Deflation and Free Markets

Deflation: An increase in the purchasing power of money.

Economists are famous for their infighting and indecisiveness on answering economic questions. As the joke goes, if you put ten economists in a room and ask them a question, you will get eleven different answers. It can often seem as if the entire discipline disagrees with itself on nearly every economic issue imaginable.

However, there is one issue that economists seem to be against very nearly in unison. This issue is deflation. One is hard pressed to find economists that have anything favorable to say about deflation at all. Thomas Sowell, a relatively free market thinker, is critical of deflation in his famous “Basic 

Economics”. Paul Krugman, arguably the most famous Keynesian of our time, has also written in numerous places the dangers of deflation as well. Even though these two are on opposite ends of the economic spectrum, deflation beings them together.

Why is there such a unity over this issue of deflation? Are the evils of deflation simply so obvious as to lead all economists to condemn it? Is deflation truly harmful to an economy?

The task before us is the examination of deflation to gauge its actual effects on an economy. Deflation can occur two different ways: a decrease in the amount of money, or an increase in the amount of goods available to buy. Both of these have the same effects of increasing the purchasing power of money, but we will handle them separately.

Deflation as an Increase in Goods

A simple Supply/Demand graph shows us that whenever there is an increase in the amount of goods available for sale, there will be a decrease in price. When prices decrease, the value of money goes up. Although we often don’t think about deflation in these terms, a decrease in prices for a single industry is an example of deflation. When prices start to decline in many different industries, we see widespread deflation.

Small scale deflation is something that we experience every day. Under free markets, there is a tendency towards increasing productivity, and therefore, increases in the amount of goods available. Rather than being harmful, these lower prices have resulted in the high standards of living that the modern world enjoys today.

Luxury goods such as TVs and Cell Phones had much higher prices 20 years ago than they do now. Those prices have fallen significantly and are now much more affordable than in the recent past. Our living standards today have increased because of it. Demonized as it is, this is deflation at work.

Many economists recognized the advantages of lower prices in specific industries, even if they do not recognize it as deflation, but object to large-scale deflation. The usual argument goes roughly as follows: When deflation occurs in an economy, it encourages individuals to abstain from consuming in the present because prices will be lower in the future. Thus, consumers will put off consumption now, which will injure businesses and overall harm the economy.

However, we can observe empirically that consumers rarely behave this way. In industries, such as consumer electronics mentioned above, we can see that falls in prices are expected year over year. If consumers know that a product could be bought for cheaper a year from now, why d o they buy it now? The answer is because they prefer to have the good at a higher price now than to wait and have it at a lower price a year from now. Their Time-Preference is skewed in such a way that they value the use of the good now more than the discount of purchasing a year from now.

This is not to say that there are not situations where consumers may prefer to wait for lower prices to buy a good. However, it is an error to assume that all consumers would value that future lower price over present goods. The anti-deflation argument implicitly presumes this in its argument, however. 

We know that consumers time-preferences will tend to be different, not uniform, because of the way different individuals value present versus future goods.

Deflation resulting from an increase in goods is not harmful, but rather, the natural course of a free market economy. Rather than dealing great harm to the economy, the abundant increase in goods has driven civilization forward.

Deflation as a Decrease in the Money Supply

In this sense, deflation can be thought of as the reciprocal to inflation. They are two sides of the same coin. Whereas the results of the two are different, both processes result in a redistribution of wealth according to where the inflation/deflation starts.

Those at the who receive the new money first in an inflation benefit as they have their income increased relative to everyone else’s income. This new money makes its way through the economy, rising prices all along the way. Those near the end of the inflation, i.e. those who have their incomes affected by new money last, are the losers of the process, as they have to pay higher prices for the goods and services they consume without having their own income increased as well.

A similar redistribution effect takes place with deflation. First, a central authority, likely a central bank, takes money out of the economy. Prices will now fall, but not all at once. Converse to inflation, those that benefit from deflation are those farthest away from where the money was taken out of the economy. This is because other prices around them are falling while their incomes are still at the pre-deflationary levels. Thus, they are the winners from the decrease in the money supply, while those closest to the start of the deflation are the losers.

Inflation is almost universally the result of central banks. They generally engage in inflation because they can use the new money created to increase their own income at the expense of the public. Because of the windfalls gained from inflation, central banks rarely engage in deflation. However, when it does, it similarly results in an artificial redistribution of wealth from one area of society to another, and is thus reprehensible.

Decreases in the money supply, similarly to increases in the supply, are almost always the result of central banking. As such, the state engages in artificial income redistribution. Deflation in this form is not the natural deflation that we see on the market, but rather, a created deflation. Increased amounts of goods expand the wealth of society, whereas a money deflation redistributes that wealth. Induced deflation by decreasing the supply of money is not true deflation at all, but rather, a redistribution scheme imposed on the public.

Conclusions

There is a critical and crucial difference between an imposed inflation and a natural deflation. A natural deflation is the true result of the market. More goods and services exist, which leads to lower prices. These lower prices increase the amount of these goods and services individuals can buy, making everyone wealthier in the process. An imposed deflation from a central bank does not share these beneficial qualities. It is not a mechanism for the advancement of society, but rather, a burden of income redistribution. It is harmful and should be recognized as such.

Deflation as a whole is a concept that can be said to be good or bad. When prices fall naturally, it is beneficial. When prices are forced down, it is harmful. Whether or not a deflationary mechanism is commendable depends on the situation at hand. Thus, it is not a concept which lends itself to a single and final judgement. Rather, we should look at the concept of deflation, as well as inflation, as mechanisms which are favorable when occurring naturally on markets. However, when imposed coercively, they can deal irreparable damage to the socio-economic order

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