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Inflation, Deflation, and the Future

October 7, 1999

Tags The FedFinancial MarketsFree MarketsLegal SystemU.S. HistoryMoney and BankingMonetary TheoryInterventionismCapital and Interest Theory

[Delivered at the Mises Institute conference, Austrian Economics and the Financial Markets, September 16, 1999, Toronto, Canada.]

The word deflation is currently on the lips of many economists. Bank of Japan Governor Masaru
Hayami has reiterated in parliament that the central bank will keep its ultra-easy monetary policy
unchanged until the threat of deflation has gone. Also US Federal Reserve Board Chairman Alan
Greenspan has indicated in his various speeches that the role of the central bank is to protect the
economy not only from inflation but also from deflation.

The majority of economists view deflation as a major threat to the public's well being. For
deflation is seen as a major factor that plunges the economy into a depression. However, most
economists do not realize that it is not deflation but rather inflation which is the root of economic
hardship. This confusion over the nature of deflation stems from a misleading view as to what
inflation is.

In what follows, I will show that inflation is not price rises but rather rises in money supply
emanating from loose monetary policies of the central bank and fractional-reserve banking.
Increases in the money supply cause the misallocation of resources, lay the foundation for the
shrinking pool of funding, and in turn lead to deflation. Moreover, I will argue that depressions
are not caused by deflation, but are the result of the loose monetary policies of the central bank.

Finally, I will argue that it is not the size of indebtedness that determines the severity of a
recession, but rather how aggressively loose monetary policies of the central bank are.
Notwithstanding the popular view, the US economy is severely out of balance. This, I suggest,
could culminate in a severe economic slump.

Is inflation about price increases?

According to Mises (Human Action, p. 432), "What many people today call inflation or
deflation is no longer the great increase or decline in the supply of money, but its inexorable
consequences, the general tendency toward a rise or fall in commodity prices and wage rates."

Once inflation is defined as a general rise in prices, then anything which contributes to price rises
is called inflationary and therefore must be guarded against. In short it is no longer the central
bank and fractional-reserve banking that are the sources of inflation, but rather various other
causes. In this framework, not only has the central bank nothing to do with inflation, but on the
contrary: the bank is regarded as an inflation fighter. Thus a fall in unemployment or a rise in
economic activity are all seen as potential inflationary triggers and therefore must be restrained by
central-bank policies. Some other triggers like rises in commodity prices or workers wages are also
regarded as potential threats and therefore must be always under the watchful eye of the central

Most economists believe that inflation is a general rise in prices that can be captured by the
Consumer Price Index (CPI), but they disagree about the causes of inflation. In one camp the
monetarists, argue that changes in money supply cause changes in the CPI. In the other camp, we
have economists who argue that inflation is caused by various real factors. These economists are
having doubts about the proposition that changes in money supply cause changes in the CPI. They
believe that it is likely to be the other way around. So if inflation is regarded as a rise in the CPI
why is it viewed as bad news? After all, if inflation is only an increase in the price level then surely
it is possible to offset its impact by linking salary and wages to rises in the CPI. Also, many
economists who follow Milton Friedman believe that the market economy could function
efficiently with inflation, provided it is not suppressed, i.e. prices are allowed to move freely.

Contrary to the accepted belief inflation is not a general rise in prices, caused either by money
supply growth, or by real factors. It is simply an increase in the money stock. Pay attention to what
we are not saying. We don't say, as monetarists do, that inflation is rises in prices caused by rises
in the money supply. All that we suggest is that an increase in the money stock is what constitutes
inflation. Looking at inflation this way makes it very clear why it is bad news. When money is
increased there are always first recipients of money who can buy more goods and services at still
unchanged prices. The second recipients of money also enjoy the new money. However, the
successive recipients derive less benefit as prices of goods and services begin to rise.

So long as the prices of goods they sell are rising much faster than prices of goods they buy, the
successive recipients of new money still benefit. The sufferers are those individuals who get the
money last or not at all. They find that the prices of goods they buy have increased while the prices
of goods and services they offer have hardly moved. In other words monetary growth or inflation
causes a redistribution of wealth. On a closer inspection we can also establish that monetary
injections give rise to demand for goods and services, which is not supported by the production of
goods and services, implying that monetary growth results in economic impoverishment.
Furthermore, monetary inflation gives rise to the menace of the boom-bust economic cycle.

While increases in money supply ( i.e. inflation) are likely to be revealed in price increases
registered by the CPI, this need not always be the case. Prices are determined by real and monetary
factors. Consequently it can occur that if the real factors are pulling things in an opposite
direction to monetary factors no visible change in prices might take place. In other words, whilst
money growth is buoyant i.e. inflation is high, prices might display low increases. Clearly, if we
were to regard inflation as rises in the CPI, we would be reaching misleading conclusions
regarding the state of the economy.

On this Rothbard wrote (America’s Great Depression, p. 153), "The fact that general prices
were more or less stable during the 1920’s told most economists that there was no inflationary
threat, and therefore the events of the great depression caught them completely unaware."

Is deflation the root of all the evils?

So while inflation is rises in the money stock, deflation can be seen as the opposite, which is the
fall in the money stock. Or we can say that whereas monetary expansion gives rise to a bubble, the
monetary contraction leads to the deflation of the bubble. It seems therefore that deflation in this
sense must be preceded by inflation.

Most economists regard deflation as bad news. For instance, Irving Fisher labeled deflation the
root of almost all the evils (Irving Fisher, Booms and depressions, London: George Allen,
p. 39). However, deflation is the beginning of the process of economic healing. Deflation arrests
the process of impoverishment inflicted by the prior monetary inflation. Contrary to mainstream
thinking then, deflation of the money stock strengthens the producers of wealth, thereby
revitalizing the economy.

On this Rothbard wrote (AGD, p. 24), "deflationary credit contraction greatly helps to
speed up the adjustment process, and hence the completion of business recovery, in ways as yet

Obviously the side effects that accompany monetary deflation are never pleasant. However, these
bad side effects are not caused by deflation but rather by the previous monetary inflation. All that
deflation does, is to shatter the illusion of prosperity created by monetary inflation.

The popular belief that a fall in the money stock leads to general economic impoverishment
emanates from a view that money can grow the economy. What however, enables economic
growth is not more money but more capital goods per capita. Furthermore, economists who regard
a general fall in prices as an important cause of depression overlook the fact that what matters for
business is not the general behavior of prices, but the price differentials between selling prices and

A general fall in prices need not be always in response to monetary deflation. For instance, for a
given money stock an increase in the demand for money can take place on account of a growing
economy and rising living standard. This in turn will lead to a general fall in prices and hence will
be labeled as deflation. Should then this fall in prices be regarded as bad? In the market economy a
fall in prices in response to an increase in real wealth is a mechanism through which wealth
expansion permeates throughout the economy. With the increase in the purchasing power of
money people can now secure for themselves a greater amount of goods and services. The key to
this mechanism, so to speak, is that the stock of money is kept unchanged.

Does money disappearance cause depression?

In his writings Milton Friedman blamed the central bank policies for causing the Great
Depression. According to Friedman the Federal Reserve failed to pump enough reserves into the
banking system to prevent the collapse in the money stock. For Friedman, the failure of the US
central bank is not that it caused the monetary bubble but that it allowed the deflation of the
bubble. Murray Rothbard, while agreeing with Friedman that the money stock fell sharply, found
that the Federal Reserve had been aggressively pumping reserves into the banking system.
Notwithstanding this pumping, the money stock continued to fall. The sharp fall in the money
stock, contrary to Friedman, is not indicative of the Federal Reserve’s failure to pump the money
supply. It is indicative of the shrinking pool of funding brought about by the loose monetary
policies of the central bank.

Essentially, the pool of funding is the quantity of goods available in an economy to support future
production. In the simplest of terms: a lone man on an island is able to pick 25 apples an hour.
With the aid of a picking tool, he is able to raise his output to 50 apples an hour. Making the tool,
(adding a stage of production) however, takes time. During the time he is busy making the tool,
the man will not be able to pick any apples. In order to have the tool, therefore, the man must first
have enough apples to sustain himself while he is busy making it. His pool of funding is his means
of sustenance for this period-the quantity of apples he has saved for this purpose.

The size of this pool determines whether or not a more sophisticated means of production can be
introduced. If it requires one year of work, for the man to build this tool, but he has only enough
apples saved to sustain him for one month, then the tool will not be built-and the man will not be
able to increase his productivity. (This point is drawn from Richard von Strigl, Capital and
). The island scenario is complicated by the introduction of multiple individuals
who trade with each other and use money. The essence, however, remains the same: the size of the
pool of funding sets a brake on the implementation of more productive-but longer-stages of

Trouble erupts whenever the banking system makes it appear that the pool of funding is larger
than it is in reality. When a central bank expands the money stock, it does not enlarge the pool of
funding. It gives rise to the consumption of goods, which is not preceded by production. It leads
to less means of sustenance. As long as the pool of funding continues to expand, loose monetary
policies give the impression that economic activity is being boosted. That this is not the case
becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens,
the economy begins its downward plunge. The most aggressive loosening of money will not reverse
the plunge (for money cannot replace apples).

By fulfilling the role of the intermediary, banks are an important factor in the process of real
wealth formation. Banks facilitate the flow of real funding i.e the flow of the means of sustenance
by introducing suppliers of real funding to the demanders.

The introduction of money to our analysis will not alter the fact that the subject matter remains
the pool of means of sustenance. When a saver lends money, what he in fact lends to borrowers is
the goods he has not consumed. Credit then means that unconsumed goods are loaned by one
productive individual to another, to be repaid out of future production.

The existence of the central bank and fractional reserve banking permits commercial banks to
generate credit which is not backed up by real funding i.e. credit out of "thin air." Once the
unbacked credit is generated it creates activities that the free market would never approve, i.e.
these activities are consuming and not producing real wealth. As long as the pool of funding 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 the flow of real savings is arrested and a
decline in the pool of funding is set in motion. Consequently, the performance of various
activities starts to deteriorate and bank’s bad loans start to rise. In response to this, banks begin to
call back their loans and this in turn sets in motion a decline in the money stock

We can thus conclude that depression is not caused by the collapse in the money stock, but in
response to the shrinking pool of funding, which also causes the disappearance of money out of
"thin air." Consequently, even if the central bank were to be successful in preventing the
disappearance of money, this would not be able to prevent a depression if the pool of funding is
declining. Also, even if loose monetary policies were to succeed in lifting prices and inflationary
expectations, this couldn’t revive the economy as long as the pool of funding is declining.
Furthermore, it is the loose monetary policies of the central bank and fractional reserve banking
that cause the misallocation of resources, which in turn weakens the flow of savings and hence
weakens the buildup of the pool of funding. This in turn implies that the primary causes of
depression are loose monetary policies of the central bank and fractional reserve banking.

Can deflation in one country spread to other countries?

It is widely accepted that deflation in one country constitutes a threat to other economies. It is
maintained that deflation like a virus can spread across the globe and therefore the central bank
has the duty to vigilantly defend the economy against the deflationary virus.

This analysis however, is flawed. For instance let us assume a country A that has a free market
economy and unchanged money stock. In country B on the other hand, the loose central bank
monetary policies have caused severe misallocation of resources. This in turn has impaired the
formation of real wealth, thereby causing a decline in the pool of funding. The ensuing fall in
economic activity caused banks to call back their loans and this in turn set in motion a decline in
the money stock and to a fall in prices of goods and services. As a result of a fall in prices of goods
and services in B, the popular thinking argues that businesses in this country could export
deflation to A, by offering their goods at lower prices. This in turn, it is held, will depress the
overall price index in A thereby causing deflation and depression there.

We have however, seen that deflation is not a fall in prices but rather a fall in the money stock.
Since however, in country A the money stock is unchanged, no deflation can emerge there.
Furthermore, because the money stock remains unchanged in A, no damage is inflicted on the
pool of funding and consequently no depression will occur. That producers from country B dump
their products at low prices in A, will only benefit consumers in A. We can thus conclude that
deflation in a particular country must be the product of its central bank monetary policies and
cannot be imported from other countries.

Debt and deflation

Following Irving Fisher, some economists argue that deflation and the following depression is the
result of over indebtedness. Fisher regarded over-indebtedness as a situation where the debt is out
of line i.e. too big relatively to other economic factors. He held that, "If a debtor has not borrowed
enough, he can, under normal conditions, easily correct the error by borrowing more. But, if he
has gone too far into debt, especially if he has misjudged as to maturity dates-freedom of
adjustment may no longer be possible. He may find himself caught as in a trap."

Fisher maintained that all kind of shocks can set in motion the liquidation of debt, which in
turn triggers a fall in the money stock and in prices of goods. These events in turn lead to a
depression. According to Fisher, over-indebtedness gives rise to the following nine stages that are
instrumental in causing deflation and depression.

  • Debt liquidation in response to a random shock such as the bursting of a bubble in stock
    prices. To liquidate debt people are forced into a distressed selling of assets.
  • The liquidation of debts leads to the shrinking of money and to a slow down in the velocity of
  • This causes declines in the price level
  • The fall in the asset value while the value of liabilities remains constant leads to a fall in
    businesses net worth, precipitating bankruptcies.
  • Profits are curtailed and losses emerge.
  • Production, trade and employment are curtailed.
  • These losses, bankruptcies and unemployment lead to pessimism and loss of confidence.
  • Which in turn leads to hoarding and a further slowing in the money velocity.
  • A fall in nominal interest rates and a rise in real interest rates.
  • Fisher’s explanation of what causes depression is based not on theory but on historical events.
    However, data by itself doesn’t talk. The explanation cannot be regarded as a economic fact until
    it is identified by means of a theoretical framework. In the Mises and Rothbard framework, in
    order to identify various observed events, they must be reduced to the primary facts of reality. This
    amounts to the establishment of a link between the observed data and a non refutable axioms that
    form the basis of economic theory. Following this procedure, by means of a deductive process,
    both Mises and Rothbard have established that boom-bust cycles and hence inflation and
    deflation are not an inherent part of a free capitalistic economy, but rather the result of
    inflationary policies of the central bank.

    Since Fisher never bothered to identify the true causes of over-indebtedness it is not surprising
    that he advocated loose monetary policies to arrest depression. Had he investigated further, he
    would have discovered, as Mises and Rothbard did, that general over-indebtedness cannot occur in
    a free market economy. For general over-indebtedness means that most borrowers have misjudged
    the state of economic conditions. This, according to Mises and Rothbard can only take place as a
    result of loose monetary policies of the central bank, which causes businessmen collectively to
    commit errors in their business decisions. This in turn implies that over-indebtedness is not the
    primary cause of instability that leads to an economic slump.

    According to Fisher the size of the debt determines the severity of a depression. Thus he observed
    that the deflation following the stock market crash of October 1929 had a greater effect on real
    spending than the deflation of 1921 had because nominal debt was much greater in 1929. We
    however, maintain that it is not the size of the debt that determines the severity of a recession, but
    rather the aggressiveness of the loose monetary policies of the central bank. It is loose monetary
    policies of the central bank that cause the misallocation of resources and the depletion of the pool
    of funding and in turn can be manifested in over-indebtedness. So to put the blame on the size of
    the debt as the key factor in causing depression is no different to blaming the thermometer for
    causing the high temperature.

    Have we learned the lesson of the Great Depression?

    Today’s prevailing view is that central banks and other policy makers are
    knowledgeable enough to pre-empt severe economic slump. It is held that as long the
    central bank can succeed in stabilizing the price level nothing could threaten the
    economy. Furthermore, it is argued that in the 1930’s central banks lacked the
    necessary flexibility to maneuver the economy away from the depression because of
    the gold standard. However, today central banks don’t have this problem. If all that
    is required to create prosperity is greater monetary flexibility, why are so many
    economies today in the midst of a severe economic hardship? After all, every central
    bank has learnt by now how to pursue "flexible" monetary policies.

    It seems that following in the footstep of John M. Keynes most economists have
    convinced themselves that money can grow the economy. The theory goes something
    like this: more money will stimulate the demand for goods, which in turn will give
    rise to a greater production of goods and services and--abracadabra!--economic
    prosperity will follow suit. It is overlooked that more money can only weaken and
    not strengthen the economy. It is precisely the lack of flexibility of the gold standard
    that politicians and central bankers dislike. It is precisely this lack of flexibility that is
    needed most, to revitalize world economies, including the US.

    Notwithstanding the popular view, the US economy is severely out of balance. The
    reason for this is the prolonged loose monetary policies of the US central bank. The
    federal funds rate which stood at 17.6% in April 1980 fell to the current level of
    5%. At one stage in 1992 the rate stood at 3%. The money stock M3 climbed from
    $1824 billion in January 1980 to $6152 billion at the end of June 1999. In a time
    span of less than a decade it grew by over 200%. Another indicator of the magnitude
    of monetary pumping is the Federal debt held by the US central bank. It jumped to
    $465 billion in the first quarter of 1999 from $117 billion in the first quarter 1980,
    a 300% rise. Obviously the sheer dimension of the monetary pumping and the
    accompanied artificial lowering of interest rates has caused a massive misallocation
    of resources which ultimately will culminate in a severe economic slump.

    The intensity of the misallocation of resources was further strengthened with the
    early 1980’s financial de-regulation. The idea of financial deregulation was to free the
    financial system from the excessive controls of the central bank. It is held that
    freeing financial markets will permit a more efficient allocation of economy’s scarce
    resources, thereby raising individual well being. It was argued that the overly
    controlled monetary system leads to more rather than less instability. Nonetheless,
    rather than producing more stability, the "liberated" system gave rise to more shocks.

    The 1980’s financial de-regulation resulted in a reduction of the central bank
    supervisory powers. The weakening in the central bank controls gave impetus to a
    greater competition in the financial sector. This in turn through the fractional
    reserve banking sparked the unrestrained creation of credit and money out of "thin
    air". The money out of "thin air" in turn has been further processed by creative
    entrepreneurs, who have converted this money into a great variety of financial
    products, thereby contributing to a wider dissemination of the monetary pollution .

    The failure of financial de-regulation seemed to vindicate the view of interventionists
    and opponents of the free market economy, that the facts of reality dictate that
    markets must be tightly supervised. It is however, overlooked that all these reforms
    i.e. financial de-regulation have nothing to do with the true free market. For as Mises
    has shown, in a true free market no paper money can become independent of a
    commodity money gold, which was chosen by the market. Furthermore, in a free
    unhampered market there is no place for the central bank.

    The sudden collapse of the Japanese and South East Asian economies raised doubts
    about the potency of central banks and government policies. Notwithstanding, most
    economists are supportive of central banks pre-emptive policies. Consequently they
    are very critical of the Austrian view that the best cure for economic depression is for
    governments and central banks to cut their interference with the economy. For
    instance in an interview with the Barron’s economics editor Gene Epstein, Milton
    Friedman has argued that to fix the current economic crisis in Asia Japan should
    pump money. During the interview Milton Friedman expressed strong misgivings
    about the hands off approach of the Austrian school economic framework. Similarly,
    in his writings Keynes criticised those economists, labeling them "the so-called
    economists," who were advocating a hands off approach to the great depression of
    the 1930’s.

    It seems therefore that the chaotic state of world financial markets will continue to
    get worse, unless gold is allowed to assume its monetary role. Notwithstanding that
    there is very little reason for being optimistic in the current economic climate, one
    can see some bright lights. These lights are the growing realization that the only
    viable alternative to the present chaotic monetary system is a true free market.

    * * * * *

    is chief economist for Ord-Minnett, Australia. Also see
    the Austrian Study Guide for more information on the Austrian Theory of the
    Business Cycle.

    Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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