Is deflation bad for the economy? 

By Dr Frank Shostak 

For most experts, deflation 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 purchase these goods at lower prices in the future. Consequently, this weakens the overall flow of current 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 reduce their spending 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 cuts his spending. A general decline in prices that is associated with the decline in the circular flow of money is therefore bad news for the economy’s growth rate.

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.

For Bernanke 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 is associated with large decline in the overall demand, which is associated with deep economic recessions. That is a fall in demand causes a fall in supply.

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 wealth 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 can 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. . . . The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do. 

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 wealth.

Again, we suggest that the subject matter of inflation is the diversion of wealth from wealth generators towards the holders of the newly generated money. The increase in the money supply out of “thin air” sets in motion this diversion. The increase in the money supply out of “thin air” is what inflation is all about. 

Note that deflation emerges once the process of wealth diversion comes to a halt. This occurs once the money supply out of “thin air” starts to decline.  In this sense a decline in money supply, i.e. deflation is good news for the economy since the diversion of wealth is coming to a halt. 

Lending out of “thin air” sets platform for non-productive activities 

We hold that a major factor behind the expansion of money out of “thin air” is bank lending not backed by savings i.e 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 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 leads to 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. Note that savings do not support the newly formed demand deposits here. 

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 positive flow of savings is arrested and a decline in the pool of wealth is set in motion. 

Thus, 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 wealth from productive activities.

Some economists such as Milton Friedman are of the view that once money supply starts to decline to prevent an economic slump the central bank should embark on aggressive monetary pumping. 

We suggest that an economic slump is not caused by the decline in the money supply as such, but comes in response to the shrinking pool of wealth because of the previous easy monetary policies. 

The shrinking pool of wealth leads to the decline in economic activity and in turn to the decline in the lending out of “thin air”. This in turn results in 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 wealth is declining. 

Hence, the greater the central bank efforts to lift the economy by attempting to counter the decline in prices and rising unemployment, the worse things become.  

We suggest that the policies of tampering with financial markets are always bad news to the economy since such policies give rise to the misallocation of resources. Hence, the best policies is to have a genuine free market without the central bank tampering with financial markets.

Summary and conclusion

We suggest that the subject matter of deflation is not a general decline in prices. Deflation emerges in response to the decline in the pool of wealth. An important cause behind this decline is the increases in money supply. 

The emergence of deflation is always good news since it is in response to the liquidation of various activities that caused the erosion of the wealth generation process. Again, we suggest that an economic slump is not caused by the decline in the money supply as such, but comes in response to the shrinking pool of wealth because of the previous easy monetary policies. 

The shrinking pool of wealth leads to the decline in economic activity and in turn to the decline in the lending out of “thin air”. This in turn results in the decline in the money supply.