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Is Deflation Really Bad for the Economy?

Economics / Deflation Aug 12, 2010 - 03:56 AM GMT

By: Frank_Shostak

Economics

Best Financial Markets Analysis ArticleOn Friday, July 30, the St. Louis Federal Reserve Bank president, James Bullard, speaking on CNBC television, said that the Fed must weigh medium-term inflation risks against near-term deflation risks. For most economists and commentators, a general fall in prices, which they label deflation, is a terrible thing. They hold that a fall in prices generates expectations for a further decline in prices. As a result of this, consumers postpone their buying of goods at present because they expect to buy these goods at lower prices in the future. Consequently, this weakens the overall flow of spending, and that in turn weakens the economy.


A fall in consumer expenditure subsequently not only weakens overall economic activity but also puts further pressure on prices, so it is argued. Note that from this it follows that deflation causes a spiraling decline in economic activity.

From this way of thinking, one could conclude that a general fall in prices should be associated with an economic slump. Indeed, during 1932, the fall in the CPI of 10.3% was associated with a fall in industrial production of 21.6%. But is it true that a fall in prices should always be bad news for the economy?

Take, for instance, a case where a general fall in prices results from an expansion in the production of goods and services. Why should this be classified as bad news? On the contrary, every holder of money can now command a larger quantity of goods and services; therefore, people's living standards are going up — so what is wrong with that?

Does a General Fall in Prices Cause People to Postpone Buying?

If prices are trending down, does it mean that people will stop buying at present? As a rule, most individuals are trying to maintain their life and well-being. This of course means that they will not postpone their buying of goods at present.

For instance, since January 1998 the price of personal computers has fallen by 93%. Did this fall in prices cause people to postpone buying personal computers? Not at all. Consumer outlays on personal computers have increased by over 2,700% since January 1998.

Now, if deflation leads to an economic slump, then, following the logic of the popular thinking, policies that reverse deflation should be good for the economy. Since reversing deflation means introducing policies that boost a general increase in the prices of goods — inflation — this means that inflation could actually be an agent of economic growth.

For most experts, a little bit of inflation can actually be a good thing. Hence they would like the Fed to generate an inflation "buffer" to prevent the economy from falling into a deflationary black hole. They hold that a rate of inflation of around 3% could be the appropriate protective "buffer." It is held by mainstream thinkers that inflation of 3% is not harmful to economic growth, but inflation of 10% could be bad news.

In this way of thinking, at an inflation rate of 3%, consumers will not postpone their spending on goods and hence will not set in motion an economic slump. But then, at a 10% rate of inflation, it is likely that consumers are going to form rising inflation expectations. According to the popular thinking, in response to a high rate of inflation consumers will speed up their expenditure on goods at present, which should boost the economic growth. So why, then, is a rate of inflation of 10% or higher regarded by experts as a bad thing? Clearly this type of thinking is problematic.[1]

A General Fall in Prices and the Money Supply

A general fall in prices can also emerge as a result of a fall in the money stock. An important cause for such a fall is a decline in fractional-reserve lending. The existence of a central bank and of fractional-reserve banking permits commercial banks to generate credit not backed up by real savings, i.e., credit created out of thin air. Once the unbacked credit is generated, it creates activities that the free market would never support — activities that consume, and do not produce, real wealth. As long as the pool of real savings is expanding and banks are eager to expand credit, various false activities continue to prosper.

Whenever the extensive creation of credit out of thin air lifts the pace of real-wealth consumption above the pace of real-wealth production, this undermines the pool of real saving. Consequently, the performance of various activities starts to deteriorate, and bank's bad loans start to rise. In response to this, banks curtail their loans by not renewing maturing loans and this in turn sets in motion a decline in the money stock.[2]

The point that must be emphasized here is that the fall in the money stock that precedes price deflation and an economic slump is actually triggered by the previous loose monetary policies of the central bank and not by the liquidation of debt.

It is loose monetary policy that provides support for the creation of unbacked credit. Without this support, banks would have difficulty practicing fractional-reserve lending.

The unbacked credit in turn leads to the reshuffling of real savings from wealth generators to non–wealth generators. This in turn weakens the ability to grow the pool of real savings, which in turn weakens economic growth.

It must also be emphasized here that government outlays are another important factor undermining the pool of real savings. The larger the outlays are, the more real savings are diverted from wealth generators.

"Under deflation, it is those non–wealth generating activities that end up having the most difficulties in serving their debt, because these activities were never generating any real wealth and were really supported or funded, so to speak, by genuine wealth generators."

Many commentators, including Bernanke, are of the view that a fall in prices raises the debt burden and causes consumers to repay their debt much faster. Rather than using the money in their possession to buy goods and services, consumers use a larger portion of their money to repay their debt.[3]

In this way of thinking, a continuous debt liquidation could put severe pressure on the money stock and in turn on household demand for goods and services. All this, Bernanke believes, could lead to a prolonged decline in the price level. A fall in the price level in turn raises the debt burden and leads to a strengthening in the process of debt liquidation. Hence, to prevent this downward spiral, Bernanke recommends aggressive monetary pumping by the central bank.

Again, the debt liquidation and emerging price deflation are not the causes of the economic slump but the necessary outcomes of the previous loose monetary policies of the Fed, which have weakened the pool of real savings. Also note that it is not a fall in prices as such but instead the declining pool of real savings that raises the debt burden and intensifies price deflation. The declining pool weakens the process of real-wealth generation and in turn weakens borrowers' ability to serve the debt.

Similarly, it is not increases in real interest rates, as suggested by many commentators, but a shrinking pool of real savings that undermines real economic growth. On the contrary, increases in real interest rates put things in proper perspective and arrest the wastage of scarce real savings, thereby helping the real economy.

Now if the pool of real savings is falling, then even if the Fed were to be successful in dramatically increasing the money supply and increasing the price level, i.e., countering deflation, the economy would still follow the declining pool of real savings.

Contrary to the popular view, in this situation the more money the Fed pushes into the economy, the worse the economic conditions become. The reason for this is that more money only weakens the wealth-generating process by stimulating nonproductive consumption (consumption that is not preceded by the production of real wealth).

Why Deflation Heals the Economy

As we have seen, deflation comes in response to previous inflation. Note that as a rule a general increase in prices, which is labeled inflation, requires increases in the money supply. Hence a fall in the money supply leads to a fall in general prices — labeled as deflation. This amounts to the disappearance of money that was previously generated out of thin air. This type of money gives rise to various nonproductive activities by diverting real savings from productive real wealth generating activities.

Obviously, then, a fall in the money stock on account of the disappearance of money out "of thin air" is great news for all wealth-generating activities; the disappearance of this type of money arrests their bleeding. A fall in the money stock undermines various nonproductive activities. It slows down the decline of the pool of real savings and thereby lays the foundation for an economic revival.

But what about the fact that a general decline in prices is accompanied by a fall in general economic activity? Surely this means that deflation may be bad news for productive and nonproductive activities? The fall in economic activity, as we have already shown, comes not on account of falling prices, but on account of a fall in the pool of real savings.

The emergence of deflation is the beginning of the process of economic healing. Deflation arrests the process of impoverishment inflicted by prior monetary inflation. Deflation of the money stock, which as a rule is followed by a general fall in prices, strengthens the producers of wealth, thereby revitalizing the economy.

Obviously, the side effects that accompany deflation are never pleasant. However, these bad side effects are not caused by deflation but rather by the previous inflation. All that deflation does is shatter the illusion of prosperity created by monetary pumping.

Again, it is not the fall in the money supply and the consequent fall in prices that burdens borrowers but the fact that there is less real wealth. The fall in the money supply, a money supply created out of "thin air," puts things in proper perspective. As a result of the fall in money, various activities that sprang up on the back of the previously expanding money supply now find it hard going.

It is those non–wealth generating activities that end up having the most difficulties in serving their debt, because these activities were never generating any real wealth and were really supported or funded, so to speak, by genuine wealth generators.

Contrary to the popular view then, a fall in the money supply is precisely what is needed to set in motion the buildup of real wealth and a revitalizing of the economy. Printing money only inflicts more damage and therefore should never be considered as a means to help the economy.

Conclusion

Despite the almost-unanimous agreement that deflation is bad news for the economy's health, that idea is false. As we have seen, deflation comes in response to previous inflation. This amounts to the disappearance of money that was previously generated out of thin air. This type of money gives rise to various nonproductive activities by diverting real saving from productive activities.

Obviously then, a fall in the money stock on account of the disappearance of money created out of thin air is great news for all wealth-generating activities. The disappearance of this type of money arrests their bleeding. A fall in the money stock undermines various nonproductive activities; it therefore slows down the decline of the pool of real savings and lays the foundation for an economic revival.

Notes
[1] George A. Akerlof, George L. Perry, William T. Dickens. "Near Rational Wage and Price Setting and the Long Run Phillips Curve." Brookings. June 2, 2000.

[2] It must be realized that it is only commercial-bank lending not backed up by proper savings (fractional-reserve banking) that can disappear into "thin air," thus causing the decline in the stock of money. Money, which is fully backed up by savings, once repaid by the borrower to the bank, is passed back to the original lender and therefore cannot disappear unless the original lender decides to physically destroy it. From this, we can infer that the greater the percentage of credit created out of thin air is in relation to overall credit, the greater is the risk of a large fall in the money stock once the pool of real savings starts declining.

[3] Remarks by Governor Ben S. Bernanke. "Deflation: Making sure 'It' Doesn't Happen Here. Federal Reserve." November 21, 2002.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of M.F. Global. Send him mail. See Frank Shostak's article archives. Comment on the blog.

© 2010 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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