The Anatomy of Deflation
"...Let me put it this way. Deflation is not falling prices. It is monetary contraction. Falling prices are necessary as a response to deflation, which is prior, and which exists whether prices do or do not fall, and can exist even if prices rise. Falling prices in response to deflation are economically beneficial, in that they enable a reduced quantity of money and volume of spending to buy as much as the previously larger quantity of money and volume of spending bought. In other words, the effect of falling prices is always positive..."
George Reisman
8/29/2003
Fears of deflation, prominent a month or two ago, are now rapidly subsiding, and soon may disappear entirely. Nevertheless, deflation is still a subject about which it is important to have a correct understanding.Deflation is usually thought to be a synonym for falling prices. There could be no more serious error in all of economics. Calling falling prices 'deflation' results in a profound confusion between prosperity and depression. This is because the leading cause of falling prices is economic progress, whose essential feature is an increasing production and supply of goods and services, which, of course, operates to make prices fall.
Yet the term deflation is also closely associated with a plunge in business profits and a suddenly and substantially greater difficulty of repaying debts, with the consequence of widespread insolvencies and bankruptcies. The plunge in profits and sudden sharp increase in the burden of debt are, of course, leading symptoms of a depression.
Hence, the proximate cause of prosperity -- increasing production and supply -- comes to be confused with depression and the widespread impoverishment that accompanies depressions. This is closely related to the absurdities of the overproduction doctrine, which claims that we are poor because we are rich.
What must be realized is that there are two distinct causes of generally falling prices. One is the increase in production and supply, which should never, never be confused with deflation, depression, or poverty. The other is a decrease in the quantity of money and or volume of spending in the economic system. Falling prices is the only effect these two trends have in common. They differ profoundly with respect to their other effects.
Falling prices caused by increased production do not reduce the general or average rate of profit in the economic system. Neither do they make debt repayment more difficult. Indeed, to the extent that such falling prices take place in the face of an increasing quantity of money and rising volume of spending, and result merely from the fact that the increase in production and supply outstrips the increase in money and spending, they are accompanied by a positive elevation of the rate of profit and a greater ease of repaying debts.
This would be precisely the case under a gold standard, inasmuch as the supply of gold modestly grows from year to year as the result of continued and expanded gold mining operations, and the volume of spending in terms of gold grows commensurately. In such circumstances, the average seller in the economic system would be in the position of selling at lower prices and at the same time have a supply of goods to sell at those lower prices that was larger in greater degree than prices were lower.
For example, if falling prices result from the fact that while the quantity of money and volume of spending in the economic system are rising at a two percent annual rate, production and supply are rising at a three percent annual rate, the average seller in the economic system is in the position of having three percent more goods to sell at prices that are only one percent lower. His sales revenues will be two percent higher, and that is what counts for his nominal profits and his ability to repay debts. His profits will be higher and his ability to repay debt will be greater. There are lower prices here, but absolutely no deflation.
What wipes out profits and makes debt repayment more difficult is not falling prices but monetary contraction, i.e., the reduction in the quantity of money and or volume of spending in the economic system. This is what serves to reduce sales revenues, and, in the face of costs determined on the basis of prior outlays of money, causes a corresponding reduction in profits. It is also what makes debt payment more difficult, in that there is simply less money available to be earned and thus available to be used for the repayment of debts. It is monetary contraction, and monetary contraction alone, which can be termed deflation.
Moreover, in the face of any given monetary contraction, the reduction in profits and increase in the burden of debt would in no way be diminished if prices did not fall. Indeed, these phenomena would not be alleviated even if prices rose. Prices would not fall if production and supply fell to the same extent that money and spending fell. They would actually rise if production and supply fell to a greater extent than the quantity of money and volume of spending. But irrespective of what might happen to production, supply, and prices, the same monetary contraction would cause the same reduction in sales revenues and, in the face of the same prior outlays of money showing up as costs, the same reduction in profits. And it would cause the same increase in the burden of repaying debt.
The point is that falling prices are simply not the cause of a plunge in profits and increase in the burden of debt. At most they can be the accompaniment of these things, when all three result from monetary contraction. But they need not even be an accompaniment. For the phenomena of plunging profits and a rising burden of debt, as I've just shown, can also be accompanied by rising prices -- to the extent that a reduction in production and supply were to outstrip the reduction in money and spending.
What deserves special stress is the fact that even when falling prices are the result of monetary contraction, rather than increases in production and supply, and are accompanied by actual economic hardship rather than by general prosperity, their specific contribution to the situation is not only not that of cause, but of remedy. Falling prices in response to monetary contraction are precisely what enable a reduced quantity of money and volume of spending to buy as many goods and to employ as many workers as did the previously larger quantity of money and volume of spending. Preventing the fall in prices, including a fall in wage rates, serves only to prevent the restoration of production and employment.
Let me put it this way. Deflation is not falling prices. It is monetary contraction. Falling prices are necessary as a response to deflation, which is prior, and which exists whether prices do or do not fall, and can exist even if prices rise. Falling prices in response to deflation are economically beneficial, in that they enable a reduced quantity of money and volume of spending to buy as much as the previously larger quantity of money and volume of spending bought.
In other words, the effect of falling prices is always positive. They should not be confused with deflation or depression and are certainly not their cause. On the contrary, as we have seen, they are a remedy for the effects of deflation. And this is true even for debtors. It is not the level of prices that makes it difficult to repay a debt, but the amount of money one can earn in relation to the size of the debts one must pay. If the average member of the economic system can no longer earn as much money as he used to, and thus finds it more difficult to repay any given amount of money debt, then the fact that prices fall does not make him earn still less. Rather it enables his reduced spending power to buy more. His problem is in the relationship between the amount of money he can earn and the amount of money he must repay. His problem is not caused by a greater buying power of that money.
Deflation, which, it cannot be repeated too often, means monetary contraction, not falling prices, is at best in the category of a pain to be endured only in order to avoid greater pain later on. It should never be, and virtually never is, regarded as any kind of positive in its own right. Indeed, opposition to credit expansion, and to the fractional-reserve banking system that makes credit expansion possible, rests for the most part precisely on the fact they are responsible for deflation, which would not exist in their absence.
The most important point I have made, namely, that falling prices caused by increased production are not deflation and should never be confused with deflation, is illustrated by the following table, which can be taken as a summary of this article.
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