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It is the opposite phenomenon to inflation.
Deflation and falling pricesEdit
Deflation can cause a fall in prices. But calling falling prices "deflation" is a profound confusion between prosperity and depression. There are two distinct causes of generally falling prices. The leading cause of falling prices is economic progress, whose essential feature is an increasing production and supply of goods and services, which operates to make prices fall. The other is a decrease in the quantity of money and or volume of spending in the economic system. Falling prices is the only effect that they have in common. They differ profoundly with respect to their other effects.
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.
What wipes out profits and makes debt repayment more difficult is not falling prices but monetary contraction, i.e., the reduction in the quantity of money and or volume of spending in the economic system. This is what serves to reduce sales revenues, and, in the face of costs determined on the basis of prior outlays of money, causes a corresponding reduction in profits. It is also what makes debt payment more difficult, in that there is simply less money available to be earned and thus available to be used for the repayment of debts. 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.
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.
Deflation and falling creditEdit
When Joe lends $100 to Bob via a bank, this means that Joe (via the intermediary) lends his money to Bob. On the maturity date, Bob transfers the money back to the bank and the bank in turn (after charging a fee) transfers the $100 plus interest to Joe. The money never disappears or is created; the original $100 is paid back to Joe.
But things are very different when Joe keeps the $100 in the demand deposit, ready to employ it at any time he likes. If the bank lends Bob $50 by taking it from Joe's demand deposit, the bank will have created $50 of unbacked credit, out of "thin air." By lending $50 to Bob, the bank creates $50 of extra demand deposits. Thus, there is now $150 in demand deposits that are backed by only $100. In this sense, the lending is without a lender. The intermediary, i.e., the bank, has created a mirage transaction without any proper lender. On the maturity date, when Bob repays the money to the bank, that money disappears.
An increase in credit out of thin air, all other things being equal, results in an expansion of the money supply. A fall in credit out of thin air, all other things being equal, results in a contraction of the money supply. A fall in normal credit (i.e., credit that has an original lender) doesn't alter the money supply and hence has nothing to do with deflation. For instance, if Joe directly lent Bob his $100, when Bob repays the money there will be a fall in credit with no change in money supply.
Opinions on DeflationEdit
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.
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 have 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.
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 a massively increased debt on all levels.
As a consequence of deflation, firms financed per credits go bankrupt because at the lower level of prices they can no longer pay back the credits 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 had to be imposed by the state.
- ↑ Murray N. Rothbard. "C. Secondary Developments of the Business Cycle", Man, Economy and State, referenced 2010-03-09.
- ↑ George Reisman. "The Anatomy of Deflation", Mises Daily, August 2003, referenced 2010-03-09.
- ↑ Llewellyn H. Rockwell, Jr. "Deflation: Hurrah!", The Free Market Volume 23, Number 8, August 2003. Referenced 2010-03-09.
- ↑ Frank Shostak. "Does a Fall in Credit Lead to Deflation?", Mises Daily, October 2009, referenced 2010-03-09.
- ↑ Ben S. Bernanke. "Deflation: Making Sure "It" Doesn't Happen Here", Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C., November 21, 2002, referenced 2010-03-16.
- ↑ 6.0 6.1 Philipp Bagus. "Deflation: When Austrians Become Interventionists", The Quarterly Journal of Austrian Economics, Vol. 6, No. 4 (WINTER 2003), referenced 2010-03-16.
- ↑ Murray N. Rothbard. "America's Great Depression", The Positive Theory of the Cycle, p. 17, referenced 2010-03-16.
- ↑ Jörg Guido Hülsmann. "Deflation and Liberty", Mises Daily, December 2008, referenced 2010-03-25.
- Deflation on Wikipedia
- An Austrian Taxonomy of Deflation (pdf) by Joseph T. Salerno, February 2002
- The Imaginary Evils of Deflation by Christopher Mayer, September 2002
- 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
- Why is the US Federal Government Afraid of Deflation? by Harry Dent, May 23, 2012