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.