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Austrians on Deflation

A commenter on an older post about hyperinflation says the following:

“deflation is not the end of the world, and there are different kinds of deflation, too.”

Then he posts links to a bunch of Austrian posts about inflation and deflation. They are highly confused and I want to go through them point by point. First though, let me say that I agree there are different types of deflation. This is what I have been trying to say all along. If money were an organic and decentralized phenomenon, then there would most likely be steady mild (price) deflation at most times. This is altogether different from what happens when we have a central bank regime which encourages a highly leveraged society and then tightens monetary policy (or fails to loosen it sufficiently to keep the leveraging going). I’m not confusing these two, Austrians are confusing them. When they say “deflation is not the end of the world” they (seemingly) are talking about the first kind. But they say this in contexts which have nothing to do with that type of regime.  They don’t see the difference.  Deflation in a highly leveraged economy is the end of the world. 

Now for the “Deflation Bogey.”

This is the argument being criticized:

While the idea of lower prices may sound attractive, deflation is a real concern for several reasons. Deflation discourages spending and investment because consumers, expecting prices to fall further, delay purchases, preferring instead to save and wait for even lower prices. Decreased spending, in turn, lowers company sales and profits, which eventually increases unemployment.

I totally agree that that argument is bogus and actually, I find it hard to believe that any serious economists believe that but apparently some do.  The critique of this argument, however, is completely nonsensical.  It focuses on whether or not it makes sense to expect future decreases in price based on past decreases and that is completely beside the point.  The whole issue is what happens when people expect prices to fall not why they would expect them to fall.  This type of confusion is the result of getting your impression of mainstream economics from Wikipedia instead of actually learning how economic models work and what they mean.  But I don’t want to spend a lot of time on that right now.

Instead let me just point out that the mere fact that someone makes an erroneous argument about why inflation is bad, does not mean it isn’t bad.   So let me try to explain why it is bad and it is a self-reinforcing cycle in a highly leveraged economy with central banking and fiat money.

The reason many deflation hawks end up with this misguided argument based on people delaying consumption in anticipation of lower prices in the future is that they are trying to come up with an argument which explains the type of deflationary spiral we have observed without mentioning debt.  That overlooks the real reason this happens.  The Krugman quote gets it right.

… the economy crosses the black hole’s event horizon: the point of no return, beyond which deflation feeds on itself. Prices fall in the face of excess capacity; businesses and individuals become reluctant to borrow, because falling prices raise the real burden of repayment; with spending sluggish, the economy becomes increasingly depressed, and prices fall all the faster [emphasis added].

If we had an economy where people just held money and no debt and, for whatever reason, everyone expected prices to fall 1% per year forever, it would be silly to say that they would all stop consuming and producing because prices were falling.  That’s not what we have.

What we have is an economy where the money supply expands when people borrow money.  The more they borrow, the more it expands.  Or, to put it another way, the more we want to expand it, the more they have to borrow.  To get them to borrow, the Fed tells us that it will create a certain amount of inflation in the future (for instance 2%).  They then peg a nominal interest rate.  We decide how much to borrow/lend based on these two things.  The higher the level of inflation between when we take out the loan and when we have to pay it back, the cheaper the loan is in real terms and the more we will borrow.

But what happens if you took out a 30-year mortgage ten years ago expecting your income to rise at 2% per year every year and then suddenly your income instead falls by 2% and you expect this to continue in the future?  Answer: you just got a lot poorer.  And not only did you get poorer, your mortgage got more expensive relative to other forms of consumption.  You will reduce your consumption over all future time periods and you will most likely reduce it more in the future and try to pay off your mortgage faster because the real rate you are paying on it became higher.

When everybody has a mortgage, and credit card debt, and student loans, and car loans, and boat loans, and they all suddenly stop taking out more loans and start trying to pay them down, the money supply contracts.  This causes prices to fall further which causes debt to become even more expensive etc.  It’s all about debt!

Okay, now let’s deal with “What’s so Scary About Deflation?”  I will go point-by-point.

First, the empirical evidence (I thought Austrians didn’t believe in empirical evidence…).  I haven’t read the paper they site but the numbers they mention are essentially meaningless because we usually have inflation.  An appropriate approach to the empirical question would be to use some kind of probability model (logit, probit, etc.) to estimate the effect deflation has on the probability of recession.  More importantly, you don’t need actual deflation to get the proposed effects, they can result from less-than-expected inflation.

The “main argument against deflation” he says is the ridiculous one addressed above.  It may be true that this is the main argument against it but it is not the right one.  He then goes on to make the same meaningless arguments against this straw man that were made in the previous article.  Then he adds this one which is where he really misses the point.

A third mistake is that if we are consuming less, we must be saving more. Investment must therefore be higher. Therefore increased saving that can lead to deflation does not reduce aggregate demand but simply alters the composition of demand.

Wrong!  Saving more (or borrowing less) does not mean investment must be higher, it means that the money supply contracts as explained above which does reduce aggregate demand.  Again, this is the result of imagining a simplified version of the economy without the monetary system we actually have.  Then he says this.

Growth lowers prices: that is a good thing. The period of the greatest growth in the U.S. during the nineteenth century, from 1820 to 1850 and from 1865 to 1900, was associated with significant deflation. In those two cases, prices were cut in half.

I agree.  When that happened we didn’t have the monetary system we have now.  You know what can also lower prices?  A contraction in the money supply and/or drop in velocity caused by a dramatic deleveraging.  That kind of deflation is not such a good thing. (Remember there’s different kinds…)

The example he then uses to explain this assertion (which, remember, I agree with) is a disaster. Here are some of the problems with it.

1.  There is no actual mechanism for determining prices proposed, he just says ” Suppose you have 10 pencils and $10. What is the price of a pencil?”  That makes no sense.  But presumably he is driving at some form of the quantity theory of money and he means there is $10 in the economy and 10 units of output which get traded (note that it would make no sense if this were all the same good, then there would be no reason to trade) and the velocity of money is 1.

2.  Low prices don’t mean things are less scarce.  In that model, what would happen if the number of pencils stayed the same but the quantity of money was cut in half?  Would this mean that we are “winning the battle against scarcity?”  He seems to arrive at this conclusion by assuming that the quantity of money doesn’t change.  That assumption prevents any meaningful investigation of the subject at hand (remember: different kinds).

3.  He says that the problem is sticky prices and that the reason this isn’t a problem is that prices probably reset pretty quickly.  “Sticky prices” is kind of a smokescreen used by mainstream macro which obscures the real problem.  “Prices” include the terms of debt (most macroeconomists are aware of this by the way but I think they tend to underemphasize it) how fast does the rate on your 30-year mortgage reset?

4.  He talks about the Fed distorting relative prices when he only has one good in his model.

At this point we get to the real problematic stuff.

There is possibly no more clearly erroneous Austrian belief than this: “It initially benefits those that receive the money first, the government and banks, and penalizes the late receivers of the money.”  If you missed the Great Monetary Injection Debate of 2012, click the link and try to work through it.  I don’t want to refight that battle here, smarter people than me have tried and failed and frankly I find the subject amazingly emotionally draining.

Instead let’s take a look at this: “Also, the printing of money is distortive. When the government adds $5 to the economy, it is not neutral.”  It’s also not “neutral” when the Fed causes a deflationary contraction.  There’s no such thing as “neutral” monetary policy.  If you are going to have monetary policy, it is going to have to determine the quantity of money.  There is no quantity that is “neutral” but one dollar more is “printing extra money.”  I, for one, don’t think we should have any monetary policy but we are a long way from that and burying your head in a gold-standard economy, drawing conclusions about money and prices and then prognosticating about the policy of the Federal Reserve based on these conclusions is not helping the cause.

This part is basically right.

Many times deflation follows a period of central bank inflation. Deflation is part of the deleveraging process that is necessary following such an excessive policy by the central bank. As Austrian economists have always said, “fear the boom, not the bust.” Delaying the deflation by extending the bubble or creating new bubbles by printing more money only delays the adjustment making it much more painful.

However, Austrians don’t seem to understand that the “period of central bank inflation” has been the last hundred years.  Should we not have done that?  Yes.  But we have done it.  At this point, if you just suddenly started dramatically tightening monetary and fiscal policy, you would get a little recession that would be over in a couple years and then happy times ever after, you would get an unwinding of a century worth of artificial leveraging.  How many people do you think would come out of that in good shape?  If Austrians and libertarians keep saying “don’t worry deflation isn’t that bad” and then we go down that road, it won’t be a new libertarian paradise that follows.

Finally there’s this.

The real solution is to end fractional reserve banking and central banking. A world without fractional reserve banking and central banks would be a world of gentle deflation, which should be hailed as indicative of one of mankind’s greatest achievements: the raising of living standards for all.

I agree completely (except for the fractional reserve banking).  But remember there’s more than one kind….







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