Mises Wire

Does deflation have a life of its own?

Does deflation have a life of its own?

In an interesting article "The Anatomy of Deflation" professor Reisman makes a valid criticism of all those commentators who view deflation as a fall in prices. According to Reisman deflation is not a fall in prices but rather a decline in money supply. Consequently, he argues that all the bad things that are attributed to declining prices, which is misleadingly labelled as deflation, should be in fact attributed to a fall in money supply.

Professor Reisman maintains that contrary to popular thinking it is not a fall in prices that burdens borrowers and companies but a fall in the amount of money. As a result of this fall it is much more harder for borrowers to earn money in order to repay their debts since there is much less money available in the economy. Likewise, it is a fall in the money stock that makes it much harder for companies to make profits.

Furthermore, argues professor Reisman, if the money stock shrinks then regardless of what is happening to the production of goods and regardless of whether prices are falling or rising companies will continue to experience difficulty in making profits, while the debt burden of borrowers will intensify.

In short, deflation, or a fall in the stock of money is bad news for the economy, in his view. Now, the conclusion that professor Reisman reaches is not very much different from that of professor Milton Friedman who also views a fall in the money stock as the sole destabilising factor as far as economic activity is concerned.

If one were to follow professor Reisman’s analysis further then it would sound logical that in order to soften the blow of deflation the central bank ought to lift the money stock. This in turn would reduce the debt burden and will make it much easier for companies to become profitable. Incidentally, this is precisely what Professor Friedman and popular economics advocates.

The problem with this way of thinking is that deflation is presented as an independent destructive force. However, deflation doesn't have a life of its own - it is always dependent on prior monetary inflation. Consequently, it is not possible to reach any meaningful conclusion regarding deflation without addressing the issue of monetary inflation. (Interestingly Professor Reisman is aware of this yet he only mentions it at the end of his article very briefly and without much discussion of the importance of inflation in activating deflation ).

Monetary inflation gives rise to the diversion of real wealth from wealth generators to activities that only squander wealth. As long as monetary inflation is going on it impoverishes the genuine builders of the economy and funds various non-productive activities. So the fall in the money stock is great news for all wealth generating activities since the disappearance of money arrests their bleeding. In short, since a fall in the money stock undermines various non-productive activities it slows down the decline in the formation of real wealth and thereby lays the foundation for an economic revival.

It must be appreciated that monetary inflation, which undermines the formation of real wealth, at the same time also sets in motion the mechanism that weakens monetary inflation. The mechanism that enables this is the fractional reserve banking.

For instance, Tom places $1000 in a saving deposit for three months with Bank X. The bank in turn lends the $1000 to Mark for three months. On the maturity date Mark repays the bank $1000 plus interest. Bank X in turn after deducting its fees returns the original money plus interest to Tom. Observe that since lending is fully backed up by savings no new money is created. Also, note that fully backed up by savings money cannot disappear.

Things are, however, completely different when Bank X lends $1000 out of thin air. In short, the bank creates an unbacked by savings loan. On the maturity date once the money is repaid to the bank $1000 will disappear from the system, and since this money is ownerless it goes back into thin air. Obviously if the bank is continuously renewing its lending out of thin air then the stock of money will rise again. Note that only credit that is not backed up by proper savings can disappear into the thin air, which in turn causes the shrinkage in the stock of money.

In other words, the existence of fractional reserve banking is the key instrument as far as money disappearance is concerned. However, it is not the cause of the disappearance of money as such. There must be a reason why banks don't renew lending out of thin air. The main reason is the severe erosion of real wealth that makes it much harder to find good quality borrowers. This in turn means that the trigger for deflation is the effects of prior inflation that has diluted the pool of real wealth. It follows then that a fall in the money stock is just a symptom as it were. It doesn’t do any harm as such. The fall in the money stock reveals the damage caused by inflation but it has nothing to do with the damage.

Furthermore, it is not the fall in the money stock that burdens borrowers but the fact that there is less real wealth. The fall in the money stock, which was created out of “thin air” puts things in proper perspective. Additionally, as a result of the fall in money various activities that sprang up on the back of the previously expanding money now find it hard going. It is those non-wealth generating activities that end up having the most difficulties in serving their debt since these activities were never generating any real wealth and were really supported or funded, so to speak, by genuine wealth generators. With the fall in money out of thin air their support is cut-off.

Contrary to the popular view then, a fall in the money stock i.e. money out of 'thin air', is precisely what is needed to set in motion the build-up of real wealth and a revitalising of the economy. Printing money will only inflict more damage and therefore should never be considered as a means to help the economy.

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