Its been pointed out to me that deflation causes incomes to fall and also that debt, in real terms, rises as a consequence. These two factors would combine to retard business investment and therefore economic growth. Is this true?
(you could start at 16m50s)
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I notice that you don’t write that incomes fall in real terms. Because of course they don’t. So why would business investment fall?
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One could argue equally that due to inflation lenders will not get their money back, and so either will not lend or will charge very high interest rates, thus retarding business investments.
In any case Rothbard addresses this q in What has Govt Done to Our Money.
Some theorists charge that a free monetary system would be unwise, because it
would not “stabilize the price level,” i.e., the price of the money-unit. Money, they
say, is supposed to be a fixed yardstick that never changes. Therefore, its value, or
purchasing power, should be stabilized. Since the price of money would admittedly
fluctuate on the free market, freedom must be overruled by government
management to insure stability. [12] Stability would provide justice, for example, to
debtors and creditors, who will be sure of paying back dollars, or gold ounces, of the
same purchasing power as they lent out.
Yet, if creditors and debtors want to hedge against future changes in
purchasing power, they can do so easily on the free market. When they make their
contracts, they can agree that repayment will be made in a sum of money adjusted
by some agreed-upon index number of changes in the value of money. The
stabilizers have long advocated such measures, [39] but strangely enough, the very
lenders and borrowers who are supposed to benefit most from stability, have rarely
availed themselves of the opportunity. Must the government then force certain
“benefits” on people who have already freely rejected them? Apparently,
businessmen would rather take their chances, in this world of irremediable
uncertainty, on their ability to anticipate the conditions of the market. After all, the
price of money is no different from any other free prices on the market. They can
change in response to changes in demand of individuals; why not the monetary
price?
Artificial stabilization would, in fact, seriously distort and hamper the workings
of the market. As we have indicated, people would be unavoidably frustrated in their
desires to alter their real proportion of cash balances; there would be no opportunity
to change cash balances in proportion to prices. Furthermore, improved standards of
living come to the public from the fruits of capital investment. Increased productivity
tends to lower prices (and costs) and thereby distribute the fruits of free
enterprise to all the public, raising the standard of living of all consumers. Forcible
propping up of the price level prevents this spread of higher living standards.
Money, in short, is not a “fixed yardstick.” It is a commodity serving as a
medium for exchanges. Flexibility in its value in response to consumer demands is
just as important and just as beneficial as any other free pricing on the market.
Since inflation has you paying back less money in real terms in the future, deflation does have you paying back more money in real terms in the future, and makes debts more expensive.
Deflation need not cause incomes to fall, but simply working fewer hours for the same pay rate, or working less hard for the same pay rate. Interestingly, because inflation may cause people to work longer for less pay, it rewards dishonest people over honest ones, and high-inflation regions like India have many people trying to make a quick buck dishonestly.
Deflation can not retard investment or economic growth. It merely removes bad investment by removing bad debtors and ensures the allocation of funds to people with more credit-worthiness. There is no increase or decrease in capital stock. On the other hand, inflation causes less savings and consumption of capital. Also, all economic growth or industrial expansion is limited to the amount of capital in a society. It can not exceed that. If it so happens that financial institutions sit on idle capital, they have not reduced investment but simply chosen to invest in the future in more promising ventures. It does not matter whether that investment happens in the future or the present; it simply depends from time to time.
I came across an article once that I thought explains it well. Yes, here it is: http://www.thefreemanonline.org/featured/deflation-the-good-the-bad-and-the-ugly/
As I understood it, there are two kinds of deflation. Price deflation, that’s if increased productivity leads to lower prices. That’s good. And monetary deflation, that’s when there’s insufficient money supply. In that case everyone will sell their assets to get money and reduce their spending to keep their money. The economy grinds to a halt.
In many ways, the critical component of the “deflationary spiral” argument is that as prices fall, buyers become reluctant to buy, holding off consumption in the expectation that prices will fall further, causing prices and wages to fall further resulting in a depressing “spiral”, and the economy grinding to a halt. What is odd about the argument is that it is self contradictory. Every sale is a purchase, those who are selling are essentially “buying money”, with the goods they sell in exchange.
By the same token, shouldn’t sellers be reluctant to sell when there is inflation, given that they know prices are rising, and expect them to continue to do so, hence by their actions of withholding trade, cause prices to increase further, and the economy to grind to a halt? The fact that neither statement is true should be obvious, what matters are the relative prices of the goods bought and sold to acting men, not the “price level.”
So that article is the argument that “proves” the existence of “insufficient money supply”. This is indeed a happy day for me, because I will finally be enlightened. Let’s get right into it, with my comments in bold:
The “Bad” sort of deflation arises from an insufficient supply of money. When people do not have as much of their wealth in the form of money as they would like, they will make attempts to increase those money balances.
I see. The problem is people want their wealth in the form of money. Wonder why that is? Have they developed an affection for the artistry and color scheme of the US paper dollar? Have they childishly been hypnotised by the glitter of gold coins? Is that what is going on? I doubt it. I imagine they want to save their money for later. And I think we can agree that they want their money to have the same purchasing power later as it does now, if not more. They certainly don’t want it to have less.
We can also agree that the law of supply and demand is true. And that it applies to money, as it does to everything else. The greater the supply of money, the lower will be its price. Also, I hope we can all agree to this little subtlety, that the “price” of money is its purchasing power. So the more money we print, the less will be its purchasing power.
OK, back to the non problem this article has made up. People want to save their money for later, and want that money to have the same purchasing power later. The article claims that this is a great tragedy. We will examine that claim later. Right now we focus on the solution to this great non problem. The solution is that people want to save their money, why sure, let’s give it to them. Print, print, print them to happiness and a robust economy. That way the savers will have their money, and “the economy” will have a generous supply, too.
I get it. If people have decided to save their purchasing power for later, let some dictator decide he knows what is good for them, and destroy their purchasing power instead. I’m sure this kind of thinking is very appealing to certain personality types, but I find it repulsive.
Assuming that in the short run additional income is not possible, people have essentially only two other options: sell off other assets or reduce their expenditures. Either one will work, but selling off assets is problematic for two reasons. First, it is not totally under the individual’s control since it requires a buyer, and second, if everyone is short on money, finding a buyer will be especially difficult because everyone else is looking to sell. Therefore, the most likely result of a deficient money supply is that people will restrict their expenditures to allow more of their income to build up as checking account or currency balances.
The technical term for this train of reasoning is “begging the question”. in which the proposition to be proven is assumed implicitly or explicitly in the premise. You are trying to show me there is such a thing as as a “deficient supply of money” by assuming its existence. You talk about the “result of a deficient money supply” in the paragraph that purportedly explains why there is such an animal in the first place.
Let’s summarize the article’s argument in simple English. If you have a given amount of money in your wallet, you can either spend it or save it. You cannot do both with the same dollar bill. If you decide to save it, that is bad. You are, by definition, creating a deficient money supply. You have no right to do this, and you must therefore lose all your money’s purchasing power.
“But Your Honor,” one may ask. “What is so bad about saving money?” The answer lies in the next Keynesian paragraph:
As everyone reduces spending, firms see sales fall. This reduction in their income means that they and their employees may have less to spend, which in turn leads them to reduce their expenditures, which leads to another set of sellers seeing lower income, and so on. All these spending reductions leave firms with unsold inventories because they expected more sales than they made. Until firms recognize that this reduction in expenditures is going to be economy-wide and ongoing, they may be reluctant to lower their prices, both because they don’t realize what is going on and because they fear they will not see a reduction in their costs, which would mean losses. In general, it may take time until the downward pressure on prices caused by slackening demand is strong enough to force prices down. During the period in which prices remain too high, we will see the continuation of unsold inventories as well as rising unemployment, since wages also remain too high and declining sales reduce the demand for labor. Thus monetary deflations will produce a period, perhaps of several months or more, in which business declines and unemployment rises. Unemployment may linger longer as firms will try to sell off their accumulated inventories before they rehire labor to produce new goods. If such a deflation is also a period of recovery from an inflation-generated boom, these problems are magnified as the normal adjustments in labor and capital that are required to eliminate the errors of the boom get added on top of the deflation-generated idling of resources.
John Maynard, you may smile in your grave. The Austrians have a spy in their midst, preaching your sermon for you. To see the incredible silliness of the above, we must note the beginning of the last sentence, which says "If such a deflation is also a period of recovery from an inflation-generated boom…". In other words, everything but that last sentence is talking about normal times. No inflationary boom here.
Murray Rothbard has asked a very simple question to challenge the above fairy tale: How did so many normally clever businessmen, on such a grand scale as to affect the whole economy of a large wealthy country, not realize they were making too much stuff that nobody wants? Their mistake was so huge as to be "economy-wide and ongoing". These things happen for a reason. What is the reason? Austrians admit such scenarios exist, but say they are always the result of an inflation generated boom. You are talking about a case where there is no inflation generated boom. What new reason have you discovered for this scenario, dear article author?
Of course, there is another question here, too. Why have people all decided too save “too much” on such a grand scale as to cause a recession. Was it animal spirits?
Over the course of U.S. history the economy has been subject to a number of deflationary episodes, all of which were the consequence of a variety of government interventions in the monetary system. In each of those cases before the Great Depression, policymakers largely allowed the economy to repair itself by standing by and doing little to nothing while prices and wages fell sufficiently to get the demand for money back into alignment with the supply. No doubt these were painful recessions that could have been avoided by having a banking system that responded to changes in money demand by more quickly adjusting the money supply,
See that last sentence? No doubt? I doubt it very much. Rothbard and all his disciples doubt it. But the author claims that there is no doubt that the banking system is supposed to respond to changes in money demand by increasing the money supply.
There is a very subtle, but very foolish, mistake in such reasoning. If we were talking about, say, dog food, and there was a shortage of dog food, then the solution is to produce more dog food. But if there is a shortage of money [which we will assume for the sake of argument, ridiculous as the assumption is], the solution is not to print more money. Because the newly printed money dilutes the value of the old money, as explained above. Supply and demand, old chap.
And not only that, the new money is not handed over to the people who are "hoarding’ their money. When the govt prints money, it never says “OK guys. You all want more money, as evidenced by your putting it in banks instead of spending it. So we will give everyone with a bank account 10 percent more money”. Instead it says “OK guys, the govt doesnt have enough money. Here you go, govt. Spend freely”.
In the case of dog food, what the author is advocating is this. When there is a shortage of dog food in the White House, the president should take away half of everyones dog food, mix what little dog food he has left them with some sand, and feed his pooch with the pure stuff.
During the Great Depression, what should have just been a Bad deflation became an Ugly one. This deflation was unlike earlier ones for two reasons…
OK, there follows some twisted reasoning about the Great Depression. The gist is analogous to this. Trying to show that eating oatmeal causes concussions, the author finds the case of a boxer. He points out that the boxer ate oatmeal in the morning, at 9 AM. And sure enough, at 9 PM the boxer was lying on the floor unconcious, deeply concussed. The poor boxer’s actual concussion was even worse than the usual oatmeal induced concussion, because he got hit in the face repeatedly by a superior opponent at 8:45 PM.
Truly, I would be ashamed to print such stuff for all the world to see. You make up a new imaginary reason for the Great Depression [insufficient money supply], and one paragraph later, admit that another, totally different reason [repeated govt bungling and medlling], accounts very well for the Great Depression.
Current observers are quite right to point to the Great Depression as an example of what can go wrong from deflation.
Are you suffering from amnesia? Have you forgotten what you just wrote about “misguided attempts at price and wage maintenance” doing the damage?
The rest of the article just rehashes and repeats the same errors when analyzing our current mess.
Thank you, Smiling Dave.
The very first sentence you quoted blew my mind.
A rise in the demand for money is not the same as savings…
I’m not supporting Horwitz per se. But just saying ‘well, savings is good!’ is not a response. A rise in the demand for money is not the same as savings. He’s talking about when people want a rise in there cash balances, not in there savings account. And yes; there is a praxeological difference.
I’m not too convinced that a sudden rise in the demand for money should be problematic: it’s just people saying ‘i don’t want this stuff, but I would like to have the option to pay for stuff immediately’. (Something not available on your savings account.)
That’s new.
What is the praxeological difference?
“That’s new.”
Not really.
“What is the praxeological difference?”
Why do you care?
A rise in the demand for money actually might cause a reductioj in savings, if people spend just as much.
(Or might cause a reduction of spendings, if people save as much. Or any combination of these 2 effects.)
Deflation has exactly the same harmful, economy-distorting effects inflation does, except in reverse.
Every single reason you could cite for inflation being bad has a matching reason why deflation is.
(a) For example, inflation does not happen evenly. You don’t simply get paid more exactly the same as your expenses are higher. Different prices rise at different rates, causing a maldistribution of resources.
(b) Likewise, with deflation prices don’t magically fall perfectly. They fall faster in some places than others, causing a maldistribution of resources.
(a) Similarly, inflation causes malinvestment, as it creates the appearance of more demand than exists, causing too much money to be invested, too much of some products and services to be produced, et cetera.
(b) Likewise, deflation causes malinvestment, as it creates the appearance of LESS demand that exists, causing too little money to be invested, too little of some products and services to be produced, et cetera.
(a) Inflation discourages savings, encourages (over) investment and (over) spending. It is foolish to hold onto money losing value, but wise to invest it in ways that will automatically weather inflation, or better still, invest it in the price bubbles created as prices rise unevenly.
(b) Deflation discourages investment and spending. It is foolish to use money that is gaining value, but wise to pass up lending, investing, or buying, especially with prices falling erratically.
What it boils down to is that, as Max Weber identified and Hayek made famous, the reason the free market wins is the efficiency of communication that comes through its pricing system. The natural price of each and every thing produces the optimal amount of investment, production, and consumption of that thing, compared to other things, available resources, and the priorities of society:
But ANY change in pricing, away from its natural state, distorts and deadens that communication. If the price is higher or lower than its natural amount, this is a growing disaster. Deflation isn’t magically exempt from this central property of capitalism.
Would you be so kind as to elaborate a bit on this, please?
I was being sarcastic.
I’m interested to see a perspective I am missing. Is that a problem?
Smiling Dave, thanks for your enlightening post. You are right, that article is a bunch of Keynesian errors. I misread it because I understood “deflation” in an Austrian sense, while the article defined the word in a Keynesian sense. (Phew, this is hard, with all the differing definitions and whatnot.)
Deflation is a contraction of the money supply. So an “insufficient money supply” can not be the result of saving, because saving does not reduce the supply of money. Deflation happens when the government has a monopoly on money and won’t let us have enough of it. It’s like they burned money on a pile, they are actively deflating the money supply. That’s the bad kind of deflation and the solution is to not have a government monopoly on money.
TY for the kind words, Nero.
I am not sure why the govt burning up a pile of money is bad. I understand Rothbard’s reasoning in What has Govt Done to Our Money, that no matter what the amount of money in existence at a given time, it’s fine. The problem is when the govt gives itself free money, nothing else.
From what I remember of Hazlitt’s classic work on inflation, he argues that no deflation is inherently bad. The only time deflation causes harm is when it is sudden. And even then, the problem is not so much the deflation itself [what can be bad about increased purchasing power] as the fact that people take a while to get used to it.
Worker: “You mean you are cutting my salary? No way”.
Employer: “But your purchasing power is unchanged, in fact it has improved a bit. And I cannot afford to pay you the same dollar amount, because it amounts to giving you a raise”.
Worker: “Don’t give me that. I’m on strike until you see reason.”
Fishwife: “You mean you want me to sell you fish for less?”
Customer: “The money I’m offering has the same purchasing power as before. And I cannot afford to pay you the same dollar amount etc”
Fishwife: Don’t give me that. I’m going home until you see reason".
And of course, the Worker and Fishwife will suffer for a while, until they see reason.
Demand for money is far more complex than that…which is why socialism doesn’t work, why central banks don’t work, et cetera.
One obvious source of a money shortage, manifesting itself as a disbalance toward demand, is when money is horded…for example, the banks that are keeping massive extra reserves right now, because the Fed is paying them interest to do so. They are keeping money out of the economy, creating a shortage of supply that can be described as higher demand. But when energy prices rise, then more money is needed to conduct the very same functions in the economy, which is another kind of increased demand.
In fact, I’ve just named two of the factors that caused the deflationary, depressionary crisis in 2008. Demand rose faster than supply, because of the Fed suddenly paying interest on excess reserves and because oil reached its price bubble high of 700% of its natural price.
Kaz,
- You assume there is a “natural price”, and that inflation and deflation are both equally guilty of distorting that natural amount. I don’t get it. What is the natural price of a thing? If you define the natural price as what the price would be absent inflation or deflation, that does not prove either are bad.
I could define the natural price to be what a thing would cost absent any technological innovations [like shovels] and then “prove” that shovels distort the natural price of things dug out of the ground.
- Your first argument: With deflation, not all prices fall at the same rate, causing a maldistribution of resources.
There is no need for all prices to rise and fall at the same time. Why should they? When have they ever done so?
Inflation causes maldistribution of resources for the simple reason that it gives the govt a fat pile pile of unearned [= not received in return for some good or service offered] money, which they then use to gobble up resources. How does deflation do that?
Another way inflation causes maldistribution is becuase the way things are set up in the USA, inflation is always accompanied by artificially low interest rates, which sends entrepeneurs a false signal, etc [=Austrian Theory of Business Cycle]. How does deflation do that? It is not connected to artificially low interest rates.
- Second argument: With deflation, there is an illusion of LESS demand than really exists.
What is the evidence of inflation causing an appearance of more demand than exists, and of inflation causing the appearance of less? All you gotta do is look at the shelves and see what’s what.
In classical ABCT [=Austrian Business Cycle Theory] it is low interest rates, not inflation per se, that cause the illusion of less [ not more] demand for consumer goods. Leading entrepeneurs to think that resources are not being spent on immediate consumption, so there will be enough free resources to be invested in long term projects. Why don’t they look on the shelves? Because they don’t own the stores. So they look at interest rates. But those low interets rates are because there is a glut of paper money in the banks, looking to be spent. How does deflation do any of that?
- Third argument: If the money is gaining purchasing power every day, I won’t spend it. This is bad, because I wont lend, invest, or buy.
Kaz, you gotta eat, right? And pay the rent, and buy a new suit when your old one wears out. Etc etc and so forth. You do not have control of what you need to the extent that you can just stop buying forever, or even delay it for too long. How long will you wait until you break down and buy what you already want? 50 years? 100? Or is a few weeks more realistic?
Historically, there is no evidence for your claim here. People keep on buying laptops and cell phones and TV sets, even though they know those things will be cheaper in a few months.
All of the above is about your claim that people won’t buy. As for lending, why won’t you lend? You will get your money back later [when it is more valuable, right?] with interest. Sounds like a good deal to me. And why won’t you invest? Profits are, by definition, the difference between what it costs a guy to make something, and what he will get by selling it. With deflation, a company’s expenses go down, too, so that the profits won’t suffer much, if at all. Investing is a smart move in such a case.
- Deflation tricks us about the relative worth of something compared to everything else.
I don’t get this at all. See point 0. above.