Free Market

Deflation, Free or Compulsory

The Free Market

The Free Market 9, no. 4 (April 1991)


Few occurrences have been more dreaded and reviled in the ‘history of economic thought than deflation. Even as perceptive a hardmoney theorist as Ricardo was unduly leery of deflation, and a positive phobia about falling prices has been central to both Keynesian and monetarist thought.

Both the inflationary spending and credit prescriptions of Irving Fisher and the early Chicago School, and the famed Friedmanite “rule” of fixed rates of money growth, stemmed from a fervid desire to keep prices from falling, at least in the long run. It is precisely because free markets and the pure gold standard lead inevitably to falling prices that monetarists and Keynesians alike call for fiat money. Yet, curiously, while free or voluntary deflation has been invariably treated with horror, there is general acclaim for the draconian, or compulsory deflationary, measures adopted recently—especially in Brazil and the Soviet Union—in attempts to reverse severe inflation.

But first, some clarity is needed in our age of semantic obfuscation in monetary matters. “Deflation” is usually defined as generally falling prices, yet it can also be defined as a decline in the money supply which, of course, will also tend to lower prices. It is particularly important to distinguish between changes in prices or the· money supply that arise from voluntary changes in people’s values or actions on the free market; as against deliberate changes in the money supply imposed by governmental coercion.

Price deflation on the free market has been a particular victim of deflation-phobia, blamed for depression, contraction in business activity, and unemployment. There are three possible causes for such deflation. In the first place, increased productivity and supply of goods will tend to lower prices on the free market. And this indeed is the general record of the Industrial Revolution in the West since the mid eighteenth century. But rather than a problem to be dreaded and combatted, falling prices through increased production is a wonderful long-run tendency of untrammelled capitalism.

The trend of the Industrial Revolution in the West was falling prices, which spread an increased standard of living to every person; falling costs, which maintained general profitability of business; and stable monetary wage rates—which reflected steadily increasing real wages in terms of purchasing power. This is a process to be hailed and welcomed rather than to be stamped out. Unfortunately, the inflationary fiat money world since World War II has made us forget this home truth, and inured us toa dangerously inflationary economic horizon.

A second cause of price deflation in a free economy is response to a general desire to “hoard” money, that is, to see people’s stock of cash balances have higher real value in terms of purchasing power. Even economists who accept the legitimacy of the first type of deflation react with horror to the second, and call for government to print money rapidly to prevent it.

But what’s wrong with people desiring higher real cash balances, and why should this desire of consumers on the free market be thwarted while others are satisfied? The market, with its perceptive entrepreneurs and free price system, is precisely geared to allow rapid adjustments to any changes in consumer valuations. Any “unemployment” of resources results from a failure of people to adjust to the new conditions, by insisting on excessively high real prices or wage rates. Such failures will be quickly corrected if the market is allowed freedom to adapt—that is, if government and unions do not intervene to delay and cripple the adjustment process.

A third form of market-driven price deflation stems from a contraction of bank credit during recessions or bank runs. Even economists who accept the first and second types of deflation balk at this one, indicting the process as being monetary and external to the market. But they overlook a key point: that contraction of bank credit is always a healthy reaction to previous inflationary bank credit intervention in the market. Contractionary calls upon the banks to redeem their swollen liabilities in cash is precisely the way in which the market and consumers can reassert control over the banking system and force it to become sound and noninflationary. A market-driven credit contraction speeds up the recovery process and helps to wash out unsound loans and unsound banks.

Ironically enough, the only deflation that is unhelpful and destructive generally receives a favorable press: compulsory monetary contraction by the government. Thus, when “free market” advocate Collor de Mollo became president of Brazil in March 1990, he immediately and without warning blocked most bank accounts, preventing their owners from redeeming or using them, thereby suddenly deflating the money supply by 80%. This act was generally praised as a heroic measure reflecting “strong” leadership; but what it did was to deliver the Brazilian economy the second blow of a horrible one-two punch.

After governmental expansion of money and credit had driven prices into severe hyperinflation, the government now imposed further ruin by preventing people from using their own money. Thus, the Brazilian government imposed a double destruction of property rights, the second one in the name of the free market and “of combatting inflation.”

In truth, price inflation is not a disease to be combatted by government; it is only necessary for the government to cease inflating the money supply. That, of course, all governments are reluctant to do, including Collor de Mello’s. Not only did his sudden blow bring about a deep recession, but the price inflation rate, which had fallen sharply to 8% per month by May 1990, started creeping up again.

Finally, in the month of December, the Brazilian government quickly expanded the money supply by 58%, driving price inflation up to 20% per month. By the end of January, the only response the “free-market” government could think of was to impose a futile and disastrous price and wage freeze.

In the Soviet Union, President Gorbachev, perhaps initiating the Brazilian failure, similarly decided to combat the “ruble overhang” by suddenly withdrawing large-ruble notes from circulation and rendering most of them worthless. This severe and sudden 33% monetary deflation was accompanied by a promise to stamp out the “black market” i.e., the market, which had until then been the only Soviet institution working and keeping the Soviet people from mass starvation.

But the black marketeers had long since gotten out of rubles and into dollars and gold, so that Gorby’s meat-ax fell largely on the average Soviet citizen, who had managed to work hard and save from their meager earnings. The only slightly redeeming feature of this act is that at least it was not done in the name of privatization and the free market; instead, it was part and parcel of Gorbachev’s recent shift back to statism and central control.

What Gorbachev should have· done was. not worry about the rubles in the hands of the public, but pay attention to the swarm of new rubles he keeps adding to the Soviet economy. The prognosis is even gloomier for the Soviet future if we consider the response of a leading allegedly free-market reformer, Nicholas Petrakov, until recently Gorbachev’s personal economic adviser. Asserting that Gorbachev’s brutal action was “sensible”, Petrakov plaintively added that “if, in the future, we go on just printing more money everything will just go back to square one.” And why should anyone think this will not happen?


Rothbard, Murray N. “DeRation, Free or Compulsory.” The Free Market 9, no. 4 (April 1991): 1, 3–4.

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