Mises Daily Articles
Why the Deflationists Are Wrong
An inflationist is someone who believes that price inflation is the result of two things: (1) monetary inflation and (2) central-bank policy.
A deflationist is someone who believes that deflation is inevitable, despite (1) monetary inflation and (2) central -bank policy.
No inflationist says that price inflation is inevitable. Every deflationist says that price deflation is inevitable.
Deflationists have been wrong ever since 1933.
Milton Friedman is most famous for his book A Monetary History of the United States (1963), which relies on facts collected by Anna Schwartz, who died recently.
It is for one argument: the Federal Reserve caused the Great Depression because it refused to inflate.
This argument, as quoted by mainstream economists, is factually wrong.
I often cite a study, where you can see that the monetary base grew under the Federal Reserve, 1931 to 1932. This graph is from a speech given by the vice president of the Federal Reserve Bank of St. Louis. You can access it here.
We can see that there was monetary deflation of the money supply, beginning in 1930. This continued in 1931 and 1932, despite a deliberate policy of inflation by the Fed, beginning in the second half of 1931 and continuing through 1932.
Depositors kept pulling currency out of banks and hoarding it. They did not redeposit it in other banks. This imploded the fractional-reserve-banking process for the banking system as a whole. M1 declined: monetary deflation.
The Fed could not control M1. It could only control the monetary base.
The argument of Friedman and Schwartz was picked up by mainstream economists. It is his most famous and widely accepted position. Bernanke praised him for it on Friedman's 90th birthday in 2002.
Why was the argument wrong, as applied to 1931–33? I must tell the story one more time. Four letters tell it: FDIC. Well, nine: FDIC + FSLIC. They did not exist.
Franklin Roosevelt froze all bank deposits in early March 1933, immediately after his inauguration. This calmed the public when the banks reopened a few days later. He verbally promised people that the banks were now safe.
The US government created federal bank-depositor insurance in 1933. The Wikipedia article describes the Banking Act of 1933, which was signed into law in June:
- Established the FDIC as a temporary government corporation
- Gave the FDIC authority to provide deposit insurance to banks
- Gave the FDIC the authority to regulate and supervise state non-member banks
- Funded the FDIC with initial loans of $289 million through the U.S. Treasury
That stopped the bank runs. The money supply reversed. It went ballistic. So did the monetary base.
The key event was therefore the Banking Act of 1933. After that, the money supply never fell again. After that, prices never fell again by more than 1 percent. That was in 1955.
All it took for prices to reverse and rise was this: an expansion of the monetary base coupled with bank lending.
Yet deflationists ever since 1933 have predicted falling prices. They die predicting this. Then their successors die predicting this.
They never learn.
They do not understand monetary theory. They do not understand monetary history. They therefore do not learn. They do not correct their bad predictions, year after year, decade after decade, generation after generation.
They still find people who believe them, people who also do not understand monetary theory or monetary history.
I have personally been arguing against them for four decades.
Price deflation has nothing to do with the fall in the price of stocks.
There can be monetary deflation as a result of excess reserves held at the Fed by commercial banks. But this is Fed policy. The Fed pays banks interest on the deposits. Even if it didn't, there would still be excess reserves. But by imposing a fee on excess reserves, the Fed could eliminate excess reserves overnight. Then the money multiplier would go positive, price inflation would reappear, and the Fed would get blamed. So, it maintains a policy of restricting the M1 multiplier.
Every inflationist says that monetary inflation will produce hyperinflation unless reversed by the central bank. There will be a return to low prices after what Ludwig von Mises called the crack-up boom. The classic example is Germany in 1934. That was a matter of policy. The central bank substituted a new currency and stopped inflating.
John Exter — an old friend of mine — argued in the 1970s and 1980s that monetary deflation has to come, despite Fed policy. There will be a collapse of prices through deleveraging.
He was wrong. Why? Because it is not possible for depositors to take sufficient money in paper-currency notes out of banks and keep these notes out, thereby reversing the fractional-reserve process, thereby deflating the money supply. That was what happened in the United States from 1930 to 1933. If hoarders spend the notes, businesses will redeposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks. But the vast majority of all money transactions are based on digital money, not paper currency.
Today, large depositors can pull digital money out of bank A, but only by transferring it to bank B. Digits must be in a bank account at all times. There can be no decrease in the money supply for as long as money is digital. Hence, there can be no decrease in prices unless it is Fed policy to decrease prices. This was not true, 1930 to 1933.
Deflationists never respond to this argument by invoking either monetary theory or monetary history. You can and should ignore them until one of them does answer this, and all the others publicly say, "Yes. That's it! We have waited since 1933 for this argument! I was blind, but now I see! I'm on board! I will sink or swim with this."
Let me know when this happens. Until then, ignore the deflationists. All of them. (There are not many still standing.)
The fact that a new deflationist shows up is irrelevant. Anyone can predict inevitable price deflation. They keep doing this. Look for the refutation of the inflationists' position. Look for a theory.
If you do not understand the case I have just made, you will not understand any refutation. In this case, just pay no attention to either side. If you cannot follow economic theory, the debate will confuse you. It's not worth your time.
For background, see my book Mises on Money.
See also Murray Rothbard's book What Has Government done to Our Money?