The Perils of Deflation
Many financial advisers are sounding the alarm: "The forces of deflation are gathering strength and threatening to take over. The stock market is pointing the way and the economy is following." Some even are seeing signs of impending calamity: "The United States is staring into the same deflationary abyss that has swallowed Japan. Debt is becoming back-breaking and liquidity is drying up. Debt defaults are soaring and forced asset sales are exacerbating the decline." Many media reporters are echoing this reaction and attitude.
Deflation, according to these spokesmen of popular economics, is a decline in the prices of goods and services, the reverse of inflation. Both give rise to opposite effects: inflation is said to stimulate output and employment; deflation always affects them negatively. Indeed, popular economics considers deflation to be one of the most dreaded evils in the world today.
Popular economics is the offspring of genetically dissimilar notions, theories, concerns, and interests. It may spring from old economic theories that are popular and pleasing although misleading and erroneous. There are Keynesian doctrines that explain depressions as "gaps" between aggregate production and spending and, therefore, in order to fill the gaps, promote programs of government spending on public works. There are old exploitation doctrines which breed employer-worker confrontations and, hence, prevent efficient market adjustments. There is an army of civil servants who never tire of espousing and promoting popular economics because it assigns important economic functions to them. There are countless businessmen who readily embrace fashionable economics because it generally favors government regulation which, in turn, tends to reduce the pressures of competition. And finally, popular notions and doctrines please many people because they offer colorful descriptions rather than difficult explanations of causal relations.
Economists view inflation and deflation in a different light. They search for the very causes of rising or falling prices and, having ascertained the origin, know how to avoid the evils. They need not look far for the very mainspring of inflation: the increase in the stock of money by the monetary authority, the Federal Reserve System. The System sets the pace by providing legal-tender money; commercial banks and other financial institutions then add their fiduciary money and credit, always keeping an eye on the authority. The people offer or bid for money, which affects its purchasing power in the same way as it influences the mutual exchange ratios of other goods. In short, demand and supply determine its exchange value.
While the stock of money tends to increase continually at the discretion of the monetary authority, the demand for money reacts rather slowly to changes. It may vary radically, however, when people regard their economic situation with fear and, therefore, significantly change their money holdings. The fear of ever more inflation and monetary depreciation may give rise to a "flight from money," which may produce double-digit or even triple-digit inflation. The fear of a looming disaster or depression, on the other hand, may induce people to cling to their money, which increases the demand for money, raises its value, and thereby lowers goods prices. In the language of popular economics, their reluctance to spend money may lead to deflation.
At this time in our "bubble" economy the fear of stagnation and decline is increasing the demand for money and exerting a powerful downward pressure on goods prices. It is rendering the expansion efforts by the Fed and the U.S. Congress rather ineffective. In terms of popular economics, uncertainty and fear are frustrating Fed efforts to "jump-start" the economy. The Fed is"pushing on a string." It exerts ample control over banking and credit institutions through a number of regulatory instruments such as setting reserve requirements for member banks, determining the rate of discounts and advances, and engaging in open market operations. But the Fed has little control over the actions and reactions of millions of dollar holders throughout the world. Their freedom to offer or bid for U.S. dollars is the ultimate variable in monetary management and control. To the Fed it is an irritating and exasperating restraint of its power over the people's money.
The painful pressures of economic stagnation despite strenuous Fed efforts to inflate the stock of money must be seen in this light. The weight is keenly felt in the world of capital goods where businessmen must make difficult employment decisions. They often are the primary victims, easily misled by the Fed's recurrent policy of stimulation through "easy money" and "low-interest" credit. Misinformed and misdirected they embark upon costly projects and ventures which, in a fever of soaring prices and costs, are found to be costly mistakes inflicting painful losses. In the end, loss-inflicting projects need to be abandoned and unprofitable labor be discharged. Businessmen are forced to hold on to their money, which may develop the symptoms of deflation. Consumers are likely to follow suit.
Economists nevertheless refuse to be alarmed by fearful prognoses of deflation. They see instead a number of glaring inflation symptoms, such as rising commodity and energy prices, that point to more inflation to come. Analysts focus on U.S. fiscal and monetary policies that are highly inflationary and soon may erase the deflation symptoms. They always look upon inflation as the root cause of many economic evils, especially the cyclical instability. Deflation, in their view, is merely an inevitable phase of a business cycle that is engendered by inflationary policies; it is the final phase, painful but wholesome, as it forces businessmen to readjust to the demands of the market.
The deflation symptoms may soon give way to the forces of inflation. Massive imports of all kinds of goods still are keeping a lid on consumer prices. In 2002 Americans imported about $500 billion more than they exported, that is, they consumed more than they produced, financing the deficits with U.S. dollars, most of which remained abroad or were invested in U.S. government obligations. The trade deficits and foreign dollar holdings exert powerful exchange-rate pressures on the dollar which in recent months already lost more than 20 percent versus the euro and may lose more in the future. Further U.S. dollar losses are bound to reduce American imports, promote exports, and consequently raise goods prices. In short, a declining dollar in foreign exchange markets may soon rekindle the inflation fever.
The federal government itself faces budget deficits as far as the eye can see. Tax revenues are down and expenditures, magnified by the war in Iraq, are out of sight. Moreover, Congress may cut taxes, guided by the supply-side assumption that tax cuts promote economic expansion and thereby generate additional tax revenues which may offset and cover the earlier revenue losses. Unfortunately, the budget deficits do not abide by supply-side notions. They surely would raise interest rates and depress business investment, if they would consume actual savings. But the Fed continues to collaborate by creating new funds and reserves which enable commercial banks to offer their fiduciary credits. Interest rates may remain steady or even decline, but they no longer signal the true state of the capital market; they deceive and mislead investors, cause new distortions and malinvestments, and prime the markets for more inflation to come.
America's engine of inflation, the Federal Reserve System, hardly ever slows down in its portentous endeavors. As of March 19, its present data, total Fed credit rose $67.6 billion, or 9.6 percent, since a year ago. The broadest measure of money supply, M3, which includes currency in circulation, checking accounts balances, savings accounts and time deposits such as CDs and money market fund balances held by institutions, may explain the Fed's fear of deflation -- it is up only $473 billion, or just 5.8 percent. And producer prices have risen only 3.6 percent since a year ago and consumer prices just 3 percent. The 9.6 percent Fed credit expansion is the starter fluid that is to jump-start the American economy.
There is no deflation abyss that may swallow the economy. There never was a bottomless pit which swallowed Japan or any other economy. But there are abysses that swallow countries the governments of which conduct abysmal policies. Political blunders and economic follies are depressing the Japanese economy. Ever since the giant bubble burst in 1990 the Japanese government has tried frantically to spend its way out of the recession, but it merely managed to aggravate and prolong it. It sustained insolvent banks and insurance companies, subsidized favorite industries, and always prevented needed corrections and readjustments. Massive deficits continue to consume the people's savings, and false interest rates sustain old imbalances and create new maladjustments. The Japanese malaise is self-inflicted; guided by spurious notions and doctrines Japanese politicians unbendingly and doggedly pursue baneful policies.
Declining prices do not call for contravening central bank maneuvers that hopefully stabilize prices. Actually, whether the given stock of money is large or small, it renders the desired exchange service. The popular notion that an increase in the stock of money is socially and economically beneficial and desirable is one of the great fallacies of our time. It has lived on throughout the centuries, embraced by kings and presidents, politicians and businessmen. It has shattered numerous currencies, inflicted incalculable harm, and caused social and political upheavals. It springs forth, again and again, no matter how often economists may refute it.
Hans F. Sennholz