Understanding Deflation: Bring It On! Here’s Why (+3K Views)

There are two problems with understanding deflation: it is ill defined, and it has a bad name. This article puts deflation into its proper context.

The original article, written by Alasdair Maclead is presented here by munKNEE.com – “ The internet’s most unique site for financial articles! (Here’s why)” – in an edited ([ ]) and revised (…) format to provide a fast & easy read. Visit our Facebook page for all the latest – and best – financial articles!

This is an important topic for advocates of gold as money who will be aware that sound money, in theory, leads to lower prices over time and is often criticised as an objective, because it is not an inflationary stimulation.

The simplest definition for deflation is that it is when the quantity of money contracts. This can come about in one or more of three ways.

1. The central bank may reduce the quantity of base money,
2. commercial banks may reduce the amount of bank credit,
3. or foreigners, in possession of your currency from an imbalance of trade, sell it to the central bank.

The link with prices is far from mechanical, because the most important determinant of the general price level is the relative appetite for holding money, and not changes of the quantity in issue, as the monetarists would have it.

• All else being equal, a deflation of the money quantity can be offset by a decline in the public’s desire for cash and deposits in hand, so that the general level of prices is unaffected.
• Alternatively, a fall in the general price level can occur without a corresponding monetary deflation. This happens if a general preference for holding money increases.
• A further consideration is a population might collectively decide, based on increased uncertainty about the future perhaps, to hoard cash instead of leaving their savings in a bank. The resulting mismatch between production on the one side, and consumption, both immediate and deferred, on the other, caused by changes in physical cash withheld from circulation, can have a noticeable effect on prices.

At times of monetary stability, price deflation is likely to occur because of economic progress.

• In free markets when money is sound, a healthy relationship between consumption and savings develops.
  • Competing businesses have access to savings to invest in more efficient production of better goods, leading to improved products and lower prices.
  • Furthermore, production chains lengthen, bringing fully the benefits of specialisation to the assembly of the component parts in every product.
• Crucially, however, these conditions can only last if money is sound, by which we mean the factors that upset overall preferences relative to goods are broadly absent.

Critics of price deflation in a sound money environment fail to understand that the level of interest rates is self-regulating.

• Interest rates adjust the split between consumption and deferred consumption, and do not affect the overall quantity of money.
  • Rates rise when businesses bid for funds to finance investment in production. Businesses investing in production calculate their costs based on expected prices, and if they experience a decline in prices, that will impact on the interest rate they are prepared to pay for new investment.

Therefore, Gibson’s paradox, that interest rates correlate to the general price level, is explained, and why interest rates do not correlate with the rate of price inflation, as the monetarists believe.

Sound and stable money is the optimum condition for an economy to deliver the most economic progress. These were the conditions broadly experienced in Britain during the nineteenth century through a mixture of a gold standard and free trade. Government stood to one side, and let people pursue their individual objectives…but the world of yesteryear’s laissez-fare is not that of today.

Classical economics has been replaced by post-Keynesian interventionism.

• The welfare state, more than free markets, drives individual expectations, particularly in the advanced economies.
• The combination of a free market, sound money and price deflation is now beyond our grasp without a major economic and financial reset. For that to happen, we must undergo both political and monetary upheavals, reversing the trend towards state control of everything and that is only likely to happen through crisis, which is the context in which deflation is feared today.

As stated above, one of the factors that contributes to monetary deflation is the contraction of bank credit.

• The normal trading policy of a bank is to maximise profits by ensuring, as much as possible, lending risk is properly assessed, then leveraging credit expansion on the bank’s capital base. Therefore, if a bank manages to obtain an average spread of 3% net of estimated lending risk, and lends ten times its capital, it obtains a gross return of 30% after expected loan losses.
• However, if there is an unexpected increase in lending risk, so that the bank is faced with the possibility of losses on its overall lending, the bank’s capital could begin to disappear rapidly. Therefore, banks can suddenly decide to contract their balance sheets to protect their capital. The process, left unchecked, leads to a financial and economic crisis, driven by a deflation of bank credit when banks, en masse, decide to contract their balance sheets.

Irving Fisher’s 1933 paper titled The Debt-Deflation Theory of Great Depressions formed the basis of subsequent analysis and understanding of deflation, and while his analysis of the causes of a deflationary is questionable, his central conclusion, that contracting bank credit does widespread damage, is unarguable.

• Banks are forced by falling collateral values on their geared balance sheets to liquidate what they can.
• A general panic ensues, with collateral being liquidated, driving down asset values and raising the cost of debt in real terms…

We saw this confirmed in the financial crisis ten years ago, when central banks and governments did everything to prevent prices falling.

• It became clear that production of goods had become over-dependant on the inflation of asset prices, which in turn had been inflated by bank credit.
• When that process halted because of the residential property crisis in America, bank credit (including off-balance sheet securitised finance) stopped expanding, property prices crashed everywhere, and goods remained unsold.

The free-market response was correct.

• Prices of big-ticket items were lowered, and production cut back. The overcapacity in the motor industry was exposed, and manufacturers slashed their prices.
• Workers, who understood the crisis at a practical level, were prepared to take wage cuts and work part-time.

This could not be permitted by governments, scared by the spectre of deflation.

• The state subsidised prices by paying consumers to scrap their existing cars,
• and the central banks wrote open-ended cheques to stop the banks foreclosing on bad and doubtful loans.

They were scary times for everyone. The debt-deflation crisis threatened to wipe out the banks. Falling prices, and their effects on capital values could not be permitted. The reversal of inflationary wealth transfers from lender to borrower was a systemic threat…

Having stared into the abyss, the establishment agreed that deflation is a very bad thing, and that central banks should ensure that prices rise for ever and a day. This is now official policy everywhere. Eventually, though, the error in believing that prices must continually rise, rather than gradually fall through the combination of free markets and sound money, will revisit us.

The deflation and economic progress of the nineteenth century should be aspired to, and moves towards this objective are our only hope of escape from yet another, potentially worse financial crisis than that of ten years ago. There is no sign of any such move, with governments insolvent everywhere, terrified of even the mere mention of deflation.

The decade from the last credit crisis has been wasted, with no steps taken to ensure either it doesn’t happen again, or alternatively, when it happens we will not face the systemic collapse that was so frightening last time. Ten years was a reasonable time to change market and public expectations and to gradually move towards a more stable world, time that was utterly wasted.

Here, for any government prepared to listen, are the minimum policy changes required to escape from the credit-fuelled merry-go-round that will end up destroying us all.

1. Accept that another nation’s business is not your affair. Cease all military spending, other than required for purely defensive purposes. The resources and technologies released by this move would be redirected by entrepreneurs for the service and benefit of consumers.
2. Stop colluding at the supra-national level to follow common monetary and economic policies. G20, G8 meetings only promote interventionist groupthink, to the exclusion of a proper understanding of policy errors.
3. Embrace the benefits of free trade, removing all tariff barriers. If a foreign manufacturer wishes to dump excess capacity into your economy, let your consumers reap the benefit.
4. Deregulate, making it clear that individuals must look out for themselves. The state is useless at protecting the consumer. Companies that plan to prosper will realise their reputations for fairness and honesty are paramount, instead of hiding behind regulations.
5. Encourage family cohesion, instead of automatically expecting the state to look after your elderly, your handicapped and your children. Socialising family values is not the business of the state, which cannot deliver welfare services effectively.
6. Reduce the state’s role in the economy with a long-term objective of absorbing less than 20% of GDP.
7. The state should be banned from running deficits. Tax must match state spending. Capital loaned to the state will no longer be drained away from productive use in the private sector.
8. Re-introduce sound money, by means of a currency-board arrangement tied to physical gold, which is deliverable on demand to all-comers.
9. Make it clear to the banks and their customers there is no lender of last resort, and no deposit guarantees. Deregulation of financial services and the removal of this safety net will force banks to stop speculating in financial markets and be conservative in their financial gearing, to protect their reputations. Interbank loan rates will penalise financial aggression.
10. Sack all government economists, and close all government statistical offices. At best, they serve no constructive purpose, and at worst they are repositories for bad advice, as growing economic and financial instability attest.
11. Close the central bank, and replace it with a currency board with one purpose: to regulate the issuance of the currency convertible into the national stock of gold.

We can but dream. The above 11 bullet points would set the clock back to when the gentle deflation of prices, which fostered genuine economic progress, improved the human condition more effectively than at any other time in the history of mankind. All the improvements since have come not from governments, but from ordinary people, despite governments.

Do not forget that the strength of a liberated economy in the decades after the Napoleonic Wars allowed the British government to pay down levels of debt significantly higher, relative to the size of the economy, than it has today. This is the practical alternative to the belief that debt should be inflated away. Governments are on a diametrically opposed course, which will end up suppressing free markets entirely. It is the path towards the ultimate failure of the state. (We criticise Venezuela and Zimbabwe, because their mistakes are obvious to us but we fail to realise the only difference between them and us is the speed of their failure compared with ours.)

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