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Forget What the “Experts” Claim about Deflation: It Strengthens the Economy

For most experts, deflation is bad news since it generates expectations for a continued decline in prices, leading consumers to postpone the purchases of present goods, since they expect to purchase them at lower prices in the future. Consequently, this weakens the overall flow of current spending and this, in turn, weakens the economy. Economic activity, believe the experts, is a circular flow of money. Spending by one individual becomes the earnings of another individual, and spending by another individual becomes a part of the previous individual’s earnings.

If people have become less confident about the future decide to reduce their spending, this weakens the circular flow of money. Once an individual spends less, this worsens the situation of some other individual, who in turn also cuts his spending.

According to the former Federal Reserve chairman Ben Bernanke,

Deflation 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. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress.

Murray Rothbard, however, held that in a free market the rising purchasing power of money (shown by declining prices) makes goods more accessible to people. He wrote:

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.

Economist Joseph Salerno adds: 

Historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.1

Money and Money out of “Thin Air”

Money emerged because it could support the market economy more efficiently than barter. The distinguishing characteristic of money is its role as general medium of exchange, evolving from the most marketable commodity. On this Ludwig von Mises wrote: 

There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.

All goods and services are traded for money. This fundamental characteristic of money must be contrasted with other goods. For instance, food supplies the necessary energy to human beings. Capital goods permit the expansion of the infrastructure that in turn permits the production of a larger quantity of goods and services. Through the ongoing selection process over thousands of years, individuals settled on gold as the standard for money.

In a market economy, money’s key function is to be the medium of the exchange. By means of money, a product of one specialist is exchanged for the product of another specialist.

Alternatively, we can say that something is exchanged for money, and then money is exchanged for something else, which means that something is exchanged for something else with the help of money.

This process is disrupted once an increase in the money supply out of “thin air” emerges. When money is generated out of “thin air,” no wealth has been exchanged for it, but the holder of newly generated money now can exchange it for wealth. Therefore, we have an exchange of nothing for something. An exchange of nothing for something amounts to a diversion of wealth from people that have produced wealth to the holders of the generated money. We emphasize that the act of wealth diversion is made possible because of the increase in money supply, or the inflation of money.

The Essence of Deflation

In order to establish the essence of deflation, we first must understand the essence of inflation. Contrary to popular thinking, inflation is not about general increases in the prices of goods and services. Inflation is not set in motion by increases in wages, nor is it set in motion by a decline in unemployment or an increase in economic activity (the “overheating” economy), as popular thinking goes.

Another popular viewpoint is that a growing economy creates a growing demand for money that must be accommodated in order to prevent economic disruptions. As long as the increase in money supply is in line with the increase in the demand for money, there are no negative economic effects. Now, irrespective of the state of the demand for money, an increase in the money supply out of “thin air” leads to an exchange of nothing for something, which diverts wealth.

Because any given amount of money can perform the job of a medium of the exchange, there are no requirements to increase the supply of money in order to accommodate an increase in the demand for money. According to Mises:

The services which money renders can be neither improved nor repaired by changing the supply of money. . . . The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.

We can conclude that the subject matter of inflation is the diversion of wealth from wealth generators towards the holders of newly created money. The increase in the money supply out of “thin air” sets in motion this diversion. The increase in the money supply out of “thin air” is what inflation is all about.

Note that deflation emerges once the process of wealth diversion comes to a halt. This occurs once the money supply begins to decline. A decline in money supply, or deflation, is good news for the economy, since the diversion of wealth is coming to a halt. We also hold that a major factor behind the expansion of money out is bank lending not backed up by savings.

Nonproductive Activities Come from Lending Fake Money

When loaned money is fully backed by savings on the day of the loan’s maturity, it is returned to the original lender. For instance, Bob borrows $5 and will pay back on the maturity date the borrowed sum and interest to the bank. The bank in turn will pass to Joe the lender his $5 plus interest adjusted for bank fees. The money makes a full circle and goes back to the original lender. Note that the bank here is just a facilitator; it is not a lender, so the borrowed money is returned to the original lender.

In contrast, when lending originates out of “thin air” and the borrowed money is returned on the maturity date to the bank, this leads to a withdrawal of money from the economy and the money supply declines. The reason is that we never had a saver/lender, since this lending emerged out of nothing. Note that savings do not support the newly formed demand deposits here, so when Bob repays the $5, the money leaves the economy since there is no original lender to whom the loaned money should be returned.

Observe that the $5 loan out of “thin air” is a catalyst for an exchange of something for nothing, and it provides a platform for various nonproductive activities that prior to that generation of lending would not have emerged. As long as banks continue to expand credit in that manner, various nonproductive activities continue to prosper. At some point, however, the relentless expansion of the money supply diverts wealth, and a structure of production emerges that ties up more consumer goods than it releases. (The consumption of final consumer goods exceeds the production of these goods). The positive flow of savings is arrested and a decline in the pool of wealth is set in motion.

Consequently, the performance of various activities starts to deteriorate and bad loans start to pile up. In response to this, banks curtail their lending and this in turn triggers a decline in the money supply. A decline in the money supply begins to undermine various nonproductive activities, so an economic recession emerges. Some economists such as Milton Friedman believe that once the money supply starts to decline the central bank should embark on the monetary pumping to prevent an economic slump. An economic slump is not caused by the decline in the money supply as such, but comes in response to the shrinking pool of wealth because of the previous easy monetary policies. The shrinking pool of wealth leads to the decline in economic activity and, in turn, to the decline in the lending out of “thin air,” which results in the decline of the money supply.

Even if the central bank could prevent a decline in the money supply, such as reverting to something like dropping money from helicopters, it still cannot prevent an economic slump if the pool of wealth is declining. The more the central bank attempts to lift the economy by fixing the symptoms such as the fall in prices and rising unemployment, the worse things become.

Once various nonproductive activities are allowed to go bankrupt, and the sources of money supply out of “thin air” are sealed off, one can expect a genuine wealth expansion to ensue. With the expansion of wealth and for a given supply of money, we will have a fall in prices. Observe that when prices decline because of the liquidation of nonproductive activities and because of wealth expansion, it is always good news. This indicates that more savings is now available for wealth generation, and secondly that more wealth is generated.

The fall in the money supply, which precedes price deflation and an economic slump, is triggered by the previous loose monetary policies of the central bank, which provide support to the generation of unbacked credit. Without this support, banks would have difficulty offering an unbacked by savings credit, since some of them will not be able to clear their checks because they will not have enough cash. By means of open market operations, the central bank makes sure that there is enough cash in the banking system to prevent banks from bankrupting each other. Again, note that price deflation and the fall in the economy are due to the decline in the pool of wealth brought about by previous loose monetary policies.

Because deflation works toward reducing the wealth diversion from wealth generators toward non–wealth generators, the central bank should conduct tight monetary policies rather than loose policies. Policies that tamper with financial markets are always have bad outcomes, since such policies misallocate resources. Hence, the best policies is to have a genuine free market without the central bank tampering with financial markets.

Summary and Conclusion

Deflation is not about a general decline in prices, but rather emerges in response to the decline of the pool of wealth, which is caused by increases in the money supply. The emergence of deflation is always good news, since it is in response to the liquidation of various activities that lead to the erosion of the wealth generation process.

An economic slump is not caused by the decline in the money supply, but rather because of the shrinking pool of wealth due to previous easy monetary policies. This shrinking pool of wealth leads to the decline in economic activity and, in turn, leads to the decline in the lending out of nothing, which then results in the decline in the money supply. While inflation weakens the generation of wealth, deflation ultimately strengthens wealth creation.

1. Joseph T. Salerno, “An Austrian Taxonomy of Deflation” (paper presented at Boom, Bust, and the Future, January 19, 2002, Mises Institute, Auburn, Alabama).