The Deflation Myth

Expanding on my last post, the decline in the CPI has sparked once again the fear of a deflationary spiral. The debate between “inflation” and “deflation” still continues to get media coverage, but adequate explanations are far from satisfactory. In this missive I will clarify why deflation is merely smoke and mirrors concealing the true menace: price inflation.

What is “deflation” and why it is bad?

When you hear economists mention the word deflation, they generally mean a fall in consumer prices. More specifically, it is the sustained fall in consumer prices. On the surface, declining prices are not pernicious in and of itself because buyers can purchase more goods with their money. In other words, their wealth increases. However, for society at large this outcome may not be optimal because the wealth-gain for some could be offset by wealth-loss for others. This is particularly the case in a debt-laden society. Economists refer to this as the theory of debt deflation: lower prices increases the true cost of debt, causing spending to decline, which leads to shrinking demand and consequently higher unemployment. High unemployment means higher risk of defaults. Thus we have the beginning of a spiral taking place.

Deflationists—which include the likes of Ben Bernanke—point to the period between 1929 and 1933 when prices (as defined by the CPI) declined approximately 27% as proof of their heightened concern. As a result, the current crisis has been treated by an extraordinary surge in liquidity by the Federal Reserve. In particular, the Fed’s balance sheet has more than double since September 2008.

Yet, in context their fear is misplaced. During the early years of the Great Depression, prices declined primarily for three reasons: 1) The money supply decreased between 1929-1931, which caused a sharp contraction in economic activity.

The subsequent increase in the monetary base had no effect since production was declining and 2) there were approximately 9,000 bank failures between 1929-1933. This caused the money multiplication effect, which is the byproduct of a fractional reserve banking system, to be nullified. The FDIC was nonexistent in those days; so when a bank would fail, depositors lost their money. In this instance, the supply of money simply “disappeared” from the economy. But most importantly, 3) the U.S. operated under a domestic gold-standard as its monetary system. In addition and in contrast to today, gold coin freely circulated as money in those days.

This last point is crucial to reiterate because deflation cannot occur outside of a commodity-linked currency. Said differently, it is impossible to have price deflation (i.e. a sustained decrease in prices) under a fiat monetary system, except only when productivity outpaces money supply. Critics will point to Japan as an example of the consequences of deflation. However, Japan’s economic malice is the result of government intervention (see here and here for a detail analysis on this country).

As demonstrated by the following chart, prices declined in the U.S. from 1928-1933 and subsequently increased thereafter. (Insert Chart).

It is of utmost importance to highlight that on April 5, 1933, President FDR criminalized the private holding of gold and forbade the usage of gold coins as money to settle transactions. There is no coincidence that prices began to increase post-1933.

Why prices decline under commodity-linked money and not under a fiat?

Inflation and deflation is always a monetary phenomenon. When the safety and soundness of banks during the Great Depression was suspect, the population’s demand for gold coins increased. People subsequently withdrew their bank deposits and converted them to physical gold. This resulted in a run on banks, their failures, and an overall decrease of the money supply—all which aggravated the economic conditions of the country. Under a domestic gold standard, monetary policy is very limited. And while the FED did inflate the money supply beginning in late 1931, it had no effect on the general tendencies of prices until FDR’s intervention.

Under a fiat monetary system, however, monetary policy is amplified and thus has more power. Price might decline from time to time, but a sustained fall is impossible because money (unlike the one backed by gold) has no anchor which to hold on to. Deflation proponents under a fiat monetary regime must answer the following facts: 1) most of the currency is held in the banking system, which is part of the monetary base, 2) this currency is part of bank deposits, which get multiplied in the fractional reserve banking system, 3) the FDIC main objective is to prevent banks to disappear, thus maintaining the money multiplier effect operative, 4) despite the high debt load by the U.S., there will always be somebody willing to borrow (e.g. the Federal government needs about $4 trillion this year alone to cover its expenses), and 5) monetary policy is without limitations, in contrast to the gold-standard era.

As can be noted, there are significant differences between the Great Depression period of deflation and our own time. Ignoring these facts has led policymakers and the population in general to “reason correctly from an erroneous premise”. If there is something else to salvage from my analysis is that once governments change the rules of the game, intertemporal comparisons become an evaluation between apples and oranges. Inflation continues to be the primary risk today.