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Monday, May 30, 2011

Deflation. The Good, the Bad, and the Ugly.

Just finished Henry Hazlitt's remarkable book, The Inflation Crisis and How to Resolve It. [Get it free here].

All in all, he thinks deflation is either good or at worst harmless. For example:
When the stock of money is not increased, falling
prices are a normal result of increased production and economic
progress. They need not bring recession, because the falling prices
are themselves the result of falling production costs. Real profit
margins are not reduced. Money wage-rates may not increase, but
real wages will increase because the same money will buy more.
Falling prices with continued or rising prosperity have occurred
frequently in our history.

But every once in a while he mentions 'devastating deflation". Like here [emphasis mine]:
If the world, or at least this country, ever returns to its senses,
and decides to reestablish a gold standard, the fractional reserve
system ought to be abandoned. If by some miracle the U.S. gov-
ernment were to make this decision tomorrow, it could not of
course wipe out the already existing supply of fiduciary money
and credit, or any substantial part of it, without bringing on a
devastating and needless deflation

Or here:
As long as we were operating on a fractional-reserve gold standard,
any attempt to return to a pure, or 100 percent, gold standard
would have involved a devastating deflation, a ruinous fall of

Here he calls a fall in prices a problem and a mistake [emphasis mine]:
When the First World War ended, some of the belligerents went
back to the gold standard. England again is the outstanding ex-
ample of the problems of doing this and of the mistakes that were
. Resumption of gold payments was undertaken at the prewar
rate for the pound in 1925. But two greatly changed circumstances
were overlooked. First, there had been an enormous expansion
meanwhile in the issuance of British currency and credit, that is,
in the amount of paper promises that people might want to convert
into gold. And second, as a result of that, prices had risen substan-
tially. If in 1925 the currency had been made convertible only at
a correspondingly higher "price" for gold, the resumption of gold
payments might have worked. But the resumption at the old rate
made gold too much of a bargain, and forced a contraction of
British credit and a fall in prices

So what gives? Is inflation good, bad, ugly, or maybe even devastating?
The answer lurks in his other book, What You Should Know About Inflation.

Here's the quote, emphasis mine:

"The case of Great Britain is clear. It had gone off gold
in World War I. The pound had dropped from a gold
parity of $4.86 to a low of $3.18 in February 1920, and had
returned in late 1924 to approximately 10 per cent below the
gold parity. But wholesale prices in Britain in 1924 were
still 70 per cent above their prewar level.

The British Government decided to resume the gold standard at the old
par in 1925. The result was a steady fall in wholesale prices
over the next seven years from an index number of 171.1
(1913 equals 100) in January 1925 to 99.2 in September 1931,
the month in which England abandoned the gold standard.

As the British all during this period were unwilling to make
corresponding cuts in retail prices and wage rates, the result
was falling exports, stagnation, and unemployment.

And it was the gold standard itself, not the false rate (or the in-
ternal inflexibility of wages), that got the blame."

So there you have it. Bottom line: Deflation [=decrease in amount of paper flying around, or if there is a gold standard, the rise of the value of the currency in terms of gold] is not in an of itself a bad thing. Lower prices are not a bad thing, nor are lower wages, if prices of everything go down.

The trouble with deflation happens when it is induced from the outside, with something like reintroducing the gold standard [without taking appropriate steps, as Hazlitt details in the book]. Even then all it does is lead to lower prices of everything, and that is not necessarily bad either.

The real horror of deflation happens when people are then unwilling to make
corresponding cuts in retail prices and wage rates. This of course, results  in stagnation, and unemployment.

[I left out "falling exports" in my summary, because I don't really get what's wrong with falling exports. Maybe he means that other countries are unwilling to trade, which is of course, a bad thing].


  1. Good post. I think, however, that your article can be completed with this article. See especially the study (by Atkeson and Kehoe) cited by Selgin, Lastrapes and Whites.
    The 1873-1879 Great Depression and the 1879-1896 Gold Standard Period : A So Horrible Deflation ?

  2. Nice factual article, Hu.

    As for Selgin's claim that an unsatiated thirst for money brought on the panics, I'm skeptical.

  3. Read the following passage, from The Theory of Free Banking :

    "1837 was, however, also the year in which increased public dissatisfaction with the charter or spoils system of bank establishment led to the adoption of “free banking” laws in Michigan and New York. These laws, later adopted in other states as well, brought banking into the domain of general incorporation procedures, so that a special charter no longer had to be secured in order for a new bank to open. ...

    To accomplish this they included “bond-deposit” provisions in their free-banking laws. These provisions required banks to secure their note issues with government bonds, including bonds of the state in which they were incorporated. Typically, a bank desiring to issue 90 dollars in notes would first have to purchase 100 dollars (face value) of specified state bonds, which could then be deposited with the state comptroller in exchange for certified currency.

    Though bond-deposit requirements were ostensibly aimed at providing security to note holders, they only served this function if the required bond collateral was more liquid and secure in value than other assets that banks might profitably invest in. In reality, the opposite was often true, particularly in free banking states in the west and midwest. In these places, “banks” emerged whose sole business was to speculate in junk bonds — especially heavily discounted government bonds.
    Bond-collateral, purchased on credit, was duly deposited with state officials in exchange for bank notes equal to the better part of the face value of the bonds. The notes were then used to finance further rounds of bond speculation, with any increase in the market value of purchased bonds (which remained the property of their buyers) representing, along with interest earnings, a clear gain to the bankers. The infamous “wildcat” banks were mainly of this species, most of their issues being used to monetize state and local government debt.

    Even the more responsible examples of bond-deposit banking had a critical flaw: they linked the potential growth of the currency component of the money stock to the value of government debt. This flaw became evident when, with the onset of the Civil War and the tremendous financial burden brought by it, Treasury Secretary Chase decided to employ bond-deposit finance on a national scale. Thus arose the National Banking System, in which the supply of currency varied with conditions in the market for federal bonds. The new system first revealed its incompatibility with monetary stability in the years after 1865, when state bank notes were taxed out of existence.
    After 1882, when surpluses began to be used to contract the federal debt, the system’s shortcomings were magnified: as the supply of federal securities declined, their market values increased. The national banks found it increasingly difficult and costly to acquire the collateral needed for note issue. This precluded secular growth of the currency supply. It also meant that cyclical increases in the demand for currency relative to total money demand could not be met, except by paying out limited reserves of high-powered money which caused the money supply as a whole to contract by a multiple of the lost reserves.

    These conditions set the stage for the great money panics of 1873, 1884, 1893, and 1907. Each of these crises came at the height of the harvest season, in October, when it was usual for large amounts of currency to be withdrawn from interior banks to finance the movement of crops. The crises provided the principal motive for creating the Federal Reserve System, which ended the era of plural note issue. Yet the crises would never have occurred (or would have been less severe) had it not been for government regulations that restricted banks’ powers of note issue in the first place."

  4. The Chapter 5 is important to understand what Selgin meant by "demand for inside money".

    "Bank notes change hands less frequently, and holders of demand deposits write fewer (or perhaps smaller) checks. As a result, bank liabilities pass less frequently into the hands of persons or rival issuers who return them to their points of origin for redemption. The reduction in turnover of liabilities leads directly to a fall in the volume of bank clearings. When this happens banks find they have excess reserves relative to the existing level of their liabilities, and so they are able to increase their holdings of interest-earning assets, which they do by expanding the supply of inside money in a manner that accommodates the growth in demand for it."

    But obviously, the fact that the supply of inside money mismatched with the demand for inside money is not the only reason for the depression that occurred during the 1890s. See Rothbard's History of Money and Banking in the United States (see pages 168-169 and 184-186).