Mises Daily

The Deflation Dog Didn't Bite After All

Mises Daily Gardner Goldsmith

Many people are unaware of it, but there has always been a Fifth Horseman of the Apocalypse. Overlooked in scripture, he has been there nonetheless, waiting with rancid, baited breath to gallop across the world and leave his destructive hoof-prints in the rubble of Western civilization. He is, according to many government spokesmen and media pundits, the Horseman called "Deflation."

Next to dire warnings of SARS, Mad Cow Disease, and the hegemony of conservative talk radio, the big "scare story" of 2003 was that deflation was upon us, or approaching. Beginning as a trickle in the first quarter of '03, the reports turned into a flood after April. Suddenly, dozens of "experts" and policy analysts lamented with great wailing the forbidding approach of the destructive force known as deflation. Politicians spending other people's money advised us that the Federal Reserve had better do something fast, because the dollar was, as many phrased it, "too strong."

Today, with the passage of a year to allow for dispassionate analysis, the anguish appears to have been misplaced. Not only has the US economy not fallen into a deflationary period, it has continued to see a consistent, though low, decrease in the buying power of the Dollar—a continuation of the inflationary behavior of the Fed that has been its salient characteristic for most of its existence.

In May of 2003, members of the Bush Administration began "talking down" the dollar, hinting that they wanted to see it lowered in value relative to the Euro. American Enterprise Institute economist John Makin was quoted in a May 26 Scripps Howard News Service article as believing that a 10 to 20 percent decline in the dollar would increase "economic growth" to 3% by 2004.

Three factors were cited to promote this crusade against deflation.

First, the US economy was supposedly in a recession. Reports abounded that 2.5 million jobs had been lost between August 1, 2001 and June 1, 2003. Despite the fact that new home sales set a record in May of 2003, with a jump of 12.5%, many people believed that the Fed ought to lower interest rates to "jump-start" job creation with less-expensive money.

Second, the dollar was at a premium compared to other currencies. Its value was such that our money bought more foreign goods more easily, and this was seen by US manufacturers and the politicians who pandered to them as dangerous. It had caused a long-term "trade deficit." Americans weren't buying American-made goods, and that was supposedly bad for the US economy.

Third, signs of "inflation" in most sectors of the US economy, especially the all-important sectors which comprise the "M2" money supply data1 , were virtually non-existent. Many people believed that without a little inflation there could be no increase in American wages, thus no increase in demand for US goods, and no increase in demand for US workers. The Fed board members were apparently in agreement with all of these assumptions, and they followed a loose money policy throughout the entire year.

But there was a misunderstanding at the core of nearly all the opinions and prescriptions, one which still persists today. This misunderstanding serves to deceive people about the nature of the problem, and about the remedies needed to cure it.

The trouble stems from the popular mischaracterization of inflation and deflation.

Inflation is often described by reporters as an increase in prices, nothing more. No investigation is conducted as to why prices are increasing, or what effect that has on the average person's standard of living. Even the term "standard of living" is left a sort-of mystical phrase, undefined and impenetrable.

In fact, "inflation" is what causes prices to increase. It is a general increase in the supply of money in relation to the supply of goods. More dollars chasing the same amount of goods, or a slowly growing amount of goods, means higher prices. Your dollar will buy less. You will have to work harder to get the same products, and your standard of living will be harmed.

Additionally, the loose money that causes inflation also spurs improper investments by businesses, banks, and lending institutions—what was termed by Austrian economists as a "temporal warping of the supply curve." The presence of inflated capital leads to misallocations of funds for unproductive ventures. In time, this leads to a collapse when consumers respond negatively to inflated prices, and this leads to excess inventory, loans left in default, unemployment, and a general decrease in the standard of living for nearly everyone.

Many economists used to fear inflation. They watched for it like hawks looking for mice in the fields. But recently the talk has been about deflation. Some policy makers have even proposed that we define a slower rate of increase in inflation as deflation. Why the concern? Why the manipulation of the language?

First, it should be noted that these terms have become ciphers. Inflation and deflation are often used by government economists to describe the supposed "growth" or "contraction" of the economy. In a world where political appointees try to control the value of the dollar, inflation and deflation are measurements of their own monetary manipulation. They are not really measures of "economic growth," but are estimates of capital expansion, which may, or may not, be connected to real economic growth.

According to the "experts," deflation is defined as a general decrease in prices, brought on by a decrease in consumer demand. Depending on whether you want to put the cart before or after the horse, this decrease in demand can either be the effect of a recessionary period, or the cause of it. Central bankers rarely seem to have a good handle on the concepts of cause and effect.

Recently, a few commentators at the White House and elsewhere have told us that deflation is caused by a relative decrease in the money supply itself. The scarcity of the dollar makes it more valuable. The dollar buys more goods, and prices fall. The dollar becomes more valuable and exports decrease. The dollar becomes more valuable, and people get laid off.

But in real economics, there is a reason for deflation. Deflation is an increase in the buying power of the dollar, it reflects, and is a direct result of, greater productivity. When people are more productive, more goods and services can be produced at less cost, thus making the dollar stronger, allowing it to buy more, and allowing prices to drop. This is not a bad thing!

The entire purpose of free exchange between individuals is to allow them to be more productive, to allow them to work less for the same amount of goods, or for more goods. Since we have different skills, I can produce one thing well, and you can produce another. Protecting your freedom to do what you do best, for me to do what I do best, and for us to exchange for goods and services on the market, lets society have the best products most efficiently. As you improve your skills and the tools needed to make your product, you will be able to make more for less work, which is what we all want. We want to get more for less work, not less for more work.

Being more productive means less effort is required to make certain products, allowing us to improve our lives, and allowing us the free time and free capital to make new products that will, in turn, improve our lives even more. In a free market, the dreaded horseman "Deflation" is nothing more than the decrease in prices brought about by greater productivity. As prices have dropped for goods such as DVD players and computers, we have had to use less of our money (or less of our effort as represented by our money) to buy them. Our efforts get us more, our toil is less. Our lives are better.

Contrary to the three major arguments of the pundits, one should not fear deflation.

The argument that deflation is the cause of unemployment, that a naturally strong dollar puts people out of work, is manifestly absurd. Unemployment is not caused by a strong dollar. Unemployment is not caused by greater productivity. If that were the case, the proper prescription to solve unemployment would be to destroy all technological advancements that increase productivity, thus making it harder to produce things, making more effort go into the same products we once built for less, and making it harder to use free capital to begin new job-creating ventures. Reducing the value of the dollar is akin to such a palliative. It harms the patient more than it helps.

It also hides the true reasons for unemployment, which are government spending and taxation, inappropriate monetary policy, regulations, and restrictions on market exchange. The most recent recession was visited upon Americans for precisely the reasons just noted, and due to the powerful financial impact of the terrorist attacks of 2001, not because Americans were somehow "too" productive.

The argument that a strong dollar has harmed American exporters, and thus Americans in general, is only partially right. A strong dollar does make foreign products more appealing to American consumers. Many of those consumers are also manufacturers, who can, like retail consumers, buy their products for less. This allows them to be more productive, to sell their products for less. That extra consumer capital can then be utilized to buy other products, or invested to start up new, more productive businesses. Peoples' lives are improved. By trying to protect politically connected US businesses from foreign competition, American politicians do damage to the economy as a whole. For every special US company that is helped by a barrier to trade, consumers are harmed eight times as much.2

But what of the "deficit" in our balance of trade?

The balance of trade is just that, a balance. Few people are aware of this, perhaps because very few reporters know it or bother to report it, but the numbers that comprise our balance of trade with foreign nations are composed of more than just goods and services. They also include capital. For every dollar spent on a foreign good, there is a foreigner with a new dollar. He has to do something with that, and if the US economy is appealing, if the US worker is productive, if the US dollar is strong, then all of those valuable dollars that went out to buy foreign goods will return to the US as investments and purchases in the capital market. One need not weaken the dollar in order to help US exporters at the expense of US consumers and manufacturers.

Likewise, one need not weaken the dollar to "help" spur employment.

Those who argue that inflation is needed to keep people employed might as well argue that a fire should be put out with gasoline. Placing more money into an economy does not expand that economy. It does not make the economy more productive. It merely makes more dollars chase the goods being produced, raising prices, and harming everyone. Some have argued that with a little inflation, there is incentive for consumers to buy rather than wait to buy, and that in a deflationary economy, the incentive to wait would stagnate sales.

This is fallacious. As the prices of VCR's and televisions decreased year after year, people did not wait to buy them. They bought the products as they needed them. Falling prices were beneficial to everyone, including the producer, who was able to sell more as his price of production fell.

In today's world of monetarism, economists often cite a "low inflation" or "zero inflation" policy as the optimum for the United States. But those who truly believe in human ingenuity and productivity as the greatest means by which to improve our lives must recognize the appeal of falling prices and a rising dollar. As George Selgin argues in his work "Less Than Zero"3 , such a paradigm would allow long-term improvements in productivity to lower prices in various sectors, and, possibly, in the economy as a whole. Occasional problems such as natural disasters or military conflicts would periodically cause negative supply shocks, raising prices. But these would be natural factors in the equation of supply and demand, natural parts of a dynamic economy that is responding to consumer demand and to real changes in productivity, not artificial government manipulation.

It is a wonder that people who work on monetary policy every day don't recognize the value of what Selgin calls the "productivity norm." Of course, if we had a productivity norm—allowing real prices to actually drop in response to productivity—many of those policy makers would be out of work. Right now, they can make bundles trying to explain how bonds, CD's, stocks, short-term loans, long-term loans, imports and exports will be affected by their own manipulation of the dollar.

In 1971, President Nixon and other world leaders agreed to drop the flimsy pseudo-barriers against currency inflation their governments had imposed under the Bretton Woods Accords of 1944. From the moment Nixon's team entered the meeting, it must have been understood that all bets were off regarding US monetary policy. Completely removed from any price fixed to a commodity such as gold, the buying power of the dollar was free to be reduced any time politicians saw fit. And they saw fit quite often. From 1972 to 1981 the average inflation rate was 8.48%, compared to the decade prior, which stood at 3.09%.4  Democrats and Republicans alike were aghast, asking what could be done.

But since the years 1982 through 1984, when the US monetarists supposedly took on inflation and got it under control, the problem has not gone away. The ten years following the Reagan Administration's attempt to better husband the dollar saw an average inflation rate of 4.8% (1984-1993, inclusive). The following decade saw inflation at an average of 2.4% (1994-2003, inclusive). This simply means that it has taken twice as long for the government to reduce the buying power of our work by about half.

Put in other terms, in 1972, it took $5 to buy the same amount of goods that $1 could buy in 1850. Ten years later, in 1984, it took $12.44. Twenty years later, in 2004, it is estimated that it costs $22.44 to buy what one could have bought for only a dollar in 1850.

And as government policies continue to whittle down the value of the dollar, there are still economists and media pundits telling us that it is productivity we should fear.

Given their track record, perhaps it is these government boosters who ought to make us nervous. Perhaps we ought to look critically at the monetarists' performance and realize that the value of the dollar ought to be determined instead by the people trying to buy things and make things with it. After all, it represents their sweat, toil, hopes and dreams in the ever-changing market, and as their efforts pay off in the form of greater productivity, the value of the dollar ought to rise, not fall.

  • 1This is the primary data pool which the economic sorcerers at the Federal Reserve use to measure the amount of money in the market relative to Gross Domestic Product. When they cast their magical monetary runes, the M2 is very important.
  • 2Bovard, James. 1991. The Fair Trade Fraud. N.Y.: St. Martin's Press. P. 5.
  • 3Available from the Institute for Economic Affairs, London. Visit www.IEA.org.uk for more information.
  • 4Calculations can be made by referring to the chart provided by the Federal Reserve Bank of Minneapolis.
All Rights Reserved ©
Support Liberty

The Mises Institute exists solely on voluntary contributions from readers like you. Support our students and faculty in their work for Austrian economics, freedom, and peace.

Donate today
Group photo of Mises staff and fellows