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Deflation and economic confusion
Gerard Jackson
Deflation is a greatly misunderstood phenomenon. In fact, I am inclined to go so far as to suggest that very few Australians actually know what it means. The basic problem is that many people associate deflation with a general fall in prices, which in turn they associate with depressions.
(Up to the 1930s recessions –– which used to be called depressions –– were invariably accompanied by falling prices. Today, Keynesian economics has managed to give us rising prices with recessions).
Having realised that falling prices in themselves do not pose a danger to prosperity a few brave souls have drawn the erroneous conclusion that deflations need not be bad for business and employment. The error of much of this thinking seems to be rooted in a misreading of nineteenth century price movements.
Many have now noted that nineteenth century Britain experienced 50 years of falling prices, even though living standards rose at an unprecedented rate and level. From 1875 to 1895 wholesale prices fell by about 45 per cent while industrial output and real wages continued to rise. Presto! conclude some financial advisers, deflation is not a real danger. Unfortunately for them they are not describing deflation.
Prices fell in nineteenth century Britain because productivity outstripped the gold supply. Because prices were flexible and price changes fairly slow wages and costs adjusted themselves easily to the monetary situation. This meant that as output grew faster than the gold supply prices not only fell but the benefits of increasing productivity were more evenly spread.
On the other hand, deflation occurs where the absolute quantity of money shrinks. This means that prices must now fall if the number of transactions is not to contract. Of course, true deflations are always accompanied by depressions because what is contracting is not notes or coins, i.e., cash, but fictitious bank deposits, the product of credit expansion produced by a fractional reserve banking system. This is what happened in Australian between May 1928 and June 1931 when the money supply contracted by nearly 14 per cent.
The credit expansion sparked off a boom and misdirected production. Eventually the boom bust, credit contracted and the economy fell into depression. Hence falling prices caused by deflation are money induced; falling prices caused by productivity outstripping the money supply are goods induced. Confusing these two phenomena could have dangerous consequences.
It has been argued that to allow prices to fall indefinitely would cause interest to fall close to zero and thus make it impossible for a government to use interest rate cuts to stimulate economic activity. This is just pure nonsense. Interest is a product of time preference. For it to fall to zero people would literally have to give up every kind of current consumption in favour of distant consumption. Not a very practical thing to do.
If, for example, the social rate of time preference remained unchanged, falling prices would lead to a nominal fall in interest rates while the real rate would remain unchanged. This means that if time preference brings about a 5 per cent interest rate then an annual 2 per cent price fall would create a nominal 3 per cent interest rate.
In any case, falling prices would eventually see the market respond by expanding the money supply as it did in the nineteenth century. What our commentators also overlook is that falling prices raise the price/value of money. The nineteenth century fall in prices raised the value of gold, stimulating gold prospecting and the means to extract gold from low-grade ores.
Falling prices caused by rising productivity are to be welcomed. Falling prices caused by deflation is the fruit of a badly mismanaged monetary policy that brought on a depression. I know which one I prefer.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 17 October 2005