There Is Nothing Wrong with Price Deflation

Price deflation is a decrease in consumer prices. It is usually associated with long and sustained recessions. Such decrease in prices is led by a reduction in total consumption. Total consumption in the country is dependent on several factors such as the total money invested in stock as well as the total hoarding of money by the producers and wage earners. Price deflation is not necessarily the evil it has been made out to be, since falling prices increase the standard of living of the poor, while reducing that of the business owners.

The first long deflationary phase in the U.S. was from 1873-1896. During these years, production increased due to excessive savings/investments and high productivity, while the money supply grew at a slower pace, causing a mismatch between the total money available for consumption and the value of products on sale, and resulted in a fall in prices. According to economist Murray Rothbard`s book, History of Money and Banking in the United States, during this phase, general prices in the country fell 1% on an average each year. This translates into a fall of about 20% over 23 years. Therefore, a person with stagnant wages grew 20% richer. This was also a time of growing national income and increased wealth. In fact, the GDP of the country doubled between 1879-1888, and it was the most productive decade in the nation's history, a record held until today. Ironically, this era has been called a depression by many economists, solely based on the price declines witnessed during this period.

According to economists from a certain school of thought, falling prices necessarily lead to decreases in production, high unemployment and a lower standard of living. As a result, if the production were to increase but fewer dollars were used to purchase the final products, there would be a price decrease, which would necessarily be considered a sign of trouble and reduce future production.

However, this is far from the truth, since the increase in production may have been caused by an increase in productivity, in which case, the business does not suffer a loss in revenue. Or, even if the increase in production was driven by excessive savings, which lead to an increase in production, it is far from certain that businesses would suffer a big enough loss to force them to reduce production. It is only during times of large price declines, caused by a larger mismatch between the production increase and monetary inflation that depressions begin. The period noted above did see falling prices, but the economy did not slip into perpetual recession, since the price decreases were mild and did not cause a significant shift in the profit margins.

It is important to understand what led to a lower than normal increase in money supply, which in turn decreased prices. The U.S. economy was on a Gold Standard during those years, and the scarcity of Gold led to a slowly growing money supply, eventually causing a decrease in consumer prices. This led to populist uprisings against the supporters of sound money, primarily the Republican Party, and called for a change from the monometallic standard (Gold) to a bimetallic standard (Gold and Silver) because Silver was more inflationary due to its abundance.

The justification provided by the Democrats, who supported the change, was that falling prices reduced the revenues of the farmers, who in turn, found it difficult to pay off their debts. Farmers may have been victims of falling prices, and defaults to their creditors may have increased, but historical figures clearly show that the agricultural business revenues, as a whole, grew about 20% between 1880 and 1890. Hence, it can be assumed that the general business conditions may not have been gruesome. In addition, as noted above, the average price decline each year was about 1%, hence the reduction in expected profits was not very big.

Also, it has been noted in Sidney Homer’s History of Interest Rates, 2000 B.C. to the Present that the interest rates during this entire period continued to fall. If falling prices ever lead to reduced production and fear, the first effect seen in the economy is through increased interest rates, as banks and other creditors reduce the supply of credit, since the chances of loss are high.

However, the yields on the Railroad bonds fell between 1879 and 1889, from 5.98% to 4.43%. Despite these successes, this era has been demonized by a particular class of economists, specifically those leaning towards populism, since it is politically beneficial to patronize the poor debtors rather than the creditors. William Jennings Bryan, the presidential candidate in the 1896 election, proposed moving to a Gold/Silver standard to ease the burdens on the debtors.

Deflation is bad only in cases where debtors default in large numbers, causing the creditors to become risk-averse, and if it is difficult for businesses to reduce costs. As long as businesses can swiftly reduce costs such as wages, and businesses have less debt on their balance sheets, even higher price declines caused by hoarding or insufficient monetary inflation would not lead to a decline in production. One of the reasons why the Great Depression became severe was that the debt in the country had reached historical levels, and normal price declines could not be tolerated by either households or businesses.

Inflationists often use the threat of a repeat of the Great Depression to scare people into accepting and preferring high doses of inflation to low price declines. Most central banks in the world have a policy of achieving a regular 2% annual inflation to ensure deflation does not strike. This inflationary bent leads to the boom-bust cycle, since inflation causes interest rates to rise, which then lower the supply of credit and cause businesses to shut. Compare this to the era of Sound Money, or the Gold Standard, where prices fluctuated freely and did not have a bias towards debtors, who benefit with inflation since higher incomes make repayment easier. The creditors on the other side, lose purchasing power as prices in the country rise, while their interest incomes do not. In a free market economy, prices generally tend towards stability over a longer period, and do not favor any political or business interests.

Conclusion:

Deflation does not create any reductions in production, as is understood from the deflation of the 19th century. Deflation can only be a formidable enemy if supported by the problem of high debt and rigid costs. The coming deflationary spiral, unfortunately, will be the offshoot of such high debt and the rigidity of wages in the nation. The free markets cannot provide a swift remedy for the ensuing economic decline, but they offer the only solution, which is the reduction in these debt levels through higher savings and defaults. Government programs such as Cash for Clunkers do provide immediate help to the buyers and sellers, but do nothing to address the major imbalances of high debt.

As noted above, the problem is not deflation, but high debt, but programs such as Cash for Clunkers are solely directed towards creating inflation. It is not very predictable whether the government will be able to prevent deflation in the short- term and whether the government would hurt the economy through excessive government debt, but it is a certainty that the government programs are not beneficial and cannot change the direction of the economy in the next decade.

Comments

[chap08:]

This is a good article, but suffers from your bias. You are right that "Price deflation is not necessarily the evil it has been made out to be" but I believe that you falsely characterize the issue.

Mild deflation is not likely to cause a problem. Equally, mild inflation is not likely to cause a problem. We have seen both cases in history, and in both cases the economy has grown strongly and workers have prospered due to wages rising more than prices (or not falling as much as) as a consequence of productivity gains. The problem comes when you have either high inflation or high deflation.

Consequently, you are wrong when you conclude that "Deflation does not create any reductions in production, as is understood from the deflation of the 19th century." You are wrong because you are not looking at high deflation. Let's say we had deflation of 50% per week - the deflationary equivalent of hyperinflation. Are you telling me that you would still go out and spend as if prices were stable? Of course you wouldn't. You and everyone else would hoard currency and wait for prices to fall further. As a result, production would fall hard.

This leads to the real issue - which is that now we have the conditions for high deflation rather than mild deflation. You are right to say that "Deflation can only be a formidable enemy if supported by the problem of high debt and rigid costs" - but that is exactly what we have now. Deflation now would likely lead to a deflationary spiral, just as it started to do in the 30s, because we have the same conditions. Consequently, we need to stop that happening. Of course this is not a popular view on SA but people should consider the old saying: "be careful what you ask for, because you just might get it".

Oct 19 07:45 AM

[Dave Wrixon:]

I don't think anyone would be unduly concerned about price deflation of 1% per annum. Did the US really tear up its constitution over such a minor and gradual adjustment? I think not!

Oct 19 10:20 AM

[The Geoffster:]

Compare and contrast:
seekingalpha.com/artic...

Oct 19 10:23 AM

[TCK:]

It should be no surprise that the conventional wisdom that got us here is exactly wrong, again !

When first learning about the Great Depression in school, we were told that the cause was an unsophisticated banking system and we ( collectively ) were too smart now for it to happen again.

Evidently instead of being too smart, we were just too arrogant .

Oct 19 11:05 AM

[Valley Boy:]

There was a mild deflation in 1954-1955 when adjustments were made after the Korean War. The deflation did not seem to severely effect the broad economy other than to create a drag on the agricultural sector.

Oct 19 12:08 PM

[Faisal Humayun:]

"Price deflation is a decrease in consumer prices. It is usually associated with long and sustained recessions. Such decrease in prices is led by a reduction in total consumption."

I would slightly disagree with your above statement...Price deflation is not always associated with sustained recession...Nor such decrease is lead by reduction in total consumption...

Take for example the Tata Nano Car in India...There is a price decrease in general for automobiles in India...But is it associated with recession or reduction in consumption?

Technological changes lead to deflation in certain sectors which is good for the masses in general...But not necessarily associated with recession or lack of demand...

Oct 19 02:12 PM

[Moon Kil Woong:]

The author and chap 08 are both right. Mild price changes even if deflationary are not bad and can even be good. It is rapid or massive changes that are devestating.

The dollar's rapid and massive short term devaluation is starting to be just one such destabilizing change. Unfortunately the Federal Reserve, who is the one we trust to prevent this is, in fact the mastermind of the destruction of the dollar along with all America's assets valued in US$.

Oct 19 07:46 PM

[Crocodilian:]

Author glides over the important distinction between an asset price deflation and price declines in manufactured goods brought about by productivity improvements: they are completely different things.

Price reductions in manufactured goods due to increased productivity are almost entirely beneficial-- they represent a genuine and durable increase in national wealth.

Price declines in fixed assets both signal trouble (indicating that the market expects that their future productivity will be less than that today) and _cause_ trouble (because asset price declines can cause the real interest rates to grow to levels that will cause defaults).

Author is correct in observing that high debt levels in and of themselves are the issue today-- deflation is of little concern to a net creditor.

As it happens, the United States is a massive net debtor-- not a comfortable position in which to have a deflation.

Oct 19 09:01 PM

[Michael Clark:]

I think the writer means 'across the board price decreases'. Clearly, computer chip prices declined because of supply and demand and did not happen during a depression, although the chip companies, themselves, did have a depression of a sort, in an attempt to cut down supply.

Across the board price decreases are almost always associated with a depression.

We actually NEED price deflation. We have just been through an ORGY of inflation (college tuition up 1500% in 20 years) -- housing up 200% in five years. This is insane inflation. Without deflation and inflation working together we do not have a rational market. The inflationists see it as their duty to destroy deflation -- but deflation is as necessary as is inflation, if you want to have a healthy economy. Both inflation and deflation are NOT healthy if looked at in isolation; but as a mechanism which incorporates both, one succeeding the other, we then have a healthy mechanism.

The longer the inflationists resist reason, the harsher the resulting deflation -- and perhaps a revolution, because of their strident clinging to their greed and the desire for asset price inflation, at the cost of beggaring the middle class and the lower class.

The Inflationists need to be overthrown, either peacefully, if possible, or by force if necessary.


On Oct 19 02:12 PM Faisal Humayun wrote:

> "Price deflation is a decrease in consumer prices. It is usually
> associated with long and sustained recessions. Such decrease in prices
> is led by a reduction in total consumption."
>
> I would slightly disagree with your above statement...Price deflation
> is not always associated with sustained recession...Nor such decrease
> is lead by reduction in total consumption...
>
> Take for example the Tata Nano Car in India...There is a price decrease
> in general for automobiles in India...But is it associated with recession
> or reduction in consumption?
>
> Technological changes lead to deflation in certain sectors which
> is good for the masses in general...But not necessarily associated
> with recession or lack of demand...

Oct 20 07:37 AM

[Michael Clark:]

Massive, rapid price increases are also bad. We've just been through 20 years of massive (and since 2001) rapid price increases. Massive price increases combined with lower and lower interest rates have resulted in a consumer debt-slavery that is apparently the policy the Fed wants to continue.


On Oct 19 07:46 PM Moon Kil Woong wrote:

> The author and chap 08 are both right. Mild price changes even if
> deflationary are not bad and can even be good. It is rapid or massive
> changes that are devestating.
>
> The dollar's rapid and massive short term devaluation is starting
> to be just one such destabilizing change. Unfortunately the Federal
> Reserve, who is the one we trust to prevent this is, in fact the
> mastermind of the destruction of the dollar along with all America's
> assets valued in US$.

Oct 20 07:41 AM

[Michael Clark:]

Excellent article, Nikhil. And timely. The rule of the Inflationists is about to end. The sun is setting. The Season of Greed ends, 2010.

Oct 20 07:45 AM

[Michael Clark:]

We've had two decades of price inflation on a grand scale, Chap. Of course, we haven't had wage inflation -- but everything else has gone through the roof: health-care, higher education (1500% increase in 20 years), housing (I think 150-200% increase in five years qualifies as high inflation), heavy durables (1000% increase in automobiles over 30 years).....

I don't think any of us really WANT deflation, not in an abstract sense. We want a balanced healthy economy with moderate inflation followed by moderate deflation. We want job growth and we want a relatively strong currency so we can save money for the future... But we don't have ANY of those things. Between a continuation of the policies that are FANATICALLY INFLATIONARY and DEFLATIONARY, as a balance to too much borrowing for 20 years, too much debt, yes, we need a deflationary period. The pain of any deflation has been brought on by the unbalanced, insane inflationary period we are currently trying to survive.


On Oct 19 07:45 AM chap08 wrote:
Of course this is not
> a popular view on SA but people should consider the old saying: "be
> careful what you ask for, because you just might get it".

Oct 20 07:53 AM

[a fat panda:]

Neither Inflation nor deflation is good for the economy. It interjects a new variable into economic decision making. Deflation encourages people to postpone consumption purely for currency sake. Inflation encourages people to spend money purely for currency sake. Currency should expedite the transaction not play role in whether the transaction occurs or not.

Capitalism loves stability. Stability = predictability. Instability = risk. Risk is like kryptonite to capitalism. Once it is in the system, it gets priced into everything. It is a real bitch to get out once in it in.

Oct 20 10:07 PM