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Deflation: The Biggest Myths

Mises Daily: Wednesday, June 11, 2003 by

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The prospect of deflation haunts the political and economic establishment in our western democracies. Their fears are understandable, at any rate from an economic point of view. Consider the following three basic propositions of monetary economics:

According to the first proposition, both the quantity of money and the price level are irrelevant for the wealth of a nation. Firms and households can successfully produce any quantities of consumers’ goods at any price level and with any nominal quantity of money. The ultimate springs of human wellbeing are savings, technology, and entrepreneurship – not money supplies and price levels.

According to the second proposition, while changes in the money supply do not affect the wealth of a nation in the aggregate, they change the distribution of resources among the members of society. In the case of an increasing money supply, for example, the first owners of the additional quantities of money benefit at the expense of all other money owners. Notice that these redistribution effects result not only from changes in the quantity of money, but from any changes in the supply of any good. There is a significant difference between money and all other goods only in a fiat money regime. This brings us to our third proposition:

A fiat money regime considerably facilitates the re-distribution of resources within society. It allows the owners of the printing press and their political and economic allies to enrich themselves far quicker and at much lower cost than any other producer in any other field. This explains why governments have for centuries sought to establish a paper currency. And it explains why, after they had achieved this goal in the 20th century, governments and their business allies set off on an exponential growth path. The welfare state has exploded in the 20th century, and Wall Street and the banking sector grew quicker than almost any other sector of the economy.

This would not have been possible on a free currency market, because nobody would accept banknotes the purchasing power of which depends on the whim of its producer. And indeed paper money has never existed in a truly free currency market.[1] It is essentially fiat money – money that the government imposes on its citizens. Paper money is protected through “legal tender” laws, which means that you and I can be forced to accept it as payment, even if we have contractually stipulated payment in other commodities. Moreover, in many countries paper money is shielded against its main competitors such as coins made out of precious metals through the tax code – sales taxes and capital gains taxes apply to these metals, but not to paper money. In short, paper money is monopoly money; it enriches the happy few at the expense of all others.

The deflation-phobia of our elites is therefore the rational reaction of those who profit from the privileges that our present inflationist regime bestows on them, and who stand to lose more than any other group if this regime is ever reversed in a deflationary coup. Perennial inflation is based on monopoly. Deflation brings in the fresh winds of the free market. True elites would welcome deflation for precisely this reason, because they owe their leadership positions exclusively to the voluntary support of other members of society. They have nothing to fear from deflation – a shrinking money supply – because their leadership is grounded on the useful entrepreneurial services they provide to their fellow citizens – services that would subsist through any changes in the money supply or in the price level.

But large parts of our present-day elites are “false elites” or “political entrepreneurs.” These men and women owe a more or less great amount of their income and decision-making power to legal privileges that protect them from competition and which enrich them at the expense of all other people. The fortunes of many political entrepreneurs are directly or indirectly attributable to the money monopoly of the Federal Reserve System. It is only because of this monopoly that the Fed could create a near boundless expansion of the money supply. And it is this inflation that in turn has financed a near boundless expansion of the activities of the federal and state governments, and of those who rely essentially on their lobbying effort with the Fed, rather than on the quality of their products, to reach and maintain leadership positions.

Political entrepreneurs are thus right to fear deflation. For deflation takes away the source of their illegitimate income and puts them finally back on equal footing with all other members of society, whose incomes are based on efforts and services provided in a competitive environment.

But these privileges can only survive because of widespread ignorance about the true character of deflation.[2] A closer look reveals that the case against deflation squarely rests on a litany of inflationist myths. To these we now turn.

Myth #1: You cannot earn a living and make profits when the price level falls

Most of our analysis will deal with deflation in the sense of a shrinking money supply. This case is most interesting from a political point of view, because few economists and laymen are ready to concede any benefits to deflation in this sense. But before we turn to this case, let us briefly examine the character of deflation in a somewhat different connotation, namely, in the sense of a decrease of the general price level. This type of deflation draws much less criticism than the other type, but it might be useful to deal with it first as a warm-up for out subsequent discussion.

Thus, is it true that one cannot earn a living and make profits when the price level falls? The answer is in the negative. Successful business does not at all depend on the level of prices, but on price spreads or, more precisely, on spreads between selling receipts and cost expenditure. But such spreads can exist and do exist at any level of prices, and they can exist and do exist even when there is a secular decline of prices. The essential reason is that entrepreneurs can anticipate declining prices, just as they can anticipate increasing prices. If they anticipate a future decline of their selling proceeds, they will bid down present prices of factors of production, thus assuring profitable production and paid employment for everyone willing to work. This is exactly what happened in the few periods of modern history in which deflation was not prevented through inflationist counter-measures.

For example, both the U.S. and Germany enjoyed very solid growth rates at the end of the 19th century, when the price level fell in both countries during more than two decades. In that period, money wage rates remained by and large stable, but incomes effectively increased in real terms because the same amount of money could buy ever more consumers’ goods. So beneficial was this deflationary period for the broad masses that it came to the first great crisis of socialist theory, which had predicted the exact opposite outcome of unbridled capitalism. Eduard Bernstein and other revisionists appeared and made the case for a modified socialism. Today we are in dire need of some revisionism too – deflation revisionism that is.

Myth #2: While falling prices are good, lacking aggregate demand is bad

This is a variant of myth #1. While the advocates of this myth concede the point that lower prices are advantageous from the point of view of consumers, they claim that there are manifest disadvantages from the point of view of producers. In particular, there would be few incentives to invest into any sort of business in an environment of shrinking prices. We have already rebutted this view by pointing out that the absolute future price level is irrelevant for profitable enterprise. The relevant factor is the possibility to realise a spread between selling proceeds and cost expenditure, and this possibility exists irrespective of the movement of the price level.

Now our anti-deflationist might come up with the following objection: profitable enterprise in times of falling prices presupposes that businessmen can bid down factors of production in anticipation of the event. If they are unable to bid factor prices down, they will not invest at all. QED.

But this argument overlooks that all resources are invested into some use at any point of time. Why are our farsighted entrepreneurs unable to bid the factor prices down? Clearly this is so either because the factor owners are not ready to sell them at the lower prices, or because other entrepreneurs offered slightly higher prices. In the latter case, there is clearly no lack of investment and productive activity. The factors in question are bought and sold – albeit at lower prices than would have been offered in inflationary times. And even in the former case, the factors are invested – they are invested in the “reserve stock” of the owner of these factors, and such a reservation demand fulfils a useful social function just as any other form of demand.

Myth #3: You cannot earn a living and make profits when the money supply shrinks

Human beings are able not only to anticipate a falling price level, but also the consequences of a shrinking money supply. Such anticipations will usually accelerate the deflationary process and make it reach the "rock bottom" of a stable money supply very quickly. Two cases need to be distinguished: A) the case of a fractional-reserve banking system operating on the basis of a commodity money such as gold or silver and B) the case of a paper money.

In case A, the supply of physical gold or silver can obviously not just vanish in thin air, and thus it remains to provide rock bottom in case of a deflation of fractional-reserve notes. Such a deflation usually starts when more and more people refuse to accepts these notes as payment, and it usually ends in a bank run, when even the present holders of the notes no longer wish to own them and rush to the issuing bank to redeem them in gold or silver. After the run, the money supply has often considerably shrunken because all fractional-reserve notes have disappeared from circulation. But the stock of metallic money remains and provides a rock bottom, below which the money supply cannot sink. There is no reason why this deflationary process should not be finished in a few hours or days. When it has ended, many banks will be bankrupt and many entrepreneurs will be bankrupt too, to the extent that they have financed their firms with debt rather than with equity. This explains of course why the present debt-financed establishment ferociously resists deflation. But it does not mean that production could not go on without them – in fact it can go on and will go on under new ownership.

In case B, there is no rock bottom to provide a stopping point to the deflationary process reducing the supply of a paper money. When people no longer wish to own a paper money and start selling it at any price, the result will be an ever declining purchasing power of this money, which in turn might convince even those who had bought that they better get rid of it, and the sooner the better. The result is a deflationary spiral: less willing owners – less purchasing power – less willing owners – less purchasing power and so on, until the paper money has completely vanished from circulation. Notice that this does not mean that the economy will necessarily be thrown back into a state of barter. What usually happens in such cases is that people start using other monies such as gold and silver coins, or foreign paper monies. The deflationary spiral therefore has the healthy effect of replacing an inferior sort of money – inferior from the point of view of the money users – with superior money. Again, there is no reason why this process should not be completed in a few days. And there is therefore no reason to expect that production will not resume very quickly under new ownership.

Myth #4: Deflation entails slower economic growth than inflation

Some champions of inflation concede that production can go on after a deflation, and possibly even in the midst of a deflation. But they claim that economic growth will be seriously curtailed by the necessary adjustments, to the point that it would have been preferable to avoid the deflation through inflation – or as they say, reflation.

It is difficult to discuss such claims in the absence of a commonly agreed-upon definition of economic growth. But the following consideration nevertheless applies: The problem of adjusting to deflation in the sense of a shrinking money supply is inherently a short-run problem. It is a problem of identifying those investment projects that are most profitable (and thus most socially beneficial) under the new conditions that deflation has brought into being. In particular, deflation in the worst of all circumstance induces businessmen and factor owners to hold back with their assets to avoid wasting them in any fancy venture. Deflation is therefore inherently sober, prudent, and financially conservative.

By contrast, inflation constantly lures capital into investment projects that do not find the spontaneous support of other members of society – capitalists, workers, and customers – but which are feasible only because they are financed, directly or indirectly, with money from the printing press. The most glaring example is the welfare state, which can be financed, not because there is any prospect of future returns, and not because it attracts a sufficient amount of voluntary donations, but solely because it is backed up with an ever-increasing amount of debts, which one day will be paid with new money from the printing press. This consideration applies quite apart from the fact, stressed by the Austrian economists, that inflation can induce inter-temporal misallocations of capital.

Given the enormous waste that goes in hand with inflation, it is not farfetched to assume that deflation will spur economic growth both in the long run and in the immediate run, by any definition of growth that emphasises the value scales of the individual members of society, rather than some arbitrary criterion of social justice.

Myth #5: Deflation is particularly burdensome for lower-income groups

The main asset of relatively poor people is their labour, and labour is a relatively non-specific asset, which means that it can be used in many branches of industry. If a worker can no longer be employed in his present position, it is therefore always possible for him to find new employment elsewhere, even though at a lower market price. By contrast, relatively rich people typically derive a larger part of their income from financial assets. Ultimately these assets relate to the ownership of capital goods, which in turn are highly specific assets – they can very often be used only in exactly the way in which they are presently used. If this use is no longer profitable, there will be a more or less dramatic drop of their market price, often to scrap value.

It follows that deflation affects lower-income groups less than higher-income groups.

Myth #6: Deflation destroys the credit of the state

It is true that deflation – especially deflation in the sense of a contraction of the money supply – will make it impossible for a government to ever pay back public debts. And it is also true that it will then for some time be impossible for the government to obtain new credits.

But it is a myth to believe that we have to wait for deflation to bring about this result. Public debts are on an exponential growth path and no official even talks about paying them back. Fact is that our western governments are already on a slippery slope that will inevitably end up either in hyperinflation or in state bankruptcy. It is just a question of time until they will have destroyed their credibility all on their own – deflation would merely speed up this process.

Let us also notice that there are potentially beneficial effects associated with state bankruptcy. In particular, governments would again be dependent on obtaining revenue mainly through taxation, and that puts a healthy break on their expansion path.

Myth #7: Deflation creates unemployment

Unemployment of a factor of production comes about only in two cases: A) if the owner of the factor is not willing to rent it out at the price offered to him, or B) if the law prevents him from doing so. It is therefore not true that declining wage rates bring about unemployment by any sort of inner necessity. People are not just unemployed. They choose not to work for an employer under the (pecuniary and non-pecuniary) conditions offered to them. Now it is clear that no sane person will accept to work for somebody else if the wage rate does not allow him to survive anyway. But this is not the case in a deflation. Remember that here all prices fall, and thus the decline of wage rates is compensated by a parallel decline of the prices for consumers’ goods. It is true that there might not be in all cases an exact parallel between wage rates and the prices of consumers’ goods, but any deviations will be temporary only and can easily be bridged for some time with the assistance of family, friends, and charitable institutions.

Involuntary unemployment might arise in a deflation only if the latter is combined with minimum wage laws, which prevent the worker from offering his services at lower rates. But clearly this unemployment does not result from deflation, but from the minimum-wage laws, which infringe on the freedom of association.

Myth #8: Deflation entails unequal and arbitrary burdens for the citizens

It is true that deflation involves heavy burdens for many individuals. Just consider the fact that today the great majority of U.S. household have incurred considerable liabilities, usually in the form of real estate mortgages. If a contraction of the money supply sets in, household incomes will decline and it will be impossible to pay back these liabilities. It will then be necessary o renegotiate debts, and some individuals will have to file bankruptcy. It is also true that deflation has unequal consequences for the individual citizens. Some will prosper in a deflationary environment more than they would have prospered in the present inflationary regime, and others will fare worse. Finally it is true that these re-distributions are often difficult to square with one’s notions of what is just and unjust.

So where is the myth? The myth consists in the belief that only deflation entails unequal and arbitrary burdens for the citizens. The truth is that the present inflationist regime is no less re-distributive and arbitrary than any deflation could possibly be. Inflation constantly re-distributes income from people who offer genuine services to people who happen to enjoy political alliances with the masters of the printing press.

Even if inflation is used “only” to prevent an impending deflation, these arbitrary and unequal redistribution effects cannot be avoided. The very least thing we could say, therefore, is that deflation is certainly not more unjust than inflation. But as well shall see further down, there are in fact very tangible benefits to be derived from deflation that make it actually preferable to continued inflation. But before we come to discussing this point, let us briefly deal with another issue:

Myth #9: It will take decades to settle deflation-induced legal disputes

Have we not been too over-optimistic in assuming that deflation might be a matter of a few hours or days? Is it not rather likely that deflation will upset a great number of long-term contracts, from mortgage contracts over industrial bonds to real estate leases? And is it not rather likely that it will take the courts some twenty years or so to sort out all the different claims and counter-claims?

It is true that, while the adjustment of the price structure to the new deflation-created conditions might take just a few hours or days (but could take much longer if government interventions hamper the adjustment process), the settlement of legal disputes could involve much longer times periods. But based on the empirical evidence it is certainly exaggerated to assume that more than a few months would be needed.

Consider the German deflation that set in after the bankruptcy of the Darmstädter Bank on July 13, 1931, and which lasted some two years. The crisis very quickly jeopardised the liquidity, not only of the banking sector, but also of virtually all other branches of German industry. Contractual relations were upset on a large scale, and thus it not only came to bankruptcies on an unprecedented scale, but also to a great number of revisions of previous contracts, both inside and outside of the courts, and to payment moratoria. Unemployment rose to almost 7 million, production stopped in many firms, salaries and wages plummeted, as did all other prices. The radical drop of real estate prices jeopardised the mortgage business, as well as financial titles backed up with mortgage claims.

How were these problems handled? Well, the unemployment problem was not handled at all, because government had created the conditions under which unemployment was inevitable: unemployment insurance and minimum wage laws. The result was social upheaval and twelve years of National Socialism.

But the problems relating to claims resolution were handled rather quickly and efficiently, partly because the German courts had, in the wake of the hyperinflation of 1923, gained some experience in dealing with dramatic changes in the purchasing power of money. In a great number of cases, the disputes never made it into the state courts, but were settled in private arbitration. The remainder was settled in the state courts or dealt with in a series of four emergency laws, the last of which was voted in parliament on December 8, 1931. Thus, a few months after the deflation had set in, all essential legal tools and institutions were in place and operated fairly efficiently.

There is no reason to assume that things would be handled less efficiently in the present-day United States, especially if legal scholars turn their energies into analysing the problems that are here at stake.[3]

Myth #10: Deflation confers no positive net benefit

Granted that a heavy contraction of the money supply is merely on equal footing with increases of the money supply when it comes to the distribution of burdens among the citizens. But is it not the case that we have pretty well adjusted out behaviour to the present inflationary environment, where as letting deflation happen would impose on us a re-adjustment? Even if this adjustment is only a temporary affair, still it involves costs for all members of society. So what are the benefits of deflation that could prompt a responsible citizen to endorse it, apart from the uncertain prospect of being on the winners’ side in the short-run zero-sum redistribution process that deflation entails? Here the following consideration comes into play.

First of all, deflation is a very efficient mechanism to speed up adjustment to new circumstances in the wake of a major financial crisis. The reason is, as we have noticed above, that deflation affects the prices of factors more than it affects the prices of consumers’ goods. As a consequence, deflation increases the spread between selling receipts and cost expenditure – in other words, the interest rate – and thus creates powerful incentives for increased savings and investments.

Second, and equally importantly, deflation is a one-time process that however has the potential to destroy the very institutions that produce inflation on a perennial basis, in particular, fractional-reserve banks and fiat money producers (“central banks”). The destruction of these institutions eliminates the “advantage at the margin” enjoyed by liability finance as compared to auto-finance. In other words, economic and social power is taken away from the Fed and the banks, and returned into the hands of individual citizens. Firms will operate on a far higher equity basis than before, and households will, in more cases than before, first save and then buy a home. Furthermore, the destruction of the inflation machine will destroy the main financial engine of the welfare state. Governments will henceforth have to obtain their resources exclusively through taxation, which is subject to far greater social control than the unworthy stealth method of gaining resources by inflating the money supply.

Myth #11: Letting deflation happen is “passivism”

In the light of our foregoing discussion, it is clear that letting deflation happen must not be simply equated to an apathetic resignation before the power of mysterious forces and blind market mechanisms. Deflation can fulfil extremely useful social functions and those who cherish individual liberty and the sanctity of private property are on good grounds in consciously striving to let deflation run its course. If anything, it is letting inflation happen that amounts to apathetic resignation – resignation that is before the power of a money monopoly that thrives on ignorance, and which benefits political networks at the expense of capitalistic civil society.


Jörg Guido Hülsmann is senior fellow of the Mises Institute. jgh@mises.org. See his Daily Article Archive and his vita and other links.  He is lecturing at the Mises Institute this summer. His latest lecture on deflation is available on Mises.org audio.


[1]        One might object that the banknotes of the Bank of England that circulated from 1797 to 1821 were an exception, because they were not legal tender. But these notes were not paper money, but credit money. During the entire period of this “paper pound,” the market participants expected a resumption of specie payments of the Bank of England in the near future. For the distinction between commodity money, credit money, and fiat money (in most cases: paper money), see Mises, Theory of Money and Credit, part one, chap. 3, sect. 3.

[2]        Of course we mean to defend only free-market deflation. Confiscatory deflation is in-defendable. See Rothbard in Making Economic Sense, and Salerno, “Taxonomy of Deflation.”

[3]        One of the most interesting present-day problems for libertarian legal scholarship is the development of a legal theory of deflation.