It is maintained by most experts that a general fall in prices, called deflation, is “bad news” for the economy because it postpones people’s buying of goods and services. This, in turn, allegedly undermines investment in plants and machinery. All this sets in motion an economic slump. Moreover, as the slump further depresses the prices of goods and services, this intensifies the pace of economic decline.
According to the former Federal Reserve Board Chairman Ben Bernanke,
Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.
Now, for most experts, a general decline in prices is bad since it generates expectations for a continued decline in prices. Because of this, it is held that consumers postpone the purchases of goods at present since they expect to buy these goods at lower prices in the future. Consequently, this supposedly weakens the overall spending and this weakens the economy.
According to such thinking, economic activity is presented in terms of the circular flow of money. Spending by one individual becomes the earnings of another individual, and spending by another individual becomes part of the previous individual’s earnings. If, for some reason, individuals’ have become less confident about the future and have decided to decrease their expenditure this will weaken the circular flow of money. Once an individual spends less, this worsens the situation of some other individual, who, in turn, also reduces his spending. Hence, a general decline in prices is bad for the economy’s growth rate.
For popular economics, the heart of economic growth is increases in demand. Hence, for a given supply, this is associated with a general increase in the prices of goods and services. Consequently, on this logic, a decline in the demand (all other things being equal) leads to the decline in prices. Hence, for most commentators’ deflation—associated with a large decline in the overall demand—is linked to deep economic recessions. That is, a fall in demand causes a fall in supply.
Thinkers such as Murray Rothbard held that, in a free market, the rising purchasing power of money (i.e., declining prices) is the mechanism that makes the great variety of goods produced accessible to many people. Rothbard wrote,
…improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.
Also, according to Joseph Salerno,
…historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods.
The Essence of Deflation
To establish the essence of deflation, we have to ascertain the essence of inflation. Inflation is the diversion of resources from wealth-generators towards non-wealth generators brought about by the artificial expansion of the money supply.
Much popular thinking holds that a growing economy gives rise to a growing demand for money that must be accommodated to prevent economic disruptions. It is held that, as long as the increase in money supply is in line with the increase in the demand for money, no disruptions will emerge.
According to Mises, any given amount of money could fulfill the function of the medium of the exchange, hence, there is no requirement to increase the supply of money to accommodate an increase in the demand for money. Mises wrote, “the services which money renders can be neither improved nor repaired by changing the supply of money.” Furthermore, irrespective of the state of the demand for money, an inflationary increase in money supply—from whatever source—results in an exchange of nothing for something (i.e., the diversion of resources from wealth-generators to the holders and receivers of inflated money). The inflationary increase in the money supply sets in motion this diversion. That is the true essence of inflation.
In a productive economy with sound money, the increases in production and efficiency tend to a decrease in business costs and market prices and an increase in the purchasing power of money. This is the essence of deflation. Additionally, once an inflationary money supply starts to slow or decline, deflation emerges—the process of resources diversion comes to a halt. In this sense, a decline in money supply (i.e., deflation) is good news for the economy since the diversion of resources is arrested.
Inflationary Lending Facilitates Non-Productive Activities
A major factor behind the inflationary expansion of money supply is bank lending unbacked by genuine, private savings. When loaned money is fully backed by private savings, on the day of the loan’s maturity, it is returned via the bank to the original lender. The bank here is just a facilitator; it is not a lender, so the borrowed money is returned to the original lender.
In contrast, when inflationary lending originates out of “thin air,” and the borrowed money is returned on the maturity date to the bank, this results in a withdrawal of money from the economy (i.e., to the decline in the money supply). The reason is because, in this case, we never had a saver/lender, since this lending was generated by bank inflation. Such lending is a catalyst for an exchange of nothing for something. This provides a platform for various non-productive activities that—prior to the generation of inflationary lending—would not have emerged.
As long as banks continue to expand credit via inflation, various non-productive activities continue to prosper. At some point, however, because of the artificial expansion of credit and the following inflationary increase in the money supply, a distorted structure of production emerges which ties up more resources than the amount it releases. The flow of savings is arrested and a decline in savings is set in motion.
Consequently, the performance of various activities starts to deteriorate and banks’ non-performing assets start to pile up. In response to this, banks curtail their lending and this, in turn, triggers a decline in the money supply. This decline in the money supply begins to undermine various non-productive activities (i.e., an economic recession emerges). These non-productive activities cannot stand on their own. These activities require continual inflationary increases in money supply that divert these activities’ resources from wealth-generators.
Some economists, such as Milton Friedman, are of the view that once the money supply starts to decline, then—in order to prevent an economic slump—the central bank should embark on aggressive monetary inflation.
An economic slump is not caused by the decline in the money supply, but comes in response to the shrinking market savings because of the previous expansionary monetary policies. This leads to a decline in economic activity. As a result, banks curtail the inflationary lending and this, in turn, sets the decline in the money supply. Consequently, even if the central bank were to be successful in preventing the decline in the money supply, for instance, by means of the helicopter money, this cannot prevent an economic slump.
Conclusion
Deflation is often the result of a productive growing economy with sound money. However, it also often emerges after a previous bout of inflation, especially by central banks. The emergence of deflation is always good news to the economy since it is in response to the liquidation of various activities that caused the erosion of the savings-generation process.
An economic slump is not caused by a decline in the money supply, but comes in response to the shrinking private savings because of previous expansionary monetary policies. Consequently, policies aiming at increasing the money supply via inflation, weaken savings and delay economic recovery.
