Deflation: The Most Misunderstood Word In Economics

Story Stream
recent articles

Rarely does a week go by without some financial or economic commentator proclaiming what is impossible; specifically that we're experiencing or that we're going to experience both inflation and deflation together. MarketWatch columnist Robert Powell is the latest to make such an odd statement.

It's odd because for anyone to suggest the parallel existence of inflation and deflation is the equivalent of a climatologist forecasting freezing and scalding temperatures at the very same time. Of course just as it can't be hot when it's cold, there can't deflation when there's inflation. The two are opposites.

So while some columnists and economists continue to forecast the laughable and logical impossibility that is inflation and deflation, skeptical minds will know that the two can never occur together. For those still in doubt, it's best to define deflation through examples reavealing what it is not. 

To begin, deflation is decidedly not a decline in the supply of money, as the Daily Telegraph's Ambrose Evans-Pritchard regularly presumes. That is so given the simple truth that money in circulation tautologically declines with a reduction in economic activity. To this day those who should know better believe that the Great Depression was caused by a collapse in the supply of dollars, but this odd supposition puts the proverbial cart before the horse.

Indeed, as John Stuart Mill long ago explained, the act of production in ways that the markets value is itself money demand. Looked at in light of the 1930s, the Hoover and Roosevelt administrations erected tax, trade, regulatory and monetary barriers to economic activity, and in doing so, reduced the demand for money. A money supply decline didn't cause the Great Depression, nor was it deflationary; rather a reduction in economic activity logically led to reduced money demand that revealed itself through falling money supply.

In his essential book The Theory of Money and Credit, Ludwig von Mises explained inflation as an increase in the supply of money greater than present demand for money. Considered in terms of deflation, if money supply drops thanks to a reduction in market-driven activity, far from a deflation, this would simply speak to the integrity of money being maintained; the money supply decline essential for maintaining its stable value.

Second, deflation is not a decline in equity values or any other security. This supposition is truly flawed in that the implicit underlying argument is that central bankers or politicians must act to reverse the musings of infinite market actors when it comes to value of the securities priced. In truth, falling equity prices are simply the market's way of signaling what commercial concepts need investment, and which ones don't. To believe this definition of deflation, and here it should be said that a very successful hedge fund manager once shockingly explained it to me this way, is to assume that governments should have propped up the shares of horse-carriage manufacturers at a time when the automobile was making them obsolete.

Some quite strangely define deflation as the process whereby the price of anything declines. Of course by this definition the U.S. economy has been suffering a deflation for almost as long as it's been in existence. Figure much of what used to be expensive and obscure - from cars to flat screen televisions to long-distance telephony - is now rather cheap and ubiquitous.

The problem with the above is that it too is decidedly not deflation. Instead, falling prices of seemingly everything speak to productivity enhancements wrought by gasp - savings and investment - that lead to the mass production and commoditization of the former baubles of the rich. This isn't deflation given the simple truth that if flat screen televisions cost $300 today versus $5,000 several years ago, consumers then have more money to demand new goods, thus bidding their prices up. The Keynesians who naively elevate consumption as the be-all, end-all, might consider this the next time they bash the very thrift that ultimately leads to more investment, more productivity, and down the line, due to more production, exponentially more consumption.

And then there's James Grant's definition; his attempt to define deflation having taken place during a recent speech given at the New York Federal Reserve. Grant defined it like this: "Deflation is a derangement of debt, a symptom of which is falling prices. In a credit crisis, when inventories become unfinanceable, merchandise is thrown on the market and prices fall. That's deflation."

Grant's definition is as weak as the two that came before it (goodness, should merchandizers low on credit finance be bailed out too?), or better yet, it combines the falsehoods of both. When goods are thrown onto the market at fire sale prices, that's first a sign that consumers no longer value them as much. If so, goods sold at lower prices once again free up money for others, thus driving the price of more desirable products up.

The notion of "glut" is mythical in a broad economic sense. Some goods are overproduced or debt becomes insurmountable such that manufacturers must flood the market with them, but neither can change the broad price level. That's the case because cheap goods once again free up money for more desirable objects, and then since production is itself demand, if heavy debt, a lack of finance or both throttles producers, reduced production will tautologically be matched by lower demand. These things balance. 

All of which brings us to deflation's true definition. Deflation results from the value of money rising from a non-inflationary level. That the latter is true deflation explains why it's so rare. Simply put, governments rarely seek to increase the value of their debt, so it's not often that they'll drive up the value of the currency they issue, and in which they have debt denominated.

Modernly, Japan suffered a real deflation in the post Plaza Accord ‘80s and ‘90s when the value of the yen tripled versus gold. Debtors in yen were wiped out, and then borrowing by producers became more of a fool's game for yen denominated debt becoming increasingly expensive to service. And then in the late ‘90s through the early part of the new millennium, the U.S. economy similarly experienced deflation as the price of gold measured in dollars fell all the way to $250/ounce after a non-inflationary decade when it averaged roughly $360/ounce.

True deflation pushes the nominal price of every good measured in increasingly valuable dollars down. Profits that would have revealed themselves disappear in nominal dollar terms, and then once again, debtors are crushed for having to pay dollars back that are far more valuable than those initially borrowed. It's the equivalent of borrowing $1 million for a house, only to pay the value equivalent of $2 million back.

Considered in light of the myriad columns proclaiming inflation and deflation at the same time, the latter is logically impossibly simply because money can't be rising (deflation) in value if it's falling (inflation) in value. The two are mutually exclusive, but due to a broad misunderstanding of both inflation and deflation (the Bernanke Fed believes inflation is caused by too much economic growth, something that is totally false), many in the commentariat will continue to make puzzling, and easy to discredit claims.

John Tamny is editor of RealClearMarkets, Political Economy editor at Forbes, a Senior Fellow in Economics at Reason Foundation, and a senior economic adviser to Toreador Research and Trading ( He's the author of Who Needs the Fed?: What Taylor Swift, Uber and Robots Tell Us About Money, Credit, and Why We Should Abolish America's Central Bank (Encounter Books, 2016), along with Popular Economics: What the Rolling Stones, Downton Abbey, and LeBron James Can Teach You About Economics (Regnery, 2015). 

Show commentsHide Comments

Related Articles