Relation between Inflation and Deflation

By Dr Frank Shostak

For most commentators inflation is about persistent increases in the prices of goods and services. However, is this the case?  For example, the definition of human action is not that people are engaged in all sorts of activities as such, but that they are engaged in purposeful activities–purpose gives rise to an action. 

Similarly, the essence of inflation is not a general rise in prices as such but an increase in the supply of money, which in turn sets in motion a general increase in the prices of goods and services in terms of money. 

Consider the case of a fixed stock of money. Whenever people increase their demand for some goods and services, money is going to be allocated towards these goods and services. In response, the prices of these goods and services are likely to increase– more money will be spent on them. 

Since we have here an unchanged stock of money, less of it can be now allocated towards other goods and services. Given that the price of a good is the amount of money spent on the good this means that the prices of other goods will decline i.e., less money will be spent on them. 

In order for there to be a general rise in prices, there must be an increase in the money stock. With more money and no change in the money demand, people can now allocate a greater amount of money for all goods and services.

According to Mises,    

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation.

We suggest that the subject matter of inflation is the impoverishment of the last recipients of newly created fiat money by the early recipients of this money. This process of impoverishment is set in motion as a result of an increase in the money supply. 

This increase activates an exchange of nothing for something. This amounts to the diversion of real savings from last recipients of money to the early recipients of newly generated money or money out of “thin air”. 

Now, if the growth rate of money supply stands at 10% whilst the growth rate of the production of goods and services also stands at 10% the prices of these goods and services on average will increase by 0%. By popular thinking, this will be seen as if there is no inflation here. 

However, from the perspective that inflation is increases in money supply the rate of inflation is 10%. What matters here is not changes in the prices of goods and services but the increase in money supply. This increase sets the process of impoverishment.  Consequently, we define inflation as increases in money supply. Changes in prices are just an indicator as it were that not always describes the process of impoverishment brought about by increases in money supply. 

What is the present status of inflation?  

So what is the present status of inflation? By popular thinking, as depicted by the yearly growth rate in the consumer price index (CPI), inflation stood at 2.6% in March against 1.7% in February and 1.5% in March 2020. However, in terms of money supply the growth rate of inflation stood at 69.2% in March against 13.4% in March 2020. We suggest that, massive monetary increases have weakened the process of real savings formation. As a result, businesses ability to grow the economy has been severely impaired.  

We hold that the ability of businesses to grow the economy has weakened further because of massive government spending which has diverted real savings from businesses towards various nonproductive government projects.   Note that government spending is likely to strengthen further ahead. We are of the view that because of massive fiscal and monetary spending the pool of real savings-the heart of economic growth- could be in serious trouble. 

A likely decline in the pool of real savings is expected to weaken significantly economic activity ahead; subsequently, the quality of banks assets is likely to deteriorate. Therefore, we suggest that the yearly growth rate of banks inflationary credit or lending out of “thin air” poised to weaken visibly thus putting pressure on the growth rate of money supply.  The yearly growth rate of money supply has already eased to 69.2% in March from 79.1% in the month before. We suggest that a very large financial bubble is likely to be associated with a declining pool of real savings. Note that even a slight softening in the growth rate of money supply could be fatal to current massive financial bubble.  

Observe that bubble activities cannot stand on their own feet; they require the support from increases in money supply that divert to them real savings from wealth generators. Also, note again that a major cause behind the possible decline in the pool of real savings is unprecedented increases in money supply and massive government spending. Note that if the pool of real savings is still growing then the massive money supply increase is likely to follow by an uptrend in the growth rate of the prices of goods and services. We suspect that this could start early next year.

Is the fall in prices bad news?

A general decline in the prices of goods and services is regarded as bad news by most commentators since it is seen to be associated with major economic slumps such as the Great Depression of 1930’s. In July 1932, the yearly growth rate of industrial production stood at minus 31% whilst the yearly growth rate of the consumer price index (CPI) stood at minus 10.7% by September 1932.

Contrary to the popular way of thinking, there is nothing wrong with declining prices. The essential characteristic of a free market economy is to select those commodities as money whose purchasing power is growing over time. What signifies industrial market economy under a commodity money such as gold is that the prices of goods follow a declining trend. 

According to Joseph Salerno,  

In fact, 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. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.

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. On this Murray 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.

It is argued by most experts that a general fall in prices is “bad news” for it postpones people’s buying of goods and services at present because people expect the prices of goods and services to decline in the future. 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. 

To suggest that consumers postpone their buying of goods and services because prices are expected to fall would mean that people have abandoned any desire to live in the present. However, without the maintenance of life in the present no future life is conceivable. 

Even if we were to accept that declines in prices in response to an increase in the production of goods promotes the wellbeing of individuals, what about the case when a fall in prices is associated with a decline in economic activity? Surely, this type of deflation is bad news and must be resisted.  

A tighter monetary stance that undermines various activities that sprang up on the back of previous loose monetary policy arrests the bleeding of wealth generators. The fall in prices here comes simply in response to the arrest of the impoverishment of wealth producers and hence signifies the beginning of economic healing. (The demand for various goods and services by non-wealth generators is declining because of tighter monetary stance).  Obviously, to reverse the monetary stance in order to prevent the fall in prices amounts to the renewal of impoverishment of wealth generators. 

Conclusion

We hold that both inflation and deflation originate from previous increases in money supply. As long as the pool of real savings is still holding, massive increases in money supply are likely to manifest in terms of the increase in the momentum of prices of goods and services. Once the pool of real savings starts to decline because of massive monetary pumping and reckless fiscal policies, various bubble activities are expected to plunge. This in turn is likely to result in a large decline in economic activity and in the decline in the money supply. 

As a result of the possible burst of bubble activities the prices of goods and services are likely to follow a declining trend i.e. we could face deflation. We suspect that this could occur from the second half of 2022. Note that the possibility of deflation hinges on whether the pool of real savings is declining. Our various estimates raise the likelihood that this may be so.