Deflation, according to standard economic criticism, is a Very Bad Thing. Please reconsider.
Deflation, according to most experts, is bad news since it creates expectations of ongoing price declines, causing customers to put off purchasing current goods in anticipation of cheaper prices in the future. As a result, the entire flow of current spending is weakened, which undermines the economy. Experts believe that economic activity is a cyclical flow of money. One person's spending becomes another person's earnings, and another person's spending becomes a part of the preceding person's profits.
When people grow less optimistic about the future and decide to cut back on their spending, the cyclical flow of money is weakened. When one person spends less, it worsens the situation for another person, who then decreases his spending as well.
According to the former Federal Reserve chairman Ben Bernanke,
Deflation is in almost all cases a side effect of a collapse of aggregate demand—a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress.
Murray Rothbard, however, held that in a free market the rising purchasing power of money (shown by declining prices) makes goods more accessible to people. He wrote:
Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.
Economist Joseph Salerno adds:
Historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.
Money and Money out of “Thin Air”
Money arose as a more effective means of supporting the market economy than barter. Money's distinctive feature is its function as a widespread means of trade, which evolved from the most marketable commodity. On this Ludwig von Mises wrote:
There would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.
Money is exchanged for all commodities and services. Other things must be compared to this essential feature of money. Food, for example, provides humans with the energy they require. Capital goods allow for infrastructure expansion, which in turn allows for the creation of more goods and services. Individuals chose gold as the benchmark for money after a long selection process spanning thousands of years.
Money serves as the primary medium of exchange in a market economy. A product from one specialist is traded for a product from another specialized using money.
We can also state that something is exchanged for money, and then money is exchanged for something else, implying that money is used to exchange something for something else.
When a "thin-air" increase in the money supply occurs, this process is disturbed. When money is created "out of thin air," no wealth has been exchanged in exchange for it, but the bearer of newly created money can now swap it for riches. As a result, we are exchanging nothing for something. An exchange of nothing for something is a transfer of wealth from those who have created riches to those who own the money that has been earned. We underline that the act of wealth diversion is made possible by an increase in the money supply, sometimes known as inflation.
The Essence of Deflation
To comprehend the essence of deflation, we must first comprehend the nature of inflation. Inflation, contrary to popular belief, does not refer to universal rises in the cost of goods and services. Inflation is neither triggered by wage increases, nor is it triggered by a drop in unemployment or an increase in economic activity (the "overheating" economy), contrary to common belief.
Another widely held belief is that as the economy grows, so does the demand for money, which must be met in order to avoid economic disturbances. There are no negative economic repercussions as long as the rise in money supply corresponds to the growth in money demand. Regardless of the level of money demand, an increase in the money supply out of "thin air" now results in a trade of nothing for something, diverting wealth.
There are no needs to raise the supply of money to meet a rise in the demand for money because any amount of money can perform the function of a medium of exchange. According to Mises:
The services which money renders can be neither improved nor repaired by changing the supply of money. . . . The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.
We can deduce that the issue of inflation is the transfer of wealth from wealth generators to holders of newly produced money. This diversion begins when the money supply is increased "out of thin air." Inflation is defined as an increase in the money supply that occurs "out of thin air."
When the process of wealth diversion comes to a halt, deflation arises. This happens when the money supply starts to shrink. A decrease in the money supply, or deflation, is good news for the economy since wealth diversion is slowing. We also believe that bank lending that is not backed up by savings is a major driver of money outflows.
Nonproductive Activities Come from Lending Fake Money
Loaned money is returned to the original lender when it is fully supported by savings on the loan's maturity date. For example, Bob borrows $5 and agrees to repay the bank the borrowed amount plus interest on the maturity date. Joe the lender will receive his $5 plus interest adjusted for bank fees from the bank. The money returns to the original lender in a full circle. Because the bank is only acting as a facilitator and not a lender, the borrowed funds are returned to the original lender.
When lending occurs "out of thin air" and the borrowed money is returned to the bank on the maturity date, the economy loses money and the money supply shrinks. The reason for this is that we have never had a saver/lender because this financing came from nowhere. Because the newly generated demand deposits are not supported by savings, when Bob repays the $5, the money departs the economy because there is no original lender to whom the lent money should be returned.
Observe how the $5 loan from "thin air" serves as a catalyst for an exchange of something for nothing, as well as a platform for a variety of nonproductive activities that would not have arisen without that generation of lending. As long as banks keep expanding loans in this way, other nonproductive activities will thrive. However, the never-ending expansion of the money supply eventually diverts wealth, and a manufacturing structure arises that ties up more consumer goods than it releases. (The consumption of finished consumer items outnumbers their creation.) The positive flow of savings is halted, and the pool of wealth begins to decrease.
As a result, the quality of numerous activities begins to decline, and bad loans begin to accumulate. As a result, banks reduce their lending, resulting in a decrease in the money supply. A decrease in the money supply begins to stifle numerous nonproductive activities, resulting in an economic downturn. Some economists, such as Milton Friedman, argue that once the money supply starts to drop, the central bank should start pumping money into the economy to avoid a recession. An economic downturn is not caused by a decrease in the money supply per se, but rather by a declining pool of wealth as a result of earlier loose monetary policy. The smaller pool of wealth causes a drop in economic activity, which in turn causes a drop in "thin-air" lending, resulting in a drop in the money supply.
Even if the central bank could prevent a decrease in the money supply, such as by dropping money from helicopters, it would still be unable to avoid an economic downturn if the pool of wealth is shrinking. The more the Fed tries to boost the economy by correcting symptoms like falling prices and rising unemployment, the worse things get.
When diverse nonproductive activities are allowed to fail and the sources of money supply from "thin air" are shut down, actual wealth expansion might be expected. Prices will fall as wealth grows and the amount of money available remains constant. It is usually excellent news when prices fall as a result of the liquidation of nonproductive activity and the expansion of wealth. This means that more money is accessible for wealth creation, and thus more wealth is being created.
The prior permissive monetary policies of the central bank, which enable the production of unbacked credit, generate a decrease in the money supply, which precedes price deflation and an economic collapse. Without this backing, banks would struggle to extend credit that is not backed by savings, because some of them would be unable to clear checks due to a lack of cash. The central bank ensures that there is enough cash in the financial system to prevent banks from going insolvent. This is done through open market operations. Note that price deflation and the economy's downturn are caused by a decrease in the pool of wealth caused by past loose monetary policies.
Because deflation helps to reduce wealth diversion from wealth generators to non-wealth generators, the central bank should pursue tight rather than loose monetary policy. Policies that interfere with financial markets always have negative consequences because they misallocate resources. As a result, the optimal policies are true free markets without central bank intervention in financial markets.
Summary and Conclusion
Deflation is defined as a decrease in the pool of wealth induced by increases in the money supply, rather than a general decrease in prices. Deflation is always welcome news, as it occurs as a result of many activities being liquidated, causing the wealth production process to erode.
An economic downturn is produced by a declining pool of wealth as a result of earlier easy monetary policies, not by a decrease in the money supply. This smaller pool of wealth causes a drop in economic activity, which in turn causes a drop in lending out of thin air, which leads to a drop in the money supply. While inflation makes wealth creation more difficult, deflation makes wealth creation easier.