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On Friday, July
30, the St. Louis Federal Reserve Bank president, James Bullard, speaking on
CNBC television, said that the Fed must weigh medium-term inflation risks
against near-term deflation risks. For most economists and commentators, a
general fall in prices, which they label deflation, is a terrible thing. They
hold that a fall in prices generates expectations for a further decline in
prices. As a result of this, consumers postpone their buying of goods at
present because they expect to buy these goods at lower prices in the future.
Consequently, this weakens the overall flow of spending, and that in turn
weakens the economy.
A fall in
consumer expenditure subsequently not only weakens overall economic activity
but also puts further pressure on prices, so it is argued. Note that from
this it follows that deflation causes a spiraling decline in economic
activity.
From this way of
thinking, one could conclude that a general fall in prices should be
associated with an economic slump. Indeed, during 1932, the fall in the CPI
of 10.3% was associated with a fall in industrial production of 21.6%. But is
it true that a fall in prices should always be bad news for the economy?
Take, for
instance, a case where a general fall in prices results from an expansion in
the production of goods and services. Why should this be classified as bad
news? On the contrary, every holder of money can now command a larger
quantity of goods and services; therefore, people's living standards are going
up — so what is wrong with that?
Does a General Fall in Prices Cause People to
Postpone Buying?
If prices are
trending down, does it mean that people will stop buying at present? As a
rule, most individuals are trying to maintain their life and well-being. This
of course means that they will not postpone their buying of goods at present.
For instance,
since January 1998 the price of personal computers has fallen by 93%. Did
this fall in prices cause people to postpone buying personal computers? Not
at all. Consumer outlays on personal computers have increased by over 2,700%
since January 1998.
Now, if deflation
leads to an economic slump, then, following the logic of the popular
thinking, policies that reverse deflation should be good for the economy.
Since reversing deflation means introducing policies that boost a general
increase in the prices of goods — inflation — this means that
inflation could actually be an agent of economic growth.
For most experts,
a little bit of inflation can actually be a good thing. Hence they would like
the Fed to generate an inflation "buffer" to prevent the economy
from falling into a deflationary black hole. They hold that a rate of
inflation of around 3% could be the appropriate protective "buffer."
It is held by mainstream thinkers that inflation of 3% is not harmful to
economic growth, but inflation of 10% could be bad news.
In this way of
thinking, at an inflation rate of 3%, consumers will not postpone their
spending on goods and hence will not set in motion an economic slump. But
then, at a 10% rate of inflation, it is likely that consumers are going to
form rising inflation expectations. According to the popular thinking, in
response to a high rate of inflation consumers will speed up their
expenditure on goods at present, which should boost the economic growth. So
why, then, is a rate of inflation of 10% or higher regarded by experts as a
bad thing? Clearly this type of thinking is problematic.[1]
A General Fall in Prices and the Money Supply
A general fall in
prices can also emerge as a result of a fall in the money stock. An important
cause for such a fall is a decline in fractional-reserve lending. The
existence of a central bank and of fractional-reserve banking permits
commercial banks to generate credit not backed up by real savings, i.e.,
credit created out of thin air. Once the unbacked credit is generated, it
creates activities that the free market would never support —
activities that consume, and do not produce, real wealth. As long as the pool
of real savings is expanding and banks are eager to expand credit, various
false activities continue to prosper.
Whenever the
extensive creation of credit out of thin air lifts the pace of real-wealth
consumption above the pace of real-wealth production, this undermines the
pool of real saving. Consequently, the performance of various activities
starts to deteriorate, and bank's bad loans start to rise. In response to
this, banks curtail their loans by not renewing maturing loans and this in
turn sets in motion a decline in the money stock.[2]
The point that
must be emphasized here is that the fall in the money stock that precedes
price deflation and an economic slump is actually triggered by the previous
loose monetary policies of the central bank and not by the liquidation of
debt.
It is loose
monetary policy that provides support for the creation of unbacked credit.
Without this support, banks would have difficulty practicing
fractional-reserve lending.
The unbacked
credit in turn leads to the reshuffling of real savings from wealth
generators to non–wealth generators. This in turn weakens the ability
to grow the pool of real savings, which in turn weakens economic growth.
It must also be
emphasized here that government outlays are another important factor
undermining the pool of real savings. The larger the outlays are, the more
real savings are diverted from wealth generators.
"Under deflation, it is those non–wealth
generating activities that end up having the most difficulties in serving
their debt, because these activities were never generating any real wealth
and were really supported or funded, so to speak, by genuine wealth
generators."
Many commentators,
including Bernanke, are of the view that a fall in prices raises the debt
burden and causes consumers to repay their debt much faster. Rather than
using the money in their possession to buy goods and services, consumers use
a larger portion of their money to repay their debt.[3]
In this way of
thinking, a continuous debt liquidation could put severe pressure on the
money stock and in turn on household demand for goods and services. All this,
Bernanke believes, could lead to a prolonged decline in the price level. A
fall in the price level in turn raises the debt burden and leads to a
strengthening in the process of debt liquidation. Hence, to prevent this
downward spiral, Bernanke recommends aggressive monetary pumping by the
central bank.
Again, the debt
liquidation and emerging price deflation are not the causes of the economic
slump but the necessary outcomes of the previous loose monetary policies of
the Fed, which have weakened the pool of real savings. Also note that it is
not a fall in prices as such but instead the declining pool of real savings
that raises the debt burden and intensifies price deflation. The declining
pool weakens the process of real-wealth generation and in turn weakens borrowers'
ability to serve the debt.
Similarly, it is
not increases in real interest rates, as suggested by many commentators, but
a shrinking pool of real savings that undermines real economic growth. On the
contrary, increases in real interest rates put things in proper perspective
and arrest the wastage of scarce real savings, thereby helping the real
economy.
Now if the pool
of real savings is falling, then even if the Fed were to be successful in
dramatically increasing the money supply and increasing the price level,
i.e., countering deflation, the economy would still follow the declining pool
of real savings.
Contrary to the
popular view, in this situation the more money the Fed pushes into the
economy, the worse the economic conditions become. The reason for this is
that more money only weakens the wealth-generating process by stimulating
nonproductive consumption (consumption that is not preceded by the production
of real wealth).
Why Deflation Heals the Economy
As we have seen,
deflation comes in response to previous inflation. Note that as a rule a
general increase in prices, which is labeled inflation, requires increases in
the money supply. Hence a fall in the money supply leads to a fall in general
prices — labeled as deflation. This amounts to the disappearance of
money that was previously generated out of thin air. This type of money gives
rise to various nonproductive activities by diverting real savings from
productive real wealth generating activities.
Obviously, then,
a fall in the money stock on account of the disappearance of money out
"of thin air" is great news for all wealth-generating activities;
the disappearance of this type of money arrests their bleeding. A fall in the
money stock undermines various nonproductive activities. It slows down the
decline of the pool of real savings and thereby lays the foundation for an
economic revival.
But what about
the fact that a general decline in prices is accompanied by a fall in general
economic activity? Surely this means that deflation may be bad news for
productive and nonproductive activities? The fall in economic
activity, as we have already shown, comes not on account of falling prices,
but on account of a fall in the pool of real savings.
The emergence of
deflation is the beginning of the process of economic healing. Deflation
arrests the process of impoverishment inflicted by prior monetary inflation.
Deflation of the money stock, which as a rule is followed by a general fall
in prices, strengthens the producers of wealth, thereby revitalizing the
economy.
Obviously, the
side effects that accompany deflation are never pleasant. However, these bad
side effects are not caused by deflation but rather by the previous
inflation. All that deflation does is shatter the illusion of prosperity
created by monetary pumping.
Again, it is not
the fall in the money supply and the consequent fall in prices that burdens
borrowers but the fact that there is less real wealth. The fall in the money
supply, a money supply created out of "thin air," puts things in
proper perspective. As a result of the fall in money, various activities that
sprang up on the back of the previously expanding money supply now find it
hard going.
It is those
non–wealth generating activities that end up having the most
difficulties in serving their debt, because these activities were never
generating any real wealth and were really supported or funded, so to speak,
by genuine wealth generators.
Contrary to the
popular view then, a fall in the money supply is precisely what is needed to
set in motion the buildup of real wealth and a revitalizing of the economy.
Printing money only inflicts more damage and therefore should never be
considered as a means to help the economy.
Conclusion
Despite the
almost-unanimous agreement that deflation is bad news for the economy's
health, that idea is false. As we have seen, deflation comes in response to
previous inflation. This amounts to the disappearance of money that was
previously generated out of thin air. This type of money gives rise to
various nonproductive activities by diverting real saving from productive
activities.
Obviously then, a
fall in the money stock on account of the disappearance of money created out
of thin air is great news for all wealth-generating activities. The
disappearance of this type of money arrests their bleeding. A fall in the
money stock undermines various nonproductive activities; it therefore slows
down the decline of the pool of real savings and lays the foundation for an
economic revival.
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
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