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Money Part V - Deflation is Liberty... Sort of

March 23, 2009 – Comments (8)

In my last blog, I presented three arguments for paper money and promised three more. However, I am just going to focus on the most common argument presented for this post for two reasons. First, other arguments for paper money are fairly simple to reject on practical and ethical grounds. Second, the subject of deflation is foremost in people's minds today as well as foremost in the arguments presented by defenders of paper money such as Ben Bernanke.

Before I move on to the arguments, however, I want to talk about the effect that deflation has on society. Due to the way in which information is disseminated in America, most Americans are under the false belief that deflation is a terrible thing and produces only bad results, precisely because that's what they are told by the inflationists, i.e. government and bankers. This line of thought requires no questioning and is accepted as if it were spoken by a deity. Just for a moment though, allow yourself to consider an alternative view.

One of the basic economic facts of human existence is that resources are scarce, while human wants are virtually unlimited. Thus, decisions must be made. Resources used for one project can not be used simultaneously for another. During an inflationary boom, however, many resources are tied up in projects that can not possibly be finished precisely because of this scarcity. If every entrepreneur could complete their projects during a time of easy credit, the logical implication would be that resources are not scarce, and the money supply could be inflated ad infinitum with no harm done. Unfortunately, as the events of 1929-1933 and 2007-present have shown, economic reality always wins in the long run.

During the inflationary boom there are winners and losers. Those who exercise time preference, i.e. the desire to accumulate capital for investment, are the losers. Those who borrow heavily, and their creditors, are the winners. Honest money takes a back seat to the quick buck and easy money. The opposite, however, holds true during the deflationary bust.  The big winners are the holders of capital. They can purchase items at bargain prices and accumulate many assets. 

The problem with deflation is identifying the losers. Homeowners, you say? Yes, but in respect to their creditors, homeowners are inconsequential. In fact, any losses recovered by anti-deflation policies are taken right back through the Cantillon Effect (or Inflation Tax) as the new money steps through the economy.  The big losers in such a scenario are the banks, and in turn, their creditors.  Our banking system (which is not a banking system at all by standard definition, but that's a subject for later discussion) is a heirarchical cartel, in which increasing debt burdens are passed up to senior banks. The Federal Reserve, a private for-profit bank, is the central bank and holds this most senior position. Therefore, it has the most to lose in a deflationary scenario. Is it any wonder then, that Bernanke and the government would take the position that deflation should be avoided at all costs?

But how is deflation liberty, as the title implies? Well, it's liberty for productive, resourceful, honest individuals. Those who have taken the conservative route (economically, not politically) become the owners of wealth, free to engage resources in a much more productive way. The poor stewards of the economy, who frivolously pissed away resources during the boom, are thrown out of their seats of power. They are relegated to finding work in the division of labor that is more suitable to their lack of economic acumen.  There are other side effects of deflation, from this perspective, that should be easily deduced by the reader.

The impact of deflation, should it be allowed to run its course, on society as whole is therefore a net gain. Certainly, it would be better altogether if we could avoid the booms and busts brought about by inflationary fractional reserve banking, paper money, and legal monopoly priviledge. In light of the fact that these evil monstrosities aren't going away any time soon, it would be beneficial for society if the busts that they caused at least allowed for a transfer of assets from inefficient to efficient managers.

Bernanke and crew, however, will have none of this and they have made it clear, through word and action, that they will never allow the deflationary cycle to finish. The boom must be re-inflated at all costs. Why? Because they have the most to lose. Deflation, my friends, is liberty.

Allow me to leave you with this excerpt from Jorg Hulsmann's excellent book, The Ethics of Money Production, from which I have learned a great deal. Here, he tackles the standard anti-deflation arguments presented by the supporters of unbacked paper money. The entire book is available free on PDF here.

"The champions of the fight against deflation usually present six arguments to make their case.One, in their eyes it is a matter of historical experience that deflation has negative repercussions on aggregate production and, therefore, on the standard of living. To explain this presumed historical record, they hold, two, that deflation incites the market participants to postpone buying because they speculate on ever lower prices. Furthermore, they consider, three, that a declining price level makes it more difficult to service debts contracted at a higher price level in the past. These difficulties threaten to entail, four, a crisis within the banking industry and thus a dramatic curtailment of credit. Five, they claim that deflation in conjunction with “sticky prices” results in unemployment. And finally, six, they consider that deflation might reduce nominal interest rates to such an extent that a monetary policy of “cheap money,” to stimulate employment and production, would no longer be possible, because the interest rate cannot be decreased below zero.

First, in historical fact, deflation has had no clear negative impact on aggregate production. Long-term decreases of the price level did not systematically correlate with lower growth rates than those that prevailed in comparable periods and/or countries with increasing price levels. Even if we focus on deflationary shocks emanating from the financial system, empirical evidence does not seem to warrant the general claim that deflation impairs long-run growth.

Second, it is true that unexpectedly strong deflation can incite people to postpone purchase decisions. However, this does not by any sort of necessity slow down aggregate production. Notice that, in the presence of deflationary tendencies, purchase decisions in general, and consumption in particular, does not come to a halt. For one thing, human beings act under the “constraint of the stomach.” Even the most neurotic misers, who cherish saving a penny above anything else, must make a minimum of purchases just to survive the next day. And all others—that is, the great majority of the population—will by and large buy just as many consumers’ goods as they would have bought in a nondeflationary environment. Even though they expect prices to decline ever further, they will buy goods and services at some point because they prefer enjoying these goods and services sooner rather than later... In actual fact, then, consumption will slow down only marginally in a deflationary environment. And this marginal reduction of consumer spending, far from impairing aggregate production, will rather tend to increase it. The simple fact is that all resources that are not used for consumption are saved; that is, they are available for investment and thus help to extend production in those areas that previously were not profitable enough to warrant investment.

Third, it is correct that deflation—especially unanticipated deflation—makes it more difficult to service debts contracted at a higher price level in the past. In the case of a massive deflation shock, widespread bankruptcy might result. Such consequences are certainly deplorable from the standpoint of the individual entrepreneurs and capitalists who own the firms, factories, and other productive assets when the deflationary shock hits. However, from the aggregate (social) point of view, it does not matter who controls the existing resources. What matters from this overall point of view is that resources remain intact and be used. Now the important point is that deflation does not destroy these resources physically. It merely diminishes their monetary value, which is why their present owners go bankrupt. Thus deflation by and large boils down to a redistribution of productive assets from old owners to new owners. The net impact on production is likely to be zero.

Fourth, it is true that deflation more or less directly threatens the banking industry, because deflation makes it more difficult for bank customers to repay their debts and because widespread business failures are likely to have a direct negative impact on the liquidity of banks. However, for the same reasons that we just discussed, while this might be devastating for some banks, it is not so for society as a whole. The crucial point is that bank credit does not create resources; it channels existing resources into other businesses than those which would have used them if these credits had not existed. It follows that a curtailment of bank credit does not destroy any
resources; it simply entails a different employment of human beings and of the available land, factories, streets, and so on.

In the light of the preceding considerations it appears that the problems entailed by deflation are much less formidable than they are in the opinion of present-day monetary authorities. Deflation certainly has much disruptive potential. However, as will become even more obvious in the following chapters, it mainly threatens institutions that are responsible for inflationary increases of the money supply."

David in Qatar