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Deflation, Easy Money, and the Boom-Bust Cycle

Tags Money and BanksMoney and Banking


According to the president of the Federal Reserve of St. Louis James Bullard the current level of US prices is noticeably lower than what it would be if the Federal Reserve had delivered on its 2% inflation target, calling the trend “worrisome.” The yearly growth rate of the consumer price index (CPI) eased in April to 2.2% from 2.4% in March. 

Many economists maintain that a fall in prices generates expectations for a further decline in prices. As a result of this, it is held, consumers postpone their buying of goods at present since they expect to buy these goods at lower prices in the future. For most economists and various commentators a decline in the growth rate of the CPI raises the likelihood of an outright general decline in prices, which is labeled deflation and is considered to be a terrible thing.

Consequently, this weakens the overall flow of spending and this in turn weakens the economy. A fall in consumer expenditure subsequently not only weakens overall economic activity but also puts further pressure on prices. Or so it is argued. Note that from this it follows that deflation sets in motion a spiraling decline in economic activity.

But is it true that a fall in prices should always be bad news for the economy? Take for instance a case where a general fall in prices has taken place as a result of an expansion in the production of goods and services. Why should this be classified as bad news? On the contrary, every holder of money can now command a larger quantity of goods and services, i.e., people’s living standard are going up — so what's the problem?

General Declines in Prices and Money Supply

A general fall in prices can also emerge as a result of a fall in the money stock. An important cause for such a fall is a decline in fractional reserve lending. The existence of the central bank and fractional reserve banking permits commercial banks to generate credit which is not backed up by real saving (i.e., credit out of "thin air"). Once the un-backed credit is generated it creates activities that the free market would never approve. That is, these activities consume and do not produce real wealth. As long as the pool of real saving is expanding and banks are eager to expand credit, various false activities continue to prosper.

Whenever the extensive creation of credit out of "thin air" lifts the pace of real-wealth consumption above the pace of real-wealth production, this undermines the pool of real saving. Consequently, the performance of various activities starts to deteriorate and banks' bad loans start to rise. In response to this, banks curtail their loans by not renewing maturing loans and this in turn sets in motion a decline in the money stock.

It must be realized that it is only commercial bank lending that is not backed up by proper savings (fractional reserve banking) that can disappear into “thin air” thus causing the decline in the stock of money. Money, which is fully backed up by savings, once repaid by the borrower to the bank, is passed back to the original lender and therefore cannot disappear unless the original lender decides to physically destroy it. From this we can infer that the greater the percentage of credit out of “thin air” is in relation to overall credit the greater is the risk of a large fall in the money stock once the pool of real savings starts declining.

The point that must be emphasized here is that the fall in the money stock that precedes price deflation and an economic slump is actually triggered by the previous loose monetary policies of the central bank and not the liquidation of debt.

It is loose monetary policy, which provides support for the creation of un-backed credit. (Without this support banks would have difficulty practicing fractional reserve lending). The un-backed credit in turn leads to the reshuffling of real savings from wealth generators to non-wealth generators. This in turn weakens the ability to grow the pool of real savings and in turn weakens economic growth.

Many commentators are of the view that a fall in prices raises the debt burden and causes consumers to repay their debt much faster. (Rather than using the money in their possession to buy goods and services, consumers use a larger portion of their money to repay their debt.)

On this way of thinking a continuous debt liquidation could put severe pressure on the money stock and in turn on households demand for goods and services. All this, it is held, could lead to a prolonged decline in the price level. A fall in the price level in turn raises the debt burden and leads to a strengthening in the process of debt liquidation. Hence to prevent this downward spiral aggressive monetary pumping by the central bank is recommended.

Again the debt liquidation and emerging price deflation are not the causes of the economic slump but the necessary outcome of the previous loose monetary policies of the Fed that have weakened the pool of real savings. Also note that it is not a fall in prices as such that raises the debt burden and intensifies price deflation but the declining pool of real savings. The declining pool weakens the process of real wealth generation and in turn weakens borrowers’ ability to serve the debt.

Similarly, it is not increases in real interest rates, as suggested by many commentators, but a shrinking pool of real savings that undermine real economic growth. On the contrary, increases in real interest rates put things in proper perspective and arrests the wastage of scarce real savings thereby helping the real economy.

Now if the pool of real savings is falling then even if the Fed were to be successful in dramatically increasing the money supply and increasing the price level, i.e., countering deflation, the economy will follow the declining pool of real savings.

Contrary to the popular view, in this situation the more money the Fed pushes into the economy the worse the economic conditions become. The reason for this is that more money only weakens the wealth generating process by stimulating non-productive consumption (consumption that is not preceded by the production of real wealth).


Contact Frank Shostak

Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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