanding central banks have implemented price stabilisation policies which in themselves carry the seeds of future recessions. The situation is so bad in the economics profession that I am inclined to go so far as to suggest that only a handful of economists actually know what deflation really means. (Classical economists had no such difficulty).


The basic problem is that deflation has been associated with a general fall in prices to the extent that today's economists unthinkingly link falling prices to recessions. (Up to the early 1930s depressions were always accompanied by falling prices. Today, Keynesian economics has managed to give us rising prices with recessions).

The main error behind much of this thinking is rooted in a misreading of nineteenth century price movements. Many in the economics profession have noted that nineteenth century Britain experienced 50 years of falling prices, even though living standards rose at an unprecedented rate. From 1875 to 1895 wholesale prices fell by about 45 per cent while industrial output and real wages continued to rise.

Presto! conclude some financial advisers, deflation is not a real danger. Unfortunately for them they are not describing deflation. Prices fell in nineteenth century Britain because productivity outstripped the money supply. Because prices were flexible and price changes fairly slow wages and costs adjusted themselves easily to the monetary situation. This meant that as output grew faster than the money supply prices not only fell but the benefits of increasing productivity were more evenly spread.

Milton Friedman was a very persuasive supporter of the apparent need for central banks to stabilise the purchasing power of the currency through the use of the price rule concept. (Expanding the money supply at a rate that is supposed to maintain a constant purchasing power by preventing prices from falling). According to Friedman this monetary policy was necessary to prevent recessions from emerging. Yet the very same Friedman could write that

[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United states to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible. (Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867-1960 , Princeton, N.J.: Princeton University Press, 1971, p. 15).

The Austrian insight that money is not neutral was completely disregarded. (In fact, the idea that money was far from being neutral -- meaning that it did not influence individual prices -- was discussed by the participants in the bullion controversy). During the 1920s qualitative economists like Benjamin M. Anderson, Ludwig von Mises and Frederich von Hayek pointed out that the Fed's attempt to stabilise the so-called price level was concealing enormous "imbalances" created by excess credit, and that these "imbalances" would eventually have to be liquidated once the economy went into an unavoidable recession. Keynes, however, strongly disagreed, stating that the Federal Reserve Board's monetary management was a "triumph". It was pointed out later on in the depression that the current

...difficulties are viewed largely as the inevitable aftermath of the world's greatest experiment with a "managed currency" within the gold standard, and, incidentally, should provide interesting material for consideration by those advocates of a managed currency which lacks the saving checks of a gold standard to bring to light excesses of zeal and errors of judgment. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle , Macmillan and Company 1937, p. 56).

On the other hand, deflation occurs where the absolute quantity of money shrinks. This means that prices must now fall if the number of transactions is not to contract. Of course, true deflations are always accompanied by depressions because what is contracting is not notes or coins, i.e., cash, but fictitious bank deposits, the product of credit expansion produced by a fractional reserve banking system.

These expansions sparked off a boom and misdirected production. Eventually the boom went bust, credit contracted and the economy fell into depression. Hence falling prices caused by deflation are money induced; falling prices caused by productivity outstripping the money supply are goods induced. Confusing these two phenomena could have dangerous consequences.

It has been argued that to allow prices to fall indefinitely would cause interest to fall close to zero and thus make it impossible for a government to use interest rate cuts to stimulate economic activity. This is just pure nonsense. Interest is a product of time preference. For it to fall to zero people would literally have to give up every kind of current consumption in favour of distant consumption. Not a very practical thing to do. If, for example, the social rate of time preference remained unchanged, falling prices would lead to a nominal fall in interest rates while the real rate would remain unchanged. This means that if time preference brings about a 5 per cent interest rate then a an annual 2 per cent price fall would create a nominal 3 per cent interest rate.

In any case, falling prices would eventually see the market respond by expanding the money supply as it did in the nineteenth century. What our commentators also overlook is that falling prices raise the price/value of money. The nineteenth century fall in prices raised the value of gold, stimulating gold prospecting and the means to extract gold from low-grade ores. Falling prices caused by rising productivity are to be welcomed. Falling prices caused by deflation is the fruit of a badly mismanaged monetary policy that brought on a depression. I know which one I prefer.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules