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What's Wrong With Declining Prices?

Perhaps the most persistent modern monetary fallacy is the belief that economic growth must be accompanied by a corresponding growth in the money supply. This is cited as a reason why precious metals are unsuitable for money in the modern age because they are not sufficiently "flexible" due to their limited supply.

Paper money on the other hand can be printed in any quantity imaginable and is therefore easily expanded to match the rate of economic growth. Price stability is an oft-spoken reason for deliberate expansion of the money supply. This is a policy aimed at sustaining a year-over-year increase (widely accepted as 2%) in the consumer price index.

But do prices need to be stable?

It is argued that if the public anticipates a general decline in the prices of consumer goods, they will begin withholding their purchases. When this occurs en masse the store shelves remain full and an economic recession begins.

It is curious that such a belief is accepted as a sound economic principle when evidence clearly shows the contrary. As the relative price of a good or service decreases, it becomes accessible to a wider market. Subsequently the demand for it increases.

Lower Prices = Higher Demand

The market for computers and information technology is an example where innovative developments have out-paced the declining purchasing power of paper money. This has caused a decreasing price trend spanning several decades. As expected, the market for these products has expanded greatly.

A larger number of people own more electronic devices and engage in more long-distance communication than ever before. People didn't restrain their purchase of a computer because the price would diminish - they bought a second one.1

The majority of people will continue buying goods and services even if they believe that their money will buy more at a later date simply because they want them now.

A second defense of the argument is that businesses will become unprofitable if they are required to reduce the prices of their products. But this argument assumes that businesses are non-adaptive and ignores the obvious effect that reduced input costs have on profitability.

So if declining prices make economic sense, why is it argued that the money supply must continuously increase?

To answer this, perhaps we should look at those who make such a claim. Numerous official speeches from central bank leaders warn against the economic perils of declining prices. Central bank officials portray themselves as being ever-vigilant against this calamity.2

The act of printing money is of greatest advantage to those who first receive the money because they benefit from its full purchasing power. Those without this privilege must actually produce a good or provide a service. The portions of the economy that are farthest removed from this influx of new money only experience a general increase in prices. Effectively their standard of living is reduced or they must work more to maintain the same level previously enjoyed.

The creation of additional paper money is simply a redistribution of income from later to earlier owners of the new money. Central banks are amongst the first recipients through their monopoly over the production of paper money. Understandably, they are the most ardent supporters of the notion that declining prices are an economic evil to be avoided.

The arguments against having declining prices in a marketplace are not made with the sincerity of sound economics - they are made with the duplicitous purpose of keeping the public appeased while transfering wealth into the hands of those who control the money supply.

1 Another example refuting the premise that prices must be stable is the rapid growth of the United States economy during the latter half of the nineteenth century which was accompanied by a continual fall in consumer prices.

2 Such ideas are commonplace among academia as well. Interestingly enough, the most prestigious award for the discipline of economics, the Nobel Memorial Prize in Economic Sciences, is not actually one of the Nobel Prizes established by the will of Alfred Nobel. It is endowed "in perpetuity" by Sveriges Riksbank, the central bank of Sweden and world's oldest such establishment.