FALLING PRICES ARE NOT DEFLATION BUT THE ANTIDOTE TO DEFLATION

George Reisman's picture
Submitted by George Reisman on Mon, 2009-01-12 01:44

FALLING PRICES ARE NOT DEFLATION BUT THE ANTIDOTE TO DEFLATION

This is the first in a series of articles that seeks to provide the intelligent layman with sufficient knowledge of sound economic theory to enable him to understand what must be done to overcome the present financial crisis and return to the path of economic progress and prosperity.

A disastrous economic confusion, one that is shared almost universally, both by laymen and by professional economists alike, is the belief that falling prices constitute deflation and thus must be feared and, if possible, prevented.

The front-page, lead article of The New York Times of last November 1 provides a typical example of this confusion. It declares:

As dozens of countries slip deeper into financial distress, a new threat may be gathering force within the American economy—the prospect that goods will pile up waiting for buyers and prices will fall, suffocating fresh investment and worsening joblessness for months or even years.

The word for this is deflation, or declining prices, a term that gives economists chills.

Deflation accompanied the Depression of the 1930s. Persistently falling prices also were at the heart of Japan’s so-called lost decade after the catastrophic collapse of its real estate bubble at the end of the 1980s—a period in which some experts now find parallels to the American predicament.

Contrary to The Times and so many others, deflation is not falling prices but a decrease in the quantity of money and/or volume of spending in the economic system. To say the same thing in different words, deflation is a general fall in demand. Falling prices are a consequence of deflation, not the phenomenon itself.

Totally apart from deflation, falling prices are also a consequence of increases in the production and supply of goods, which are an essential feature of economic progress and a rising standard of living. In such circumstances, falling prices are not accompanied by any plunge in business sales revenues or profits, by any increase in the difficulty of repaying debt, or by any surge in bankruptcies. All of these phenomena are the result purely and simply of deflation, not falling prices.

Indeed, under a full-bodied, 100-percent-reserve gold standard, falling prices, caused by increased production, are likely to be accompanied by a modest elevation of the rate of profit and a somewhat greater ease of repaying debt, both owing to the increase in the production and supply of gold and thus in the spending of gold. Under such a gold standard, prices fall to the extent that the increase in the production and supply of ordinary goods and services outstrips the increase in the production and supply of gold and the consequent increase in spending in terms of gold.

While this must certainly come as a surprise to The Times, and to everyone else who does not understand the nature of deflation, falling prices are in fact so far removed from being deflation that they are the antidote to deflation. They are what enables an economic system that has experienced deflation to recover from it and thereafter to enjoy the fruits of economic progress.

This conclusion can be demonstrated Socratically, by means of a simple question that could be used on an economics exam for sixth graders.

Thus, imagine that prior to the present financial downturn, Bill used to go shopping once a week in his local supermarket. When he went there, he could afford to spend $10 for bottled water. At the prevailing price of $1 per bottle, he was able to buy 10 bottles. Now, in the midst of the downturn, when Bill visits the supermarket, he can afford to spend only $5 for bottled water.

Here’s the question: At what price per bottle of water would Bill be able to buy for $5 the 10 bottles of water he used to buy for $10? Answer: 50¢.

As this question and its answer make clear, a fall in prices enables reduced funds available for expenditure to buy as much as previously larger funds could buy.

This point applies even when lower prices do not result in greater purchases of the particular item whose price has fallen. Thus, suppose that the price of a gallon of milk is $8 and now falls to $4. Yet Bill and his family do not need more than one gallon in any given week, and so won’t buy any larger quantity of milk at its now lower price. The fall in its price still helps economic recovery. It does so by freeing up $4 of Bill’s funds to make possible the purchase of other things, that he wants but otherwise couldn’t afford because of the lack of available funds.

Another, similar example is that of a fall in the price of gasoline or heating oil, which helps to increase the ability of people to spend in buying products throughout the economic system.

As indicated, in sharpest contrast to falling prices, deflation is a process of financial contraction. In our present crisis, it is a contraction of credit and of the spending that depends on credit. A fall in prices and, of course, in wage rates too, is the essential means of adapting to this deflation and overcoming it.

Nevertheless, the prevailing bizarre confusion of falling prices with deflation, stands in the way of economic recovery. In regarding falling prices, which are the effect of deflation and at the same time the remedy for deflation, as somehow themselves being deflation, people are led to confuse the solution for the problem with the problem that needs to be solved.

On the basis of this confusion, they advocate government intervention to prevent prices from falling. The prices they want to prevent from falling are, variously, house prices, farm and other commodity prices, and, above all, wage rates. To the extent that such efforts are successful, and prices are prevented from falling, the effect is to prevent economic recovery. It prevents economic recovery by preventing the reduced level of spending that deflation represents, from buying the larger quantity of goods and services that it would be able to buy at lower prices and wage rates.

Just as falling prices are so far from being deflation that they are the remedy for deflation, so too preventing prices from falling is so far from preventing deflation that it actually worsens the deflation. This is because it leads people to postpone buying even in instances in which they have the ability to buy. They put off buying in the expectation of being able to buy on better terms later on, when prices and wage rates have fallen to the extent necessary to permit economic recovery.

By the same token, when prices and wage rates finally do fall sufficiently to permit economic recovery, an increase in spending in the economic system will almost certainly occur. This is because the funds that people had been withholding from spending, awaiting the fall in prices and wages rates, will now, in the face of the necessary fall, be spent. Thus the necessary fall in prices and wage rates achieves economic recovery by means of creating greater buying power for a reduced amount of spending. It also brings about a partial restoration of spending and thereby definitively ends the deflation.

Just how far it is necessary for prices and wage rates to fall in order to achieve economic recovery depends on the change that has taken place in what Mises calls “the money relation.” This is the relationship between the supply of money and the demand for money for holding.

During the boom, inflation and credit expansion increase the supply of money and at the same time reduce the demand for money for holding. Then, in the subsequent bust phase of the business cycle, the demand for money for holding rises and the supply of money can actually fall. Both of these factors make for a decline in total spending in the economic system and thus the need for a correspondingly lower level of wage rates and prices to achieve economic recovery.

How far these processes might go in our present circumstances and what might be done, consistent with the principle of economic freedom, to mitigate them, is too large a subject to explain in this one article.[1] However, I must state here that a decrease in the quantity of money can be altogether prevented and that this would dramatically limit the extent of the decline in overall spending in the economic system.

Whatever the reduced levels of spending that the changed money relation will support, the freedom of wage rates and prices to fall can achieve not only economic recovery but more than economic recovery. It can achieve the employment of everyone able and willing to work, i.e., full employment. And it could do so with no decline in the real wages of the average worker in the economic system, indeed, with a significant rise in his real wages. Unfortunately, this too is a subject too large to discuss further in the present article.[2]

Bailouts

Before closing, I must say a few words about the present efforts of the government to overcome the crisis by means of “bailouts” and their associated financing by budget deficits. Ultimately, these efforts are an attempt to overcome the effects of a rise in the demand for money for holding by means of a sufficiently large increase in the supply of money. In its campaign, the government appears to care for nothing but overcoming the crisis of the moment, without regard to the fuel it is providing for the next crisis.

The government today has unlimited powers of money creation. And so it is highly likely, given its evident willingness to use those powers, and the overwhelming public support that exists for using them, that the increase in the supply of money it brings about will ultimately outweigh the present increase in the public’s demand for money for holding. When and to the extent that that happens, and business sales revenues and profits begin to rise and employment and wage rates begin to rise, the public’s demand for money for holding will once again begin to fall.

At that point the massive increase in the quantity of money the government is currently bringing about will fuel sharply rising prices and give birth to a new crisis. This time, a crisis of inflation. Then, the government will either have to be content with a US economy that resembles the economic system of a Latin American country or it will have to rein in its inflation. If it chooses the latter quickly, we’ll be back to the situation that prevailed in the early 1980s and have to undergo a fresh economic contraction, though probably one of much greater size than then, because of the unfinished business left over from the present crisis.

If the government delays too long in reining in its inflation, then when it finally does decide to do so, it may be confronted not only with prices rising as rapidly as they did in Latin America decades ago, but also with the massive unemployment rates that accompanied the efforts to rein in such major inflation. At that time, prices rising at a rate of 20, 30, or 50 percent or more were accompanied by comparably high unemployment rates. (To understand how such a thing can happen, imagine total spending and prices both rising at the rate of, say, 50 percent per year. Now the government, in an effort rein in inflation, succeeds in reducing the increase in spending to 15 percent. If the rise in wage rates and prices has any kind of significant inertia, such as continuing at 40 percent, the effect will be a drop in production and employment to a level equal to 1.15/1.4, which represents a drop of about 18 percent. In the nearer-term future, unemployment will be promoted by any additional powers the government may give to labor unions, who will use them to raise wage rates even in the midst of mass unemployment, as they did from 1932 on in the Great Depression.)

Of course, given the prevailing readiness massively to expand the powers of government in order to deal with short-term crises, it is also possible that the government will enact wage and price controls in its efforts to fight the consequences of its inflation. If and when the controls are subsequently removed, there will again be a crisis of rising prices that, if not accompanied by still more inflation, will be followed by a major financial contraction. If the price controls are not removed, the economic system will be paralyzed and ultimately destroyed.

The upshot is that there is no good way out of the present crisis other than by meeting it through the free-market’s means of a fall in wage rates and prices, mitigated to the maximum extent possible in ways consistent with the principle of economic freedom. What is required is a way out that once and for all ends the boom-bust cycle of inflation and credit expansion followed by deflation and contraction. The free market, a freer market than we have had up to now, is the only such solution.

Economic freedom and economic recovery both require that prices and wage rates be free to fall and that all legal obstacles in the way of their falling be immediately removed. In order for that to happen, as many people as possible must understand that falling prices are not deflation but the antidote to deflation.

***

Postscript: Two points need to be briefly addressed that I could not deal with in the body of my article. One concerns the effect of the prospect of falling prices on the postponement of expenditures. This postponement applies only to the case in which the fall in prices is in response to a fall in demand, not an increase in production and supply. In this case, if prices do not fall, demand falls further, as I showed.

However, the prospect of falling prices resulting from increased production and supply does not imply a postponement of purchases. This is because in this case the prospective fall in prices is not the result of any decrease either in spending or in any other major monetary aggregate. On the contrary, here the prospective fall in prices means an increase in the prospective buying power of all accumulated savings as well as of the income that will be earned in the future. In this way, the process of economic progress portends being financially better off in the future than in the present. The effect of this in turn is to enable people to afford to consume more in the present. This counterbalances the benefit to be derived by waiting to take advantage of lower prices in the future. In other words, falling prices due to increased production and supply are essentially neutral in their overall effect on the relationship between spending for present consumption versus saving for future consumption.

The second point that needs to be addressed concerns housing prices. It is often asserted that falling house prices are responsible for bank failures and that the continuation of falling prices for housing must result in more such failures and therefore must be stopped.

Falling home prices are not in fact responsible for bank failures, any more than falling prices of aging automobiles are responsible for bank failures. The fact that homeowners may owe more on their homes than their homes are worth has no more fundamental connection with defaults on mortgage loans than the fact that many or most automobiles purchased with installment loans are worth less than the outstanding loan balances owed on them. Indeed, the mere act of driving a new car off the dealer’s lot is often sufficient to put its resale value below the value of the outstanding loan balance on the car.

What leads to defaults, whether on home loans or on automobile loans, is the inability or unwillingness of borrowers to honor their financial obligations, not the market value of the homes or cars.

Only decades of inflation and credit expansion could make it possible for people to think of the houses they occupy as an investment. In reality, a house is a consumers’ good, just like an automobile or a refrigerator. The only difference is that it depreciates more slowly than they do. Only a long string of years in which inflation took place more rapidly than houses depreciated enabled their prices to rise every year and people to come to regard them as a source of financial gain. If not for inflation and the rise in prices that it produces, it would be very clear that housing is a wasting asset, a slowly wasting asset to be sure, but a wasting asset nonetheless.

If not for inflation, the price of new houses would not rise. They would probably even fall from year to year. In addition, the price of a house that was 5, 10, or 20 years old would be significantly less than the price of a new house. Thus even constant prices of new houses, let alone falling prices of new houses, implies that the price of a house declines as it ages. That is the normal situation. That is the situation in the absence of inflation.

The accelerated credit expansion of recent years and the rapid rise in house prices that it caused made it appear for a while that it was profitable to buy houses for no other reason than quickly to resell them. It also made it appear that people could live off the rise in equity in their homes, by borrowing against it. The frenzy of the housing bubble was such that at its peak the price of the median house could be afforded only by people earning the top 15 percent of incomes.

There is no reason to attempt to maintain artificially high house prices and to rescue the borrowers and lenders who were responsible for them. Furthermore, the attempt to do so must perpetuate the suspicion that the lenders are still basically unsound and cannot be counted on to be able to meet their own financial obligations. Such bad loans must be owned up to and cleared off the books of the banks and the other financial institutions that made them, before confidence can be restored in the financial system.

The fall in housing prices that is taking place needs to go further. The median home price is still considerably higher than the median income level. Calls for stabilizing house prices are a demand for government intervention on behalf of reckless borrowers and lenders, paid for by taxpayers.

The lower home prices that will result from the freedom of the housing market from government interference will reduce the size of the mortgages that are necessary to buy homes. If a house sells for half a million dollars instead of a million dollars or for one-hundred thousand dollars instead of two-hundred thousand dollars, then the amount of mortgage financing required to buy it is correspondingly reduced and the housing market comes into alignment with the reduced overall supply of credit that is available.

[1] For a discussion of the subject, see the author’s Capitalism: A Treatise on Economics, pp. 959-962.

[2] I have discussed it at length in Capitalism; see pp. 580-587.

*Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen. The book provides an in-depth, comprehensive treatment of the material discussed in this and subsequent articles in this series and of practically all related aspects of economics.


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Excellent George

gregster's picture

I gave away a few printouts and this was well received.

Keep up the good work.

Ah the true nature of the beast!

Stuart Harris's picture

Wonderful to read some real commentary on the true nature of the beast. Why can’t the newspapers come out with research like this?

 

I understand that it is a natural effect of a true deflationary recession to see commodity prices fall globally and universally. The price of oil is prime example and a clear paradox. But is a confirmation of Mr Reismans declaration that the declining price is actually an antidote. What better example could one have?

 

Because the expansion of credit has been significantly larger than any time in history, there is little to decipher where and when deflationary conditions will cease, and government bailouts only prolong the agony, again as Mr Reisman identifies. Watching events so far, I suspect that in the US there is further economic contraction to occur despite the unlimited money the government can “manufacture”. This is likely to be fuelled by negative sentiment, especially when it becomes apparent that the government can not arrest the situation. (since when do governments control economies?) Is economic pessimism a significant influence in what is happening, and therefore isn’t lack of demand a primary result of economic fear?

 

There is good material available form Bob Prechter supported by historical economic and “socionomic” data. See www.elliotwave.com.

Also read  “Inflation vs Deflation” http://www.elliottwave.com/club/Inflation_vs._Deflation.aspx?code=27252

And so which is worse? And didn’t we get into bed with inflation?

 

House prices still remain a quandary particularly here in NZ. We do not yet see houses selling for $4000(and less) on “Trade me”(NZ) as they are on “Ebay” in the US. In fact average year on year prices are down only 4.7% for NZ’s primary city (refer today’s NZ Herald)… http://www.nzherald.co.nz/property/news/article.cfm?c_id=8&objectid=10551515.

 Will today’s “socionomic” climate preserve capital sanctity in the asset most people are emotional towards (and about)? And does the real cost to build same prevent the price from falling below the “cost to build” level? History tells us we are having a correction (compare house prices now to 1938, 1978, or even 1998), all be it likely to be a deep and extended one because of events in the US.

Brilliant

atlascott's picture

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