Deflation

I've been reading these forums for a few months now as I recently came to know about Austrian economics and have been fascinated by it. I am currently pursuing a BS in Economics and am taking some of the core economics classes. I've read 'Economics in One Lesson' and am currently struggling through Rothbard's 'Man, Economy, and State'. 

Recently my instructor was talking about deflation and how it can severly hurt the economy and I was confused because it seemed to contradict some of the basic economics he had just gone over. The example he used was a farmer that grew corn. If the money supply was stagnant then ultimately the currency would become worth more as the GDP increased. This would result in a decrease in prices and the farmer would be unable to pay his mortgage because it was a "fixed" cost. This was due to the lower prices his corn sold for and therefore less profit for him.

 Now wouldn't all of the farmer's other expenses decrease as well? (Gas, food, etc...) Also, since prices have decreased, wouldn't consumers buy more corn, thus increases the total amount of corn the farmer sold? Finally, since the value of the dollar has increased, wouldn't that mean there is an increase in consumer's purchasing power, which by definition results in an outward shift in the demand curve? 

With all of these things taken into account, wouldn't deflation not be as bad as he makes it sound? Wouldn't some of those factors outweigh the fact that his mortgage would not decrease in cost?

 I approached him after that class and he pretty much said that the prices would not decrease at the same rates and it would result in the farmer not being able to pay all of his expenses. Needless to say I was unsatisfied with his answer.

Thanks for any responses, sorry for the basic economic questions... 

I think you are one the right track. If the farmers productivity increases this will result in lower corn prices but he will also have more corn to sell. It depends upon the elasticity of demand for corn whether this increased productivity will result in greater total revenue for the farmer. Either way it is part of his role as an entrepreneur to forecast the various price and output combinations and chose the right one. As long as the money supply doesn't contract there is no reason to fear a lower price level resulting from increases in productivity. Here is an article by Professor Reisman that addresses this topic: http://www.mises.org/story/1298

 From the article "Anatomy of 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."

 

So it sounds like deflation only results when consumers get spooked and do not want to spend their cash immediately. Would that not result in more savings, thus more money available for businesses to invest in capital (more spending on the part of businesses)?

 

When a market is on the gold standard, isn't deflation just the market trying to correct itself? My instructor was trying to point out the failing of the market in regards to deflation because it was on the gold standard.

Your professor is implicitly assuming that it is normal for a farmer to be heavily mortgaged. Continuous inflation has encouraged the practice of taking on long debt contracts with low down payments. Prior to the creation of the Fed it was not uncommon to have to put 50% down to get a mortage. And banks factored the price decline into their rates and approval policies. 

Sounds like your prof is engaging in the weird illogic common to nearly all mainstream economics classes - teach the basic axioms governing economic thought, then dismiss or contradict them without qualification in the third or fourth week of class.

I love deflation questions.  There is no better example of the differences in thought between Austrian Economics on one side (My Opinion Correct Side) and traditional, Keynesian and in some cases Chicago School on the other.

Your instructor is giving only the bad side of the story.  The instructor takes one person in one situation and extends to the whole economy.  Is it good for the economy to have this farmer default on his loan?  That depends on the rest of the economy.  It may be a sad situation that this farmer misjudged the fickle preferences of consumers and their desire to buy things at low prices with the interest on his loans.  But consumers are the ultimate judges in the market place.  So this poor farmer is out and he has his farm sold for pennies on the dollar and every one loses?  Right?

Not exactly.  First, consumers have decided what they are better off and have a little money left over to buy something else.  Secondly, the market distributed the remaining resources to others so they are not completely worthless.  Lastly, just because the farmer lost his farm, does not mean he loses his rights to Life, Liberty and the Pursuit of Happiness.  He can go find another job.  There are an infinite number of things for a human to do in a free society and new jobs HAVE ALWAYS REPLACED OLD ONES even in our socialist leaning mixed economy.  

Now as for deflation goodness:  Deflation is the natural result of things as entrepeneurs use technology in their ever lasting attempts to satisfy fickle consumers.  Consumers are always demanding better goods at lower prices.  Entrepeneurs use the latest technology (They may invent it themselves) to create, improve or reduce the cost of things consumers want.  Televisions and personal computers are very good examples of this.  

Now comes the real evil part brought to you by Fiat Currency and the Real Great Satan: The Central Bank.  Banks normally take in deposits and loan out multiples of that deposit (LITERALLY MAKE MONEY OUT OF THIN AIR) in a legitimate and profitable process called Fractional Reserve Banking.  Banks loan out money and keep a chunk of it in reserver in case depositors want it immediately.  Without the Central Bank, these banks live in a dog-eat-dog game of attempting to survive by lending out as much as possible but keeping enough to pay depositors.  The result is that the economy behaves efficiently as entrepeneurs loan just enought money to satisfy consumers while banks lend just enought to be able to pay depositors.  There are some hickups along the way(No system is perfect). 

 Add in the central bank and you have mayhem.  Banks can always get the money for their depositors from the central bank (Think Country Wide or Bear Sterns).  This means that they throw caution to the wind and loan money everywhere.  To control this the central bank imposese reserve rates but this isn't enought so it invents deposit insurance and other gimmicks to make up for the loss of discipline in the market.  Eventually the central bank allows smaller portions of assets to be held in reserve so banks create more and more fake money.  This signals entrepeneurs to take on projects that would not have been possible absent the central bank.  Then the worst thing happens, the central bank still has to help its banks as entrepenurs still can't pay off loans as projects fail.   So the central bank begins to create money out of thin air thus throwing more inflation on the heap and sending more signals to entrepeneurs to take on loans that they may not be able to pay back.  Of course healthy banks get pulled into the central bank mess as the have to keep up with the un-healthy banks on loaning central bank created money.

This horrible process ends when consumers figure out that the rate of price increases is greater than the rate of wealth increasing so they slow down the loaning and spending.  This causes more entrepeneurs to fail who can't pay their loans.  Now what is the central bank to do?  The can create more money as consumers are on to them and they can't reduce money as banks will not be able to pay depositors. 

 

I think the thing that confused me the most was the fact that he was trying to portray our money increasing in value as a bad thing. He used the example of the 1870's deflationary era to show how deflation was a bad thing. He stated that if there was a fixed money supply (gold standard) and the GDP rose, prices would drop because the dollar was now effectively worth more. This would result in farmers and other suppliers that are sensitive to price changes losing their jobs.

 

Even if prices dropped, wouldn't it be a gradual reduction in price because of competition? It's not like the suppliers see a GDP number and say, "Oh my gosh, I have to slash prices immediately!" They would respond to competitor prices and consumer demands. If they couldn't hack it, that's competition, i'm sorry to say. From what I can tell, i'd much rather have small amounts of deflation than small amounts of inflation.

Deflation is a 'problem' for people people who rely on inflationary mechanisms, that is, people who rely on fraud to 'pay' their debts.

Also, the word 'deflation' is not being used consistently. What does your teacher mean by it ? A decrease in the money supply ? Or a tendency for nominal prices to go down ?

Another point : Let's consider deflation as falling prices. And let's grant it 'hurts' farmers. So what ? It's obvious it also benefits consumers. Is there any reason why the 'welfare' of farmers is more important than the welfare of other people ?

 My professor did not mention a decrease in money supply, only that the money supply was not increasing. From that, I assume that he was basing it on a tendency for nominal prices to go down. From what I've learned so far in economics, it should be normal for prices to go down because of increased efficiency and technology. That is why I'm so confused as to why it was called 'deflation' and not an economy that was becoming more efficient.

I completely agree that if a farmer cannot survive on lower prices, while others can, it is not our problem. It's the farmer's job to adapt, not the consumer's (or anyone else's) job to maintain a stable price for the farmer. 

My bad. The words Inflation and deflation should really be used to mean 'increase in money supply' and 'decrease in money supply'. It should also be noted that 'money' used to be commodity money (say, gold), but now it's 'fiat' money. (and an increase in the supply of paper money is rather different from an increase in the supply of gold...)

The supply of fiat-money being held constant can be regarded as a deflation of sorts.

On the other hand, in a free market - a system wich is highly unlikely to tolerate fiat-money - prices do indeed go down reflecting improved productivity. Even in the mixed economies we live in today, the prices of a lot of items go drastically down - computers for instance. To call this tendency 'deflation' is not a good idea.

I would add that projecting future price movements is the specialty of the very farmers/businessmen that the professor is arguing to save.  Those that don't do such a good job simply must go out of business and join the labor force, not because free-marketers are a bunch of meanies, but because the farmer, through his own actions, has proven to react inefficiently to the given data.  As others have previously mentioned your prof has introduced a norm into the argument by implying that this is a bad thing.

Incidentally, while your professor is correct that prices don't all decrease uniformly, there is a tendency for them to decrease in a predictable way, which would help forecasting rather than disrupt it.  Rothbard in MES demonstrates that so far as this downward tendency goes (during periods of increasing gross investment/saving), consumers goods tend to fall in price faster than the price of original factors.  Correlatively, in any particular stage of production, the selling price of the product tends to fall faster than the price of its inputs, that is, the size of the gap between costs and sales grows smaller.  Viewed correctly, these facts agree with Austrian Capital Theory.  Increased saving is the cause of a longer and more efficient structure of production in which the "price gaps" between inputs and outputs at each stage grow smaller.  Its been awhile since I've read MES but I believe this discussion takes place in Rothbard's chapter on the prices of the factors of production.

For businesses this smaller "gap" is not an issue since, as described above, it reflects the change in overall investment.  What matters for businessmen is that there are price gaps between inputs and outputs not that they are smaller than they were before. 

Ok, I thought I understood the discussion on this thread, then I saw this:

http://www.lewrockwell.com/reisman/reisman44.html

Reisman argues in this article that deflation is the worst catastrophy that can face an economy, and must be avoided at all costs.  Is there an Austrian argument for this view?

"Since the problem behind our impending deflation is the lack of capital on the part of the banks, and beyond that the lack of monetary reserves to maintain the supply of checkbook money when banks fail, it should be obvious that what is needed to avoid the threat of deflation is an increase in the capital and reserves of the banks"

That doesn't sound very 'Austrian' to me. I though that deflation is bound to happen when the fraudulent money created by the state-backed banking cartel goes poof. So called 'credit expansion' can't go on forever. If continued for long enough it will result in runaway prices. The moment the banks/fed/whatever stop 'printing' money deflation sets in.

I confess being an amateur, so if anybody can show that Reisman's views are Austrian/libertarian I'll appreciate it.

What he's saying there is that deflation threatens an economy because of fractional reserve policies. If banks operated on full reserve or close to it, deflation wouldn't be a problem. That's consistent with libertarian ideas because (as he would argue) fractional reserve banking is fraud.

True. He seems to say that at the begining of that section. But fraudulent credit expansion did happen. So, now what ? Is he talking about the current situation ?

Well Reisman is surely correct that recessions are not fun. I haven't read the article yet, but perhaps he's trying to recommend ways to dampen its harsh effect? 

Well, the ABCT shows us how letting a recession naturally run its course, with all the deflation, as long as there is no price fixing going on, is the fastest way out of a recession.

Hah you must've read that post before I deleted it. I was going to lock the other thread, but the topic is sufficiently different so I opted not to.

Oh, I'm blind then.

Anyway, post edited, and let's leave the other one open, cause I agree, this thread doesn't talk about P + I at all. 

Inquisitor:

Well Reisman is surely correct that recessions are not fun. I haven't read the article yet, but perhaps he's trying to recommend ways to dampen its harsh effect?

Reisman's article is extremely good. He talks about the exact mechanics of deflation and describes some worst case scenarios in the current monetary framework (of fiat money). Whilst he says deflation in the current environment would be a catastrophe, I think it's clear from reading his article that he's not using that as a spring board to go concluding that inflation is the solution - quite the opposite in fact. In the second part of his article he goes on to describe how we might dig ourselves out of the current hole and avoid it in future by moving to a gold standard (for which he seems to be drawing on Rothbard's work fairly extensively).