The
Harms of Inflation Versus the Benefits of Deflation
GrassTopsUSA Exclusive Commentary
By Gennady Stolyarov II
08-08-07
Politicians,
economic planners at the Federal Reserve, and public opinion are
afraid of entirely the wrong scenario when it comes to monetary
policy. They pursue a deliberate gradual inflation of the money
supply for fear that the opposite tendency – a great deflation might
take hold. They allege that deflation is a great calamity, and that
mild inflation is a lesser evil or even a preferable policy to
follow. The Keynesians among them contend that inflation encourages
investment in business enterprises and provides an economic
stimulus.
Conventional wisdom has it all wrong. The politicians favor the
devil they know – inflation – over the angel they don’t know –
deflation. Indeed, deflation has historically been an economic
blessing, while inflation has wreaked nothing but havoc on
individual finances and entire societies.
To understand the benefits of deflation, let us consider what it
means in a simplified illustration. Initially, there is a certain
amount of money in the economy; we can call it M. There is also a
certain quantity of goods – call it Q. Let us say that, due to
improvements in productivity, businesses in this society can produce
twice as many goods. But, while the quantity of goods has increased
to 2Q, the money supply remains at M. Assuming that everything else
remains constant, what will happen is that each product will sell at
half its prior price. As a result of advances in technology and
efficiency, our hypothetical society underwent 50% deflation!
Historically, the periods of greatest progress have been accompanied
by monetary deflation. The Industrial Revolution of the 19th century
achieved unprecedented growth in productivity. The reason is that
virtually all Western countries of that time adhered to a gold
standard—under which the money supply can only increase as fast as
new gold is mined – the money supply grew slower than the supply of
goods – resulting in a sustained gradual deflation of about 1 to 2%
per year. This deflation made it possible for ever-increasing
numbers of people to purchase durable clothing, higher-quality food,
and more spacious homes. Furthermore, it enabled ordinary people to
put aside part of their incomes and have them appreciate in value
over time without making risky investments. Thus, the 19th century’s
deflation contributed to middle-class and working-class families’
accumulation of the capital stock that made possible subsequent high
standards of living.
A later and even more dramatic example of deflation occurred in the
computer and information technology (IT) industry during the recent
decades. This industry has witnessed the phenomenon known as Moore’s
Law: an approximate doubling of computer processing power every two
years. The results compounded over the past four decades have been
nothing short of astounding. Inventor and futurist Ray Kurzweil
estimates that his current computer’s processing costs about 224 or
16,777,216 times less per unit than it would have cost in 1967. This
is deflation by a factor of almost 17 million over 40 years!
Other IT products have similarly deflated in price; compare the
prices of cell phones today to what they were ten years ago –
keeping in mind the tremendous improvements in quality over the
huge, cumbersome cell phones of the mid-1990s. Or recall how rapidly
Internet bandwidth has become more and more affordable by orders of
magnitude.
Moreover, do you remember the time when you had to pay for a few
megabytes of e-mail storage? Compare that to the unlimited storage
offered today by free e-mail services such as Yahoo! and GMail.
These are cases of infinite deflation. Are we any worse off as a
result?
Those who fear deflation contend that it would do damage to
businesses producing the goods which fall dramatically in price.
After all, if the income you receive per unit sold falls
dramatically, so does your revenue – right? Wrong! Deflation
opponents assume that quantity demanded for the deflating goods will
remain constant and thus that consumers will buy the same amounts of
those goods as they bought previously. However, ceteris paribus
(other things equal), with a decline in price, quantity demanded
increases – this is simply the Law of Demand. Furthermore, the
consumers’ tastes and preferences themselves will frequently change
as well. With more widespread abundance of goods, many people will
seek to elevate their standards of living and expectations – thus
continuing to spend as much or more money on the products in
question. In the language of economics, the consumers’ demand curves
tend to shift upward as products become more affordable due to price
deflation.
For empirical demonstration of the fact that deflation does not hurt
businesses, we need only consider that the IT industry’s revenues
have grown by about 18 percent per year from 1958 to 2002 – much
faster than the revenues of other industries where price deflation
did not take place.
Indeed, deflation is a blessing to the ordinary person. It puts
within his grasp technologies, amenities, and luxuries previously
available to only the wealthiest – if to anyone at all. Even if a
sustained deflation reduces nominal wages, many will still be better
off as a result, because the value of their savings will increase –
since they will be able to purchase ever more goods with the same
amount of money. Indeed, in a society where the prices of all goods
are decreasing, one can grow wealthier simply by holding on to the
money one already has! Imagine the incentives to frugality and sound
money management that this would provide!
In contrast, inflation rewards reckless spending of money. “Why not
spend it now,” many people figure, “if it will only become
increasingly worthless in the future?” It is true that the perils of
inflation can be offset through investing one’s money and that
interest rates and rates of return on investments tend to adjust for
the rate of inflation. However, this adjustment is not
instantaneous, and many will be impoverished while it takes place.
Furthermore, virtually all investments contain a considerable degree
of risk. Banks can suffer runs, and the government can (and in the
coming decades probably will) default on its debt. The
inflation-adjusted rate of return on investments is an average rate
of return; many make less money than that and some even lose large
portions of their existing holdings. In a society imperiled by
inflation, many good people will lose their money either way. If
they invest, they will lose it due to bad luck – despite prudent
planning and the best intentions. If they do not invest, they will
lose it due to inflation.
Most people are good at what they do for a living, and making a
sufficient amount of money is not a problem for them. The problem
today comes in the form of keeping what one makes. While taxation
can often take a third of one’s earnings, inflation is far worse –
because over time it eats away at everything one earns. Taxes are
mostly predictable, and they are most often a one-time expenditure;
after one has paid them, the government will typically not take any
more of one’s remaining money. Inflation, on the contrary, keeps
taking until there is little left to take. Even a “mild” 3%
inflation will cut one’s holdings in half over less than 24 years!
Furthermore, while most people are good earners, they are not good
investors. This is not a vice or shortcoming on their part. The
world of investments is simply as complicated as any other field of
professional activity, and most individuals lack the time to learn
it well. Inflation effectively forces people to dabble in an area
they know little about – which not only imperils their hard-earned
money but also needlessly destabilizes stock markets by causing
stock prices to less accurately reflect companies’ actual
performance.
Deflation frees people from the dread of losing what they already
have. Under general price deflation, ordinary, hard-working
individuals are guaranteed that what they earned is truly theirs
until they choose to spend it. They need not – unless they wish to –
focus on anything except their work and how to dispose of its fruits
in sustaining their families, educations, hobbies, and leisure
activities.
If the government stopped printing additional money or printed it at
a slower rate than the rate of growth of production – or even
better, if it reverted to a gold standard – we would have general
price deflation. The result would be an increase in virtually
everybody’s real wealth, prudent financial habits, and genuine
economic security.
Gennady Stolyarov II is
Editor-in-Chief of
The Rational Argumentator, a magazine championing the principles
or Reason, Rights, and Progress. His works have been published by
Le Quebecois Libre,
Enter Stage Right Magazine, the
Ludwig von Mises Institute,
Rebirth of Reason, and other organizations. Mr. Stolyarov can be
contacted at
gennadystolyarovii@yahoo.com.
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