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. 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.
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.
*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.