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Price Deflation and Price Inflation Are Always Optimal

Polish National Bank Building in Wroclaw

Tags Prices

10/13/2014Mateusz Machaj

Recently, the Polish economy experienced its first price deflation since the 1980s, which sparked in the country deflationphobia (or, as Mark Thornton calls it, apoplithorismosphobia).

Media sources and many economists focus on price inflation and price deflation as the source of various economic ills, but, contrary to much of the rhetoric, price inflation and price deflation are always “optimal” in the economic sense. At first, such a claim may seem controversial, since virtually all economists have something negative to say about either inflation or deflation. This concerns almost all schools of economic thought, mainstream and heterodox, including the Austrians.

Yet in some very important sense, one can make a reasonable argument that price inflation and price deflation are optimal in one specific sense. If we notice that prices are formed by choices of market participants, we see that modifications to price levels are executed in order to “correct” the markets. Always.

Price Inflation and Price Deflation Are a Solution to a Problem

Take the case of very high price inflation. In some circumstances we may see prices suddenly rising rapidly. What this means is that private owners, selling their property, have noticed an advantage in re-pricing goods they own. Even if it happens in a very chaotic manner, they try to economize their resources to the best extent possible. Price fixing, on the other hand, would not be a solution to the problem, since it would lead to shortages.

We discover a similar situation with price deflation. Imagine that lots of sellers have to drastically lower the prices for goods and services which they offer in the market. Apparently it is their way of attracting customers and making sure that someone makes a purchase. Fixing prices would not solve the problem, since it would cause surpluses.

With both price deflation and price inflation we see adjustments to changing circumstances. The adjustments themselves are necessary, because some underlying economic conditions have changed. When we hear various economists criticizing either price inflation, or price deflation, they usually have in mind some underlying variable that causes prices to change. It is not really the adjustment of prices that they wish to attack, but really it is some underlying cause of the price adjustment that is the issue.

When 100-percent-banking Austrians criticize price inflation, they criticize expansions of the money supply, which lead to price inflation (or sometimes lack of price deflation, to be precise). They are not really criticizing private owners, who adjust their prices to shifts in conditions. That is why the Austrians are quite specific in their approach and define inflation as an expansion of the money supply, because price adjustments in themselves are not a problem. Indeed, price changes are a solution to the problem.

Similarly, when some economists of the monetarist tradition focus on price deflations, they may have in mind criticism of the banking sector, which collapses and leads to shrinking money supply, causing many businesses to go bankrupt. When price deflation happens, because banks are falling, adjusted prices are not problems. Again, they are a solution to the problem, which is a collapsing banking sector (or actually some previously-inflated sector of the economy). If banks fall, along with the money supply, prices had better adjust! The adjustment may be painful, but it is optimal under the circumstances, just as it is optimal for prices of wheat to go up when there is a drought.

This is also the case with economists in the fractional-reserve free banking tradition. When they focus on negative aspects of price deflation, they usually mean they have a problem with a lack of deposit expansion on the part of the banks, when people decide to decrease the so called “velocity” of money. When people spend less, they exercise influence on sellers to decrease the prices. If nothing additional occurs, then prices are supposed to fall, and there is nothing inefficient about it. Prices falling is what should happen. What the fractional-reserve free bankers are saying is that under conditions of people decreasing their spending, it is beneficial for banks to expand the money supply.

Prices Have a Job To Do

Prices have a job to do: adjust to conditions, no matter what they are. That is why price inflation and price deflation are always optimal — because they are the sign that market actors are ready to adjust their actions to shifts in economic variables in order to economize on their property. There is nothing inefficient about it, since this is how the market system works.

One may ask a sensible question: why make this seemingly trivial point? It is good to remind ourselves of this because economists of various traditions sometimes divert their arguments from the underlying causes of price adjustments, and instead focus on results of the problems they have identified. Such an approach can lead to obscuring the nature of economic problems and to distortion of proper macroeconomic analysis. Instead of discussing the end results (i.e., the final pricing structure) it is much better to discuss the variables which lead to the creation of that price structure in the first place. The next time we’re tempted to discuss whether or not price levels are optimal, let us discuss whether forces resulting in those price levels were optimal, instead.

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