Deflation's Inflationary Source
A cry heard often today — both on the west and east sides of the Atlantic — is that inflation levels are dangerously low. While most central banks target a price inflation level of around 2–3 percent, general price indexes of most Western countries are falling below the lower bound of that target. A fear of deflation — apoplithorismosphobia, as Mark Thornton calls it — is setting in.
Without getting into whether deflation is good, bad, or benign, we should assess where deflation comes from. (The interested reader may consult George Selgin's Less than Zero: The Case for a Falling Price Level in a Growing Economy and Philipp Bagus's "Who's Afraid of Deflation?" to see the positive side of a falling price level.)
Strictly speaking, inflation and deflation can only stem from changes in the actual amount of money outstanding. Increases in the quantity of dollars causes, everything else being the same, an increase in prices. A decrease in dollars will cause the opposite effect. While bouts of inflation can occur under any monetary regime, deflation is constrained to a specific type — the fractional-reserve-banking system.
Once upon a time there was a banking system built upon the concept of the 100 percent–reserve principal. Someone would take their hard-earned cash to the bank, deposit it in the bank's vault, and the bank would promise to protect it until that same person came back to claim it. While money is fungible (i.e., we cannot tell one dollar bill from another, much like kernels of corn), the bank promised to keep what is called a tantundem, an equivalent quantity and quality of the deposited good. If you were to deposit one dollar, the bank would promise to hold one dollar in its vaults, but not necessarily the same one.
Then the banking world switched to what we today know as fractional-reserve banking. No longer was a bank legally required to hold all of your deposit safely. After all, it was rare that everyone would come in and ask for all of their deposits at the same time. Banks loaned out a fraction of their total deposits, thus creating a larger amount of claims to money than actually existed.
The Federal Reserve today sets what is known as the reserve requirement for banks. This is the minimum percentage of all deposits that must be kept in the bank's vaults for the customers. Hence, if a depositor walks in and opens an account with an American bank so that he can deposit $100, the reserve requirement is the amount that the bank must legally keep in its vaults at all times. The bank may do whatever it wishes with the rest of it. Typically it gets loaned out to people who want to borrow money.
Today the Fed enforces a reserve requirement of close to zero percent. What this means is that American-domiciled banks have little obligation to safeguard or hold any amount that is deposited in them. Our theoretical depositor from above could potentially see almost all of his deposit loaned out to someone else the moment he entrusts it to the bank's safekeeping.
Many people think that this is a moot point. Banks keep a small precautionary reserve of money to have on hand when depositors come to call on their deposits. And when times are good, and markets are functioning with much liquidity, there seem to be no significant problems with this arrangement. Yet ask a depositor from one of the 92 banks that became insolvent in 2011 if they think that this "fractional-reserve" setup is a moot point. When markets find themselves amid falling liquidity, it becomes increasingly difficult, or in some cases outright impossible, to honor all these deposits.
While this is the most commonly viewed problem with fractional-reserve banking — a problem that all economists agree exists — there is one additional issue that is no less important.
By only insisting that a fraction of deposits be held by any bank as reserves, banks are allowed to create more "money" (or more correctly, fiduciary media) than the supply of base money can pay off. This increase in the money supply is what sets in motion the inflationary forces that central banks try to limit via the 2–3 percent inflation range discussed earlier.
What is not understood is that any deflation can only result from a previous case of inflation. Indeed, as Murray Rothbard writes in his treatise, Man, Economy, and State,
Clearly, inflation is the primary event and the primary purpose of monetary intervention. There can be no deflation without an inflation having occurred in some previous period of time. (p. 990)
The phenomenon that central bankers of the world are so resolutely scared of, and have agreed to fight with all their might — deflation — is a creation of their own hands. Without the period of inflation leading up to the present, there could be no threat of deflation. The fractional-reserve-banking system allows an expansion of the money supply that breeds the conditions enabling a period of deflation. If this deflation is to be seen as a bad thing (and I would like to place emphasis on the word "if"), then eliminating it would be sensible. By halting the fractional-reserve-banking system we would eliminate the source of the root cause of subsequent deflation: inflation.
If the Fed's, and every other central bank's, actions over the past three years have seemed confused, we should not be too surprised. They are fighting a foe — deflation — that is of their own making. To keep from admitting culpability, they try to cover their tracks by enacting ever-more-tenuous and implausible policies. Perhaps what makes sense now is a regime change away from the fractional-reserve-banking system that created this mess.