It is widely accepted that inflation is a “good thing” for the economy, and that deflation is very bad indeed. In truth however, deflation is just what we need right now. Here’s why…
Let’s get the definitions out of the way…
As I’ve written about before, most people define inflation as rising prices, however rising prices are a symptom of inflation rather than the cause. The root cause of inflation is an increase in the supply of money and credit. The same confusion exists with deflation. Deflation to a modern Keynesian economist is falling prices, but the root cause is a contraction in the supply of money and credit. As the quantity of money in circulation falls you have less money chasing the same amount of goods and services, and as a result prices fall. It’s simple supply and demand. Less money = less demand = lower prices.
So what’s wrong with deflation?
As far as economists and politicians are concerned deflation (defined as falling prices) is the economic equivalent of the Black Death, which is why the slightest whiff of deflation is immediately countered with more inflation (money printing). But what’s wrong with falling prices? Surely that’s exactly what we need at a time when incomes are falling and millions as struggling to afford basics such as food and energy?
We are told that if prices fall people won’t buy things and companies would stop spending, factories would close and we would return to the economic dark ages. But there is plenty of evidence to suggest that falling prices do not discourage spending. Take the car industry for example. In the early twentieth century Henry Ford amassed a fortune by steadily bringing down the price of cars. In doing so he employed tens of thousands of people, and his workers were among the best paid in industry.
Even today the electronics industry experiences continuous price deflation, and yet we still buy computers and iPods regardless. As a result of improvements in manufacturing and design, each year millions of people are able to buy better products for less money, and yet the industry continues to grow.
Most people assume that deflation is ok as long as it’s confined to one or two industries, however the fact is, deflation was the norm in the United States from the late seventeen hundreds until 1913. (In other words, until the formation of the Federal Reserve). Far from being characterised by low growth and high unemployment, this was a period in which the US experienced some of the fastest economic growth in history.
In an environment of deflation, £1,000 saved today could buy many more goods and services twenty years from now than it could today. This increased purchasing power allows savers to become the entrepreneurs and investors of the future, leading to greater investment and the creation of new industries and jobs. Why is this not a good thing?
Two wrongs don’t make a right
The problem here is that modern (Keynesian) economists believe that spending drives growth, and that in an environment of deflation people will curtail their spending, and that if they do spend, the diminished price contributes less to economic growth. However as I’ve said before, spending is not what produces wealth, it is production that creates true lasting prosperity.
The reality is that when consumers are saving instead of spending, they actually benefit society as a whole. However if consumers aren’t spending – either because a product is no good or because the consumer cant afford to buy it – then the best way to encourage them to do so is to let prices fall.
The fact is, that this natural deflationary force will eventually win out, the problem is that in the meantime we must all endure years of low growth, high unemployment and falling living standards.
To learn more, I highly recommend the book: How an Economy Grows and Why It Crashes: Two Tales of the Economy, by Peter Schiff.