In Defense of Deflation

Traditionally, inflation has been the focus of economics. A myriad of articles, books, and papers have been written about the costs, benefits, consequences, and causes of inflation. In contrast to inflation, which constitutes an important part of nearly every monetary theory textbook, deflation is still neglected. At times, deflation is not even mentioned in monetary theory textbooks, and at other times, it is merely defined as the reverse of inflation in a chapter about inflation.

Many economists have written about deflation or touched upon the subject in passing while focusing on their development of related monetary theories. My aim in this chapter is not to comment on every reference concerning the subject of falling prices. This endeavor would be virtually impossible. Rather, I provide an overview of the main currents and changes in economic theories of deflation. This overview aids in explaining how and when theories of deflation in economic thought were formed and why views on deflation have changed. To explain why certain theories of deflation and deflation phobia have emerged, I place special emphasis on the circumstances and backgrounds of these deflation theorists. My exposition of the theories of deflation proceeds mainly in chronological order; however, at times I will group theorists with similar views together, though they may not be contemporaries of each other.

In this current chapter, I analyze the most important causes of a price deflation. I will look at price deflation caused by economic growth, by cash building, by bank credit contraction and by government fiat. As such, these “kinds” of deflation will be called growth deflation, cash building deflation, bank credit deflation, and fiat deflation. Growth deflation represent goods-induced changes in the purchasing power of money, while cash building deflation, bank credit deflation, and fiat deflation (with the exception of price decree deflation) represent cash-induced changes (Mises. Human action: a treatise on economics. Scholar’s edition. Ludwig von Mises Institute, Auburn, AL, 1998, p. 416). Growth deflation and cash building deflation reflect changes in the demand for money, while bank credit deflation and fiat deflation (with the exception of price decree deflation) reflect changes in the supply of money.

In order to understand the consequences of price deflation, many economists have focused on a macroeconomic aggregate: price levels. They have considered its declines and its relation to other aggregates like the gross domestic product (GDP). This procedure, however, obstructs the view of consequences apart from those aggregates that are more or less meaningful. In other words, the aggregates obstruct the view on individual human action. It is individual human actions in the first place that lead to exchanges of things and thus to exchange relationships, i.e. prices. Looking at the movements of a statistical price level obstructs the analysis of consequences of individual price changes on human action. To understand the consequences of price deflation one has to analyze the consequences of a decline of individual price changes. This is what price deflation really means: the fall of a significant portion of individual prices. Of course, prices are always the result of a complex market process. It is within this dynamic of human interactions that one can determine which prices fall first, which fall later, which fall faster, which fall slower and to which extent. Which companies or individuals make higher or lower profits in a price deflation depends on this dynamic.

Completing the theoretical analysis of deflation, I will now be able to apply the theoretical knowledge in interpreting historical cases of deflation. With knowledge of the possible causes and consequences of deflation, the interpretation of these historical facts should shed new light on the historical examples. Therefore, these examples will serve to illustrate the theoretical points made in the above analysis. Two cases will be discussed: the price deflation in the United States from 1865 to 1896 and the price deflation in Germany during the Great Depression. These cases have been selected for mainly two main reasons. First, they serve as a practical demonstration of the majority of the above analyzed types of deflation. Second, these examples are particularly illustrative. The American deflation is one of the longest in history. The German deflation is one of the sharpest during the Great Depression, which is itself of great interest for the economic historians and source of important misinterpretations.

In this work, I have dealt with the question of whether price deflation could scientifically be judged as harmful for the economy.