Deflation
Deflation is a contraction in the supply of money.[1]
Deflation and falling prices
Deflation can cause a fall in prices. But calling falling prices "deflation" is a profound confusion between prosperity and depression. There are two distinct causes of generally falling prices. The leading cause of falling prices is economic progress, whose essential feature is an increasing production and supply of goods and services, which operates to make prices fall. The other is a decrease in the quantity of money and or volume of spending in the economic system. Falling prices is the only effect that they have in common. They differ profoundly with respect to their other effects.
Falling prices caused by increased production do not reduce the general or average rate of profit in the economic system and do not make debt repayment more difficult. For example, if falling prices result from the fact that while the quantity of money and volume of spending in the economic system are rising at a two percent annual rate, production and supply are rising at a three percent annual rate, the average seller in the economic system is in the position of having three percent more goods to sell at prices that are only one percent lower. His sales revenues will be two percent higher, and that is what counts for his nominal profits and his ability to repay debts. His profits will be higher and his ability to repay debt will be greater. There are lower prices, but no deflation.
What wipes out profits and makes debt repayment more difficult is not falling prices but monetary contraction, i.e., the reduction in the quantity of money and or volume of spending in the economic system. This is what serves to reduce sales revenues, and, in the face of costs determined on the basis of prior outlays of money, causes a corresponding reduction in profits. It is also what makes debt payment more difficult, in that there is simply less money available to be earned and thus available to be used for the repayment of debts. Falling prices in response to monetary contraction are precisely what enable a reduced quantity of money and volume of spending to buy as many goods and to employ as many workers as did the previously larger quantity of money and volume of spending.[2]
Falling prices have been recorded in the computer industry and appliances, which have gone down in price dramatically over the years even as sales have risen higher and higher. Why? Because the companies have gotten better and better at doing what they do, and have been able to make profits even in the face of continual price declines.[3]
Deflation and falling credit
When Joe lends $100 to Bob via a bank, this means that Joe (via the intermediary) lends his money to Bob. On the maturity date, Bob transfers the money back to the bank and the bank in turn (after charging a fee) transfers the $100 plus interest to Joe. The money never disappears or is created; the original $100 is paid back to Joe.
But things are very different when Joe keeps the $100 in the demand deposit, ready to employ it at any time he likes. If the bank lends Bob $50 by taking it from Joe's demand deposit, the bank will have created $50 of unbacked credit, out of "thin air." By lending $50 to Bob, the bank creates $50 of extra demand deposits. Thus, there is now $150 in demand deposits that are backed by only $100. In this sense, the lending is without a lender. The intermediary, i.e., the bank, has created a mirage transaction without any proper lender. On the maturity date, when Bob repays the money to the bank, that money disappears.
An increase in credit out of thin air, all other things being equal, results in an expansion of the money supply. A fall in credit out of thin air, all other things being equal, results in a contraction of the money supply. A fall in normal credit (i.e., credit that has an original lender) doesn't alter the money supply and hence has nothing to do with deflation. For instance, if Joe directly lent Bob his $100, when Bob repays the money there will be a fall in credit with no change in money supply.
Only a fall in credit created out of thin air (i.e. Fractional reserve banking) can result in deflation.[4]
References
- ↑ Murray N. Rothbard. "C. Secondary Developments of the Business Cycle", Man, Economy and State, referenced 2010-03-09.
- ↑ George Reisman. "The Anatomy of Deflation", Mises Daily, August 2003, referenced 2010-03-09.
- ↑ Llewellyn H. Rockwell, Jr. "Deflation: Hurrah!", The Free Market Volume 23, Number 8, August 2003. Referenced 2010-03-09.
- ↑ Frank Shostak. "Does a Fall in Credit Lead to Deflation?", Mises Daily, October 2009, referenced 2010-03-09.
External links
- Deflation on Wikipedia