Blaming Deflation

With the Eurozone going to the extreme of negative interest rates and the IMF belatedly revising downwards their expectations of US economic growth, deflation is now the favoured buzzword. It is time to untangle myth from reality and put deflation in context.

Keynesian and monetarist economists commonly use the word to describe the phenomenon of falling prices, or alternatively a rising value for money. Deflation is loosely meant to be the opposite of inflation. But the term inflation originally applied to an increase in the quantities of currency and credit, not to the rise in prices that can be expected to follow. The definition has drifted from cause to supposed effect. Taking its cue from this transfer of definition, deflation is now taken to describe falling prices, usually linked to failing demand, and not a contraction of money in circulation.

Keynes decided that falling prices discourage consumers because they are likely to defer their purchases. He also argued in his Tract on Monetary Reform that deflation benefited the rentier class at the expense of the borrower, calling to mind an image of the idle rich enjoying a windfall at the expense of the hard-working poor. Keynes and his followers subsequently developed this argument against falling prices to justify government intervention as the remedy. No recognition was given to the normal process where stable money leads to lower prices, the hallmark of genuine economic progress. Sound money became tarred with the deflationary brush and ruled out as a desirable objective.

The deflation problem according to another economist, Irving Fisher, is that the losses suffered by businesses from falling prices can lead to collateral being liquidated by the banks, feeding into a debt-liquidation spiral and ultimately banking failure. Fisher was describing the natural response of banks to a widespread slump, and not the normal course of business in a sound money environment.

However, while swallowing Keynes' and Fisher's arguments central bankers are ignoring the law of the markets, commonly referred to as Say's Law. It states that we make things to buy things so you cannot divorce consumption from production, and money is just the temporary lubricant for the process.

Tinkering with monetary value solves nothing. This was the accepted wisdom before Keynes turned it on its head in the 1930s. Today governments and central banks think they can do better than markets by monetary intervention and state direction. The result is businesses that should fail are supported and uneconomic activities promoted. And when this support operation shows signs of collapsing, we are told it is deflation.

If the word has any meaning, it is nothing of the sort: markets are merely trying to embrace reality and cleanse themselves of the accumulated distortions. The fact that this cleansing process has been suspended, at least since the Reagan/Thatcher era of the early 1980s, warns us that the accumulation of distortions is great; so great that when they are corrected Irving Fisher's warning about slumps will be proven to be correct.

The marker of course is the accumulation of debt, which strangles everything. My conclusion is that use of the term deflation is passing off the accumulating problems created by government and monetary interventions as the failure of markets.

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Alasdair Macleod | Head of Research

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