The logically contradictory and “terrifying” deflationary spiral fallacy

One of the most persistent and dangerous myths of modern economics, and especially economic policy, is the idea that deflation, defined as a general decrease in prices or the aggregate (averaged) “price level” (another misleading and erroneous concept), is dangerous because it could generate a mass deflationary spiral, with continually falling prices and depression due to the expectation of further falling prices. Indeed, if one happens to be institutionalized at a school somewhere within the EU, you may be unlucky enough to be force-fed the following propaganda video, courtesy of the ECB:

http://www.ecb.int/ecb/educational/pricestab/html/index.en.html

Most of the video discusses inflation and how “too much” money in the economy causes prices to generally increase and create problems. Of course, we are assured of the truly heroic victories the central bank’s planning bureau is achieving in fighting the alleged “inflation monster” by targeting its policy to keep inflation stable, between 0 and 2%. It’s too bad neither of the children near the end of the video asked the ECB bureaucrat lecturing them who was creating the money, and how they were “controlling” interest rates. Printing money and giving it to your friends, allowing them to fraudulently steal wealth and buy goods while destroying the purchasing power of everyone else’s money savings is a heinous crime. If you’re a central banker working for a government, it’s monetary policy.

At 6:45 into the video, our kindly bureaucrat warns us to be doubly wary of the other monster his agency keeps in a jar: deflation. Like any ordinary person, the girl in the video says this sounds great! Indeed, in a growing economy, and especially a modern one, we should be expecting deflation, given the extraordinary increases in real productivity that have been achieved in the private sector over the past decades.

However, the Eurocrat responds to dispel our enthusiasm: “You see, just like inflation it can also damage the economy, for example if all prices are falling you’ll delay buying something, expecting it to cost less a week later, and even a month later. For the same reason a company might decide to postpone its investments, and the economy suffers.” At its root this reasoning is rather childish, and we must hope that our schoolchildren will be able to disassemble it, without any special knowledge of economic theory.

A price is an exchange ratio at which acting individuals agree to buy and sell goods. Every transaction, by every individual, has a purchase and a sale. By selling my TV I’m “buying money”. For the purpose of this simple demonstration, let’s even dispose of the word “money” for now, and just note its definition. Money is a good that is a commonly accepted medium of exchange, originally an ordinary good with a wider marketability in its uses than other goods, causing it to eventually also be valued and used by other market actors to indirectly exchange goods. They sell to buyers producing products they did not fancy, while using it to buy goods from sellers who did not wish to buy the specific goods they themselves sold. This avoidance of the need for a “double-coincidence of wants”, and the expansion of exchange possibilities allowed, is how all media of exchange through the ages emerged in the market, whether salt, cigarettes, gold or silver. They were originally useful goods valued by a wider proportion of individuals on the market than other goods. This was before governments managed to monopolise and debase currencies “for the common good”.

In this light, we may consider a simple scenario. I am a “buyer” in a market, desiring to purchase good B, in exchange for which I can offer my good, C. I may agree to buy b of B for c of C, hence at the price c/b. In another sense however, I am a “seller” of the good C to my trading partner Jane, who offers in exchange her good B at a price of b/c.

According to the ECB, a “general” price decline of B in terms of C, however small, will mean that traders like me will resist buying B, expecting the ratio c/b to fall further and further. We are assured however that in the opposite case, such problems will not arise. Deflation must be avoided at all costs, while inflation must be considered a comparatively lesser evil. If c/b remains “stable”, or only rises at a “gradual” rate, no problems will occur.

Such reasoning contradicts itself, however. Every buyer is a seller, and every seller is a buyer. To Jane, the exact opposite scenario is observed. With c/b rising, b/c will be falling. By the same logic, she’ll be reluctant to buy C expecting its price to fall further, causing the price to fall even further. This would lead to a general deflation, depression of trade and stagnation.

Now, replacing the words C with money and B with goods, and applying the above “deflationist” conclusion, we should be expecting a drop in the price (or rather, the purchasing power) of money to mean a drop in the activity of sellers. This would imply an eventual grinding halt to all economic activity following general price increases (“inflation”).

Now the reader may have realised that this has not been the case, despite the distortions created by the credit expansion policies of central banks, due to the ultimate fact that sellers and buyers have not been motivated by, and indeed do not care one whit about, the aggregate price level. The profits they make, both psychic and monetary, are governed by the differences in the prices and perceived values of goods and services across the economy. They seek to gain exchange opportunities that allow them to profit by exploiting these mutually unequal valuations and price differences.

However, when confronted with the assertion that the “deflation” of one good relative to another will produce deleterious effects, while told that for the same reasons, the same cannot be said the other way round, I must express exasperated bafflement. Like Bastiat, we must continue to confront these strange arguments composed by self-styled intellectuals, who seem to assert “that an addition gives a different sum, according to whether it is added up from the bottom to the top, or from the top to the bottom of the column.”