Deflation

Deflation is a contraction in the supply of money, and, as such, is the opposite of inflation. A decline in the price level is known as price deflation, but outside the Austrian School of Economics, this distinction is rarely made and the term deflation often refers to falling prices.

Causes
Price deflation has two immediate causes: decreased aggregate demand and/or increased supply.

One major cause of decreased aggregate demand is an increased demand for money – that is, cash balances – due to economic uncertainty or an increase in the quality of money. An increase in the quality of money might be a change from a fiat money system to a commodity money system, in which case many individuals would convert their savings from financial instruments (such as stocks and bonds) to cash. Holding cash where the money quality is poor leads to a loss of purchasing power, but holding cash where money quality is high is a viable savings strategy.

Another cause of decreased aggregate demand is a decline in the money supply, as is the case when a bank shuts down. Any money created by the bank above its quantity of reserves (see fractional reserve banking) would be liquidated, causing that amount of money to evaporate from the money supply.

Increase supply of economic goods can be the result of natural causes, such as climate change or weather phenomena making production easier, or man-made causes. Man-made causes include improved economic policy, a higher savings rate, and an increased tendency toward entrepreneurship. Entrepreneurship, in turn, often results in new technologies and the discovery of resources.

Effects
The effects of price deflation differ depending on the cause(s), and on the state of the economy.

Falling prices caused by increased production do not reduce the general or average rate of profit in the economic system and do not make debt repayment more difficult. For example, if falling prices result from the fact that while the quantity of money and volume of spending in the economic system are rising at a two percent annual rate, production and supply are rising at a three percent annual rate, the average seller in the economic system is in the position of having three percent more goods to sell at prices that are only one percent lower. His sales revenues will be two percent higher, and that is what counts for his nominal profits and his ability to repay debts. His profits will be higher and his ability to repay debt will be greater. There are lower prices, but no deflation.

A decline in aggregate demand, especially as a result of a reduction in the money supply (a monetary contraction) leads to reduced profits, since sales revenue is reduced and costs are based on prior outlays of money. The associated decline in available money to be earned makes debt repayment more difficult, and, in a debt economy, can result in bankruptcy.

However, this decline in prices should not be viewed as a negative: in fact, falling prices in response to monetary contraction are precisely what enable a reduced quantity of money and volume of spending to buy as many goods and to employ as many workers as did the previously larger quantity of money and volume of spending.

Examples
Falling prices have been recorded in the computer industry and appliances, which have gone down in price dramatically over the years even as sales have risen higher and higher. Why? Because the companies have gotten better and better at doing what they do, and have been able to make profits even in the face of continual price declines.

Opinions on deflation
The opinions on deflation vary widely. Austrian economists define it as a contraction of the money supply, while mainstream economists, define deflation as a general fall in prices. Most mainstream economists want to prevent deflation. But even Austrians differ in their perspective of deflation, and some wish to prevent it as well.

Murray Rothbard refutes three common arguments: First, that falling prices would depress business. Second, a deflation induced increase in real debt would hamper production. Third, credit contraction would worsen and aggravate the depression. He stresses that the anticipation of falling prices "lead to an immediate fall in factor prices," since entrepreneurs would simply bid down the prices of the factors of production to the anticipated levels. "What matters for business is not the general behavior of prices, but the price differentials between selling prices and costs (the "natural rate of interest"). If wage rates, for example, fall more rapidly than product prices, this stimulates business activity and employment." He points out, that a credit contraction in a depression will have the beneficial effect of speeding up the adjustment process, since it returns the economy to free-market proportions much sooner than otherwise. Also, in a depression some of the wrong investment projects have to be liquidated, because there are not enough savings available to sustain them. A credit contraction induces an increase in savings, so fewer adjustments are necessary. While stating that deflation could at least potentially play a role in a monetary reform, he finally decides against it.

Jörg Guido Hülsmann points out that the quantity of money is irrelevant. Any quantity of money provides all the services that indirect exchange can possibly provide, both in the long run and in the short run. A change in the money supply - inflation or deflation - does not affect the aggregate wealth of society. Our tools, our machines, the streets, the cars and trucks, our crops and our food supplies — all this is still in place — but both phenomena radically modify the structure of ownership. The consequence of a century of inflation were financial crises, dominance of banks and firms financed by credit over the economy, and massively increased debt on all levels.

As a consequence of deflation, firms financed by credit go bankrupt because at the lower level of prices they can no longer pay back the credit they had incurred without anticipating the deflation. Private households with mortgages and other considerable debts to pay back go bankrupt, because with the decline of money prices their monetary income declines too, whereas their debts remain at the nominal level. Other people will run the firms and own the houses — people who at the time the deflation set in were out of debt and had cash in hand to buy firms and real estate. These new owners can run the firms profitably at the much lower level of selling prices because they bought the stock, and will buy other factors of production, at lower prices too.

The true problem with deflation is that it does not hide the redistribution connected to changes in the quantity of money. It entails visible misery for many people, to the benefit of equally visible winners. This starkly contrasts with inflation, which creates anonymous winners at the expense of anonymous losers. Both deflation and inflation are, from this point of view, zero-sum games. But inflation is a secret rip-off, whereas deflation means open redistribution through bankruptcy according to the law.

To Hülsmann, deflation is not inherently bad, so it does not follow that it should be avoided. True, it creates a great number of losers, many of them perfectly innocent people who have not anticipated the event. But it also creates many winners, and punishes many political entrepreneurs who had thrived on their intimate connections to those who control the production of fiat money. Any monetary policy has redistributive effects. There is no economic rationale for monetary policy to fight against deflation rather than letting it run its course. In a free society, all market participants should be free to produce money, while paper money always has to be imposed by the state.

Links

 * Articles and essays
 * An Austrian Taxonomy of Deflation (PDF) by Joseph T. Salerno, February 2002 (abridged version as Mises Daily here)
 * An Austrian Taxonomy of Deflation—With Applications to the U.S. (PDF)
 * The Imaginary Evils of Deflation by Christopher Mayer, September 2002
 * "Apoplithorismosphobia" (PDF) by Mark Thornton, 2003, on the "fear of deflation"
 * Deflation Teaser? Klondike Bars and the Golden 90s in Canada (PDF) by Mark Thornton, 2003
 * Deflation and Depression: Where's the Link? by Joseph T. Salerno, August 2004
 * Deflation and Japan Revisited (PDF) by Richard C.B. Johnsson, 2005
 * Deflation: Nothing to Fear, December 2008, by Jeff Bonn
 * Falling Prices Are the Antidote to Deflation by George Reisman, January 2009
 * In Defense of Deflation by Doug French, August 2010
 * Murray Rothbard and the Deflation Bogey by William L. Anderson, August 2010
 * Is Deflation Really Bad for the Economy? by Frank Shostak, August 2010
 * The Politics of Deflation by Vijay Boyapati, January 2011
 * The Politics of Deflation by Vijay Boyapati, January 2011


 * Other media
 * Economics of Deflation (video) by Jörg Guido Hülsmann