Wednesday, July 10, 2013

Inflation vs. Deflation

Inflation or deflation, which is better?  The answer can vary depending on who you ask.  Consider the question from the position of a worker as an importer or exporter.  If we have inflation, our dollar is weaker compared to other currencies so exporters will be able to sell more while importers will be able to buy less.  From this perspective it is easy to see that each profession, whether an importer or an exporter, will view inflation differently.  The same can be said for deflation.  In addition to the importer/exporter scenario the same principle holds when considering this question from the position of a borrower vs. a lender.

Let me first point out that no economist would argue that mild deflation or inflation is troubling.

Now let's consider some of the things Austrians say about deflation.  They claim it is not something to be feared and it is as silly to fear deflation as it is to think wars are good for the economy.  In a video with Tom Woods and Jeff Herbener they approach the discussion in a very frustrating way.  Tom Woods begins by saying that there are various definitions of deflation and when most economist are talking about deflation they are not referring to a drop in a money supply but rather a decrease in prices.  They go on to talk about the implications of falling prices (you can watch the video here).  One of the implications they falsely represent is that people will delay making purchases indefinitely because of the falling prices.  They laugh at the prospect of people waiting to buy coffee 10 days later because it will be five cents cheaper.  I want to address some of these arguments because they are not handled properly.

First of all, when other economists talk about deflation as a negative for the economy, they are speaking in terms of deflationary policies being implemented by the Federal Reserve.  They are not arguing that an increase in production that causes deflation is bad for the economy.  What is meant by Federal Reserve deflationary policies is exactly what Tom Woods says most economists are not referring to, which is a decrease in the money supply.  So right off the bat this video is misleading the viewer.

The next question you should be asking yourself is, why are deflationary policies unfavorable?  Consider a drastic decrease in the supply of money, say 20% (during the great depression the money supply dropped 33% over three years).  The problem is not that prices will fall eventually, the problem is that inflation/deflation takes around 9-15 months before the economy will start to feel these effects.  With this being considered, within the minimum of 9 months we would have only 80% of the the previous money supply while prices have yet to drop.  This has various implications, but clearly with less money to go around there will be less investment by businesses, less consumption by the consumer, less lending by banks etc.  The economy will slow down because of this.

I want to address the coffee argument because this is an egregious oversimplification of deflation.  First and foremost, no decent economist will ever tell you people will wait to buy coffee ten days because of falling prices nor will they say that people will postpone buying a computer because the prices will fall.  This is a straw man argument.  What needs to be considered when thinking about the economic effects of deflation is whether a businessman wanting to invest $100 million into his company would wait a few months if prices are projected to fall?  Any rational business man would consider waiting because if they were to take out a $100 million loan and prices are falling by 2% each year for 30 years how much extra would they have to pay back?  My investment will have be able to generate more profit than what I am paying back in interest to the bank in addition to having to pay back the amount the dollar has deflated.  This scenario doesn't seem quite so laughable now does it?  A business man with thinking like an economist will not think it is laughable either.

Woods and Herbener do address this issue at around the 7 minute mark but the manner in which they address it is improperly handled.  In America we cannot simply switch money, which is Herbener's solution to this problem.  He claims that in times of mild deflation, historically, this did not happen but I addressed this in argument in previous paragraphs.

What might the monetarist say?

In Milton Friedman's view, he would want a slight increase in a targeted money supply.  He usually argued somewhere between 3-5% with 3% being his best recommendation.  This itself, according to Friedman, would keep inflation or deflation mild.  This is what good economists argue for.  A stable money supply leads to a stable economy.  He argued this because of the evidence Herbener points out.  During the times of great expansion there were small increases in the gold supply.  Friedman wanted to emulate this with the Federal Reserve if our economy is to operate with a Federal Reserve.

The next time you hear an Austrian argue that it is silly to fear deflation you can argue that no economist fears mild deflation.


  1. Interesting post Jacob. I had to laugh at your postulate a consensus exists among economists that they do not fear mild deflation. What do you mean by mild? My experience has been the exact opposite. In reality, I can't seem to find many quote "mainstream" economists who think a slowdown in the money supply would be anything other than a catastrophe.

    I don't see how you, Friedman, or anyone else prescriptively know how much the money supply should grow. You're premise here is that supply of a certain good (money in this case) should grow at X%. I'm confused how you can advocate for a free economy while at the same time prescribing a normative policy prescription of the optimal level of the money supply.

    Moreover, I'm curious to know what rate should the supply of other homogenous goods such as corn, wheat, gas, oil, grow per year? While I accept that none of these are required to be money via legal tender laws, doesn't the law of marginal utility apply to money like any other homogenous good?

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  3. To your question about what a "businessman" should do with his $100m in a world of constant price deflation, we talking about an entreprenuer, correct? If so, then one would ask what this person has been doing as a businessmen/entrepreneur up until know to forecast how to best sell his output at a price that exceeds the cost of his/her inputs. After all, great entrepreneurs are defined by successfully predicting & forecasting future wants/needs of consumers. If the scenario occurs as you’ve described of a massive deflation (most likely resulting from an unsustainable bubble driven by an inflation-driven boom as articulated by Austrian Business Cycle Theory), a successful entrepreneur would hope that prices for producer/capital goods are allowed to adjust (most likely downward) so entrepreneurs (like the one you describe) can calculate the correct mixture of labor and capital to produce outputs to satisfy consumers.

    Guido Hulsmann explains this very well in this video below.

    Can you explain why the price deflation in the electronics industry is a straw man?

    1. I have to laugh at the misunderstanding of your first paragraph. There is a difference between a "slow down" in the money supply and deflationary policies. This shows to me you do not actually understand what "mainstream" economists are arguing.

      A slowdown in the money supply could be a decrease from 5% increase to a 3% increase in the money supply. This is a slow down. From my studies, I have never read a single economist say this will be a catastrophe. Never. Milton Friedman certainly didn't. To claim he did is a misrepresentation or a misunderstanding of his views

      Deflationary policies, in the sense that Milton Friedman talks about his an X% decrease in the money supply (e.g 33% decrease from 1929-1933). Not a slow down in the money supply. They do claim these have negative repercussions to the economy. It is laughable to me that Austrians want a stable dollar in regards to inflation but just do not care about a stable dollar when it comes to deflation. According to what you are saying, there would be no negative repercussions if the money supply was cut by 50% in a year. How is this not absurd? There HAS to be effects of this on the economy that will be negative.

      I don't think you understand what normative economics is. Milton Friedman and myself, argue that 3-5% increase in the money supply is the optimal amount for the money supply to be increased per year based off 100 years of evidence. If I claim tariffs have negative effects on the economy is this normative economics? It is not, and neither is advocating a policy that will yield a stable dollar.

      In Monetary history of the United States, and many other papers, Friedman explains exactly why he picks 3-5%. For one, it keeps the dollar stable. To argue that having a stable dollar is unnecessary is absurd. Secondly, these are the amounts our gold reserves were increasing during times of great economic stability. Thirdly, GDP increases on average 3-5% annually. This again keeps the dollar stable.

      To compare money and corn is absurd.

      You completely misunderstood my point of the business man trying to decide on 100m dollar investment, so let me explain it better. It has nothing to do with how much he sells goods for. Consider a businessman trying to decide to invest 100m into is company. His projections are that this investment is worth 130 million to the company. Say with interest rates and a stable dollar the loan costs him 115 million. This is a good investment, right? Furthermore, with the monetary policy recommended by Friedman he doesn't have to worry about a 33% decrease in the money supply over 4 years.

      Okay now, say with deflation on top of the interest rates the loan costs 140 million. This is now a bad investment. This is how businessmen make decisions in reality. I am not trying to argue that this is going to send us into a great depression but rather this DOES have negative effects on the economy.

      Why is it a straw man you ask? Because, as I pointed out in my write up, no one claims that the creative destruction of new technology is going to send our economy in a tailspin towards a depression. When Woods/herbener argue this it makes neo-classicals look like idiots and to the uneducated economist it makes them wonder why anyone would adhere to the neo-classical school of thought. That is why.

    2. One last thing. Do you really think the argument of a stable dollar is bad? I know, as an Austrian, you do not believe in evidence, but there was a heavy amount of research that was put into the 3-5%. It was not some arbitrary number he decided upon as a guess. Like i said in my response and my write-up, part of this reasoning is based on the increase in gold reserves during times of economics stability. Also, Hayek points out that gold standard is not enough to fight inflation. My books are currently packed up but he points out 3 instances in history where countries with gold standards had damaging inflation.

    3. Instead of writing a long-winded comment, I've compiled a blog post reply.

  4. The gold standard is not only a politically unviable idea but an economically unviable idea as well. Aside from the question of what gives gold it's value or what gives fiat money its value, all it does is serve to restrict the economy in one way or another, and still doesn't solve the problem of government intervention.

    As Friedman so eloquently states about a monetary commodity, "Actual commodity standards have deviated very far from this simple pattern which requires no governmental intervention. Historically, a commodity standard-such as a gold standard or a silver standard-has been accompanied by the development of fiduciary money of one kind or another, ostensibly convertible into the monetary commodity on fixed terms. There was a very good reason for this development. The fundamental defect of a commodity standard, from the point of view of the society as a whole, is that it requires the use of real resources to add to the stock of money."

    - Capitalism and Freedom pg 40.

    1. It's no coincidence that government's hate the gold standard since they are restrained from printing as much money as they want. This is somehow news?

      Gold derives its value from the fact individuals find it worth their time, materials, investment to pull it out of the ground and use it for non-monetary uses as well as monetary uses. Gold is a natural market good where as fiat-money must be imposed through legal tender laws and acts of aggression. A gold standard only restriction is that there is a finite amount of it and it requires labors/resources to mine it. Obviously, a gov't can go off a gold standard whenever it wants and there are plenty of incentives why a gov't would want to do this (as previously stated).

      On a side note, I do not favor a gold standard or silver standard but rather competing currencies and the abolition of all legal tender laws.

  5. Hayek V. Friedman, How network effects and/or switching costs discourage the emergence of a competing currency, an empirical analysis: