By Dr Frank Shostak
It is maintained by most experts that a general fall in prices labelled as deflation is “bad news” for the economy for it postpones people’s buying of goods and services, which in turn undermines investment in plant 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 news since it generates expectations for a continued decline in prices. Because of this, it is held consumers postpone the purchases of goods at present since they expect to buy these goods at lower prices in the future. Consequently, it is held this weakens the overall spending and this in turn weakens the economy.
In this way of 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 is going to 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, on this way of thinking a general decline in prices is bad news 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, which is 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. On this 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,
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.
The essence of deflation
To establish the essence of deflation we have to ascertain the essence of inflation. We hold that the subject matter of inflation is the diversion of resources from wealth generators towards non-wealth generators brought about by the expansion, or inflating the money supply.
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 are going to emerge.
According to Mises any given amount of money could fulfill the function of the medium of the exchange hence there is no requirements to increase the supply of money to accommodate an increase in the demand for money. On this 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 increase in money supply out of “thin air” results in an exchange of nothing for something i.e. in the diversion of resources from wealth generators to the holders of money out of “thin air”.
The increase in the money supply out of “thin air” sets in motion this diversion. Note the increase in the money supply out of “thin air” is what inflation is all about.
Now, once the money supply out of “thin air” starts to 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.
Lending out of “thin air” sets the platform for non-productive activities
A major factor behind the expansion of money supply out of “thin air” is bank lending that is not backed by savings i.e. the lending out of “thin air”.
When loaned money is fully backed by savings on the day of the loan’s maturity, it is returned via the bank to the original lender. Note that 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 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 being because in this case we never had a saver/lender, since this lending was generated out of “thin air” by the bank.
Observe that the unbacked by savings 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 lending out of “thin air” would not have emerged.
As long as banks continue to expand credit out of “thin air”, various non-productive activities continue to prosper. At some point however, because of the expansion in the credit out of “thin air” and the following increase in the money supply out of “thin air”, a structure of production emerges that ties up much more consumer goods than the amount it releases. (The consumption of final consumer goods exceeds the production of these goods). The flow of savings is arrested and a decline in the pool of 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 out of “thin air” and this in turn triggers a decline in the money supply. A decline in the money supply begins to undermine various non-productive activities i.e. an economic recession emerges. Observe that the non-productive activities cannot “stand on their own feet”. These activities require increases in money supply that divert to these activities’ resources from wealth generators.
Some economists such as Milton Friedman are of the view that once money supply starts to decline, then in order to prevent an economic slump the central bank should embark on an aggressive monetary pumping.
We suggest that an economic slump is not caused by the decline in the money supply, but comes in response to the shrinking pool of savings because of the previous expansionary monetary policies. The shrinking pool of savings leads to the decline in economic activity. As a result, banks curtail the lending out of “thin air” 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 if the pool of savings is declining.
Summary and conclusion
We suggest that deflation emerges in response to the decline in the pool of savings. An important cause behind the decline in the pool of savings is the expansionary monetary policy of the central bank.
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. Again, we suggest that an economic slump is not caused by the decline in the money supply, but comes in response to the shrinking pool of savings because of the previous expansionary monetary policies. Consequently, policies that are aiming at lifting the money supply growth rate, are weakening the pool of savings and delaying the economic recovery
