Inflation vs. Deflation – A Monetarist Perspective

Inflation vs Deflation

Inflation or deflation, which is better?  The answer can vary depending on who you ask, and from which perspective this question is being considered. Consider the question from the perspective of a person working as an importer or exporter. If we have inflation, our dollar is weaker compared to other currencies, which leads to exporters selling more while importers will be buying less. From this perspective it is easy to see that each profession, whether a person is 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.

With that in mind, let’s consider some of the things Austrian economists 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 featuring Tom Woods and Jeff Herbener, they approach the discussion in a way that I find to be frustratingly uncharitable. 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. Woods and Herbener 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 also 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 took 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 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 thinking like an economist will not find 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 on behalf of – a stable money supply leading to a stable economy. Friedman 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.

 

– JW

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2 Comments

Filed under Austrian School of Economics, Chicago School of Economics, Economic Methodology, Monetary Policy, Political Economy

2 responses to “Inflation vs. Deflation – A Monetarist Perspective

  1. phadde2

    On my blog I’ve talked at length about monetary policy, as I find it very interesting; my favorite founding father is Alexander Hamilton which shocks many conservatives, but I am surprised also with your bit of fervor against Austrian economics, as many of my “intellectual” conservative friends subscribe to the Austrian viewpoint.

    I do believe inflation is very dangerous to that of the normal citizen, This is why monetary policy continues to operate on the Quantity theory of money; which is why I still use the term, ” not worth a continental”. However, it good to make aware that governments may manipulate the monetary markets and inflate their currency, see China, as a way to boost the exports of their nation.

    It’s also good to make aware that the Austrian argument about National Debt is not the same as personal debt. The National debt if the interest is always securely paid in full and the nation’s full faith and credit in tact actually can boost the economy as it sells government bonds and stocks, TLT; the national debt of the United States can be traded, and borrowed on which in turn helps the economy. This is why an informed populace must wade through partisan politics of say the shutdown, #1 raising the debt ceiling per say isn’t inherently dangerous, #2. the shutdown of government in its mechanics didn’t prevent the paying of interest and it shouldn’t have affected our credit. However, the shutdown partisans playing chicken with each other is what caused some stress on our national credit.

    We all fear very excessive national debt or we should, but it’s not an idea that can be pinned down. Excessive debt crippled the Spanish empire, but allowed the British empire to flourish after the American revolution, which debt in 1784 stood at 245 million pounds. Funding and servicing of the debt is the key to slowing the danger. the national debt of the Spanish empire was more like our own personal debts as the King mostly owed short term loans to foreign bankers, but the British of course created a loan bureaucracy and started to fund its government in the modern sense of bonds and stocks like explained above.

    You may disagree with this assessment, as most fellow conservatives do, but the above posts shows that to me that you can at perhaps understand it; most conservatives that I know simply say, “Well Ron Paul said” Which I say great, but have you ever opened a monetary economics book, or are you just taking his word for it?

    Like

    • lgwestman

      My favorite founding father is also Hamilton. I thought I was the only one!

      If I am understanding you correctly, I agree with most of what you said.

      I would consider myself a monetarist, and I think there are three ways to improve the situation with the Fed:

      1) Audit the Fed
      2) Get ride of the dual mandate
      3) Implement Friedman’s proposal.

      Like

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