Given the current fears about deflation and calls from many on the blogosphere for a return to ‘sound money’ it is worthwhile to examine the economic effects of deflation.
The Gold Standard is deflationary – there is no getting around this. The problems of this are emphasised even more under 100% reserve banking which many neo-Austrians hold to. By neo-Austrian I mean the increasingly orthodox views of those who follow Murray Rothbard, rather than the broader range of views of those from the wider Austrian tradition many of which support fractional reserve banking in one form or another.
Lets wind back the arguments to the origins of classical economics and the origination of fractional reserve banking. This is important because many claim that the standard is not deflationary because of the scale of economic growth in the 18th and 19th centuries. Sadly the history of money is rarely taught these days and neo-classical text books take fractional reserve banking as given. This means that those instinctively opposed to neo-classical economics often long for a previous golden age – forgetting that the history of money is one of fractious theoretical arguments, multiple crises and multiple innovations. We are living through one such crises today and have yet to innovate ourselves out of it.
By most accounts this originated in 17C Amsterdam, in part because of the problems caused by it having too much gold, and this causing inflation, innovation was required. For a while this innovations were all the rage and were picked up by the Scottish adventurer, banker, conman and economist John Law.
He convinced the French King of a scheme to pay off the national debt, run up by endless war and the excesses of court, through fractional reserve banking backed by ‘real’ assets. What is known as the real bills doctrine, that issuing money was not inflationary if backed by real assets. The problem was these assets were the result of monopoly state land grants in Mississipi – a huge bubble was created where many grew rich. One of Laws colleagues, Joseph Edward (‘Beau’) Gage, even tried to buy the whole of the Kingdom of Poland. Of course because these assets were misvalued the whole scheme collapsed. France did not trust banks again for a century.
Cantillon, a friend of Law got out just in time, which made him one of the richest men in Europe. He was the George Soros of his day. He also wrote a single and remarkable samizdat book the first modern text on economics which influenced the next generation of economists.
On money though he was biased, as a banker he naturally favoured a monetary doctrine that favoured creditors and not debtors. And favoured a monetary system that would prevent the wild effects of Laws scheme.
Cantillon believed, correctly, that the view that there could be a shortage of money in circulation was a myth. If an economy grew that quite simply each piece of specie coin would buy a lot more. Cantillon was the first to break decisively with mercantilism – the idea that hording specie created wealth. Cantillon and after him Smith and Ricardo instead believed that real wealth was measured by goods and money was just fleeting in exchange.
There were a number of problems with this early classical view of money. The first being that it did not properly deal with credit. If an economy is growing then if prices are set in specie then contracts will deflate over time. Debts will get worse and worse. Secondly if something today is worth more in specie that tomorrow people will rationally hoard and not spend. This links to another problem with the theory – money is more than a fleeting means of exchange it is store of value – people can hoard. Therefore hard currency can create a deflationary spiral by reducing the necessary circulation of money throughout the whole economy. Think of that Dads Army episode where one five pound note through circulating manages to pay off all of the villages debts worth far more (based on a much older joke).
Now Austrians seem to fall into one of three camps. Though who put their head in their hands and deny any deflationary effect, those like Hayeck who because of this accepted the need for fractional reserve banking, and finally those that accept that it would be deflationary and say this would be a good thing.
Typical of the last camp is JÖRG GUIDO HÜLSMANN who has written a pamphlet for the Mies insitute on the subject in 2008 ‘Deflation and Liberty’ – Ill give you a few Quotes.
It is true that without further government intervention there would be a deflationary spiral. It is not true that this spiral would be bottomless and wipe out the economy. It would not be a mortal threat to the lives and the welfare of the general population. It destroys essentially those companies and industries that live a parasitical existence at the expense of the rest of the economy, and which owe their existence to our present fiat money system. Even in the short run, therefore, deflation reduces our real incomes only within rather narrow limits.
There is only one fundamental change that deflation brings about. It radically modifies the structure of ownership. Firms financed per credits go bankrupt because at the lower level of prices they can no longer pay back the credits they had incurred without anticipating the deflation. Private households with mortgages and other considerable debts to pay back go bankrupt, because with the decline of money prices their monetary income declines too whereas their debts remain at the nominal level. The very attempt to liquidate assets to pay back debt entails a further reduction of the value of those assets, thus making it even more difficult for them to come even with their creditors. In the memorable words of Irving Fisher: “The more the debtors pay, the more they owe.
But rather than adopting Fishers sensible conclusion that ‘the liquidiation is self defeating’ (the paradox of delevering) the author makes an extraordinary claim.
The point is that other people will run the firms and own the houses—people who at the time the deflation set in were out of debt and had cash in their hands to buy firms and real estate. These new owners can run the firms profitably at the much lower level of selling prices because they bought the stock, and will buy other factors of production, at lower prices too.
In short, the true crux of deflation is that it does not hide the redistribution going hand in hand with
changes in the quantity of money. It entails visible misery for many people, to the benefit of equally visible winners.
In short deliberate and widespread bankrpucy and debtors – that is, in todays economy, most people and most firms in western countries, and in the fallout those with capital will claim the spoils of the world.
The problem of course is the scale of debts, the downward spiral in demand and employment the deleveraging would cause and that only the very richest would be able to afford to bottom feed. The scale of the economic crisis is such, as several economists have pointed out, that there are now far fewer who can afford to bottom feed.
So deflation is alright then, if it destroys middle class wealth, small businesses and consolidates all capital in the hands of the very richest, at precisely the time on the economic cycle when debtors require forebearbace not punishment and when we need deflation like a hole in the head.
For those that advocate ‘sound money’ ask them how they would deal with deflation and these redistributive effects.