By: James Sherk

27 May 2003 Understanding Deflation: How the Federal Reserve Operates and why deflation concerns are misplaced.

Recent economic news reports have emphasized the potential threat that deflation poses to the American economy. In response, leading businessmen and policy makers for the Federal Reserve have called for lower interest rates to fight this problem. Unfortunately, most news articles and policy suggestions regarding the threat of deflation are fundamentally inaccurate and demonstrate a shallow understanding of basic economic principles and the lessons learned from past monetary policy experiences. While Christ's commandments do not provide obvious direction for a Christian monetary policy, Christians should nonetheless understand what economists and policy makers mean when they talk about this issue, and the consequences of their decisions on the lives of every American.

In order to understand what a call for the Federal Reserve Board to lower interest rates in order to fight deflation means, one has to understand how the Federal Reserve operates and how it cuts interest rates. The Federal Reserve Board is the United States' monetary authority and has control over America's money supply. It can print more money, or less money, depending on the circumstances. It does not have the authority to directly set the rates on loans that individuals and firms make with each other. However, since the late nineteen forties the Federal Reserve has also been viewed, rightly or wrongly, as a means of stabilizing America's economy, moving to stimulate the economy during recessions and temper its growth during a economic booms. By indirectly lowering interest rates, the Federal Reserve encourages businesses and individuals to increase borrowing and investment in new projects, to stimulate the economy. Higher interest rates have the opposite effect, discouraging borrowing and investment, restraining economic growth.

Mankind's entire economic history has demonstrated the destructive effect of government price controls. If the government sets a price higher than what the market determined price would otherwise be, suppliers will supply too much, creating unnecessary and wasteful surpluses. If the government determined price is below the market price, suppliers, unable to make a profit, will exit the marketplace and consumers will face shortages, incapable of purchasing as much as they would like too at the official price. The Federal Reserve is not blind to these realities, and does not directly set the interest rate, the price of loaning and borrowing money. Instead, controlling the money supply, it acts to alter the underlying supply and demand conditions that determine interest rates.

To change the money supply the Federal Reserve targets the reserve interest rate, the rate at which banks loan money to each other. To lower the reserve rate, the Federal Reserve creates new money and uses that money to purchase government bonds, essentially printing money to reduce the national debt. The former bond owners now posses the newly created money, hot off the printing presses, and in which ever way they spend it or save it, the money will ultimately wind up in someone else's bank account. This increases the money that banks have available to lend, which they are strongly inclined to do, because banks only make a profit on deposits they lend out and receive interest payments on, not on money that remains in their vaults. As the Federal Reserve prints more and more money, the supply of money that banks can lend increases, driving down the rate of interest that banks charge on their loans to each other and to clients. The Federal Reserve keeps printing money until the interest rate on inter bank loans reaches its target. Conversely, when the Federal Reserve sells bonds that it has previously purchased, it takes the money it receives for them out of circulation, decreasing the money available for banks to lend and increasing interest rates. Consequently, when economists call for a cut in interest rates, they are calling for the government to print more money - the lower the interest rate target, the more money the government must print. Increasing the rate of growth of the money supply causes prices to rise, which is why policy makers would suggest interest rate cuts to fight deflation.

Since collapse of the tech bubble in 2000, the Federal Reserve has aggressively lowered its interest rate target in an attempt to stimulate the economy. When the economy remained mired in its malaise, Alan Greenspan cut the interest rate target still lower. Today the reserve rate stands at 1.25 percent (1), a remarkably low number that could not be achieved without the Federal Reserve's pumping tens of billions of new dollars into the economy. A chief measure of the money supply, M2, has increased by almost twenty five percent since April 2000, and at an eight percent annual rate over the past year (2). In less than three years, the government has increased the money supply by over one trillion dollars. This is a major cause of the recent weakness of the American dollar relative to other foreign currencies; the increase in the supply of dollars worldwide has made each individual dollar less valuable. It has also contributed to a housing boom, with real estate prices increasing by fifteen to twenty percent a year (3). It should be kept in mind that this substantial increase in the money supply is occurring during a recession. If the economy were also growing at a rate of eight percent a year, then the increased supply of goods and services would balance the increase in the money supply, and the value of goods and services relative to the value of the dollar would remain stable. If the economy grew at a three to four percent annual rate, and the money supply at a six percent rate, as it did in the mid and late nineties, then we would expect to see mild inflation in the two to three percent range, which we did. But now the economy is stagnant, growing at only about one and a half percent a year, while the money supply is increasing by eight percent a year. It takes time for the economy to adjust to increases in the rate of growth of the money supply. Usually inflation takes about two years to fully manifest itself, and it is not that unusual that the American economy has not exhibited significant inflation, yet. It is nonetheless clear that the Federal Reserve's policy of targeting low interest rates and providing easy money runs the risk of reintroducing the American economy to the high inflation rates it last experienced in the 1970's.

Why? What economic danger justifies turning the printing presses on high and leaving them there? In recent months, despite the increase in the money supply, the consumer price index, which is the chief measure of inflation, has increased at a very low rate. Core inflation, which excludes volatile food and energy prices, is still increasing at a 1.5 percent annual rate, it is just not increasing at the two and half to three and a half percent annual rate that prevailed in the nineties. Market analysts and policy makers have nonetheless raised the specter of deflation, and suggested that it must be avoided at all costs. In order to avoid the slightest hint of falling prices, they argue that the Federal Reserve should increase the money supply at a still greater rate. These concerns are unjustified. The fact is that a government once again abusing its ability to turn large quantities of cheap paper and inexpensive ink into money, not deflation, presents the greatest danger to the American economy.

It is important to understand what deflation is, and what causes it and what does not cause it, before trying to assess the affect that it has on the economy. Deflation is a general decrease in the level of prices in the economy, the mirror opposite of inflation. In a deflationary environment, some goods might increase in price, while others decrease, but on the whole most goods will cost less in the future than they do in the present. Deflation is caused by one of two events.

First, deflation can be caused by the monetary authority decreasing the money supply, taking dollars out of circulation in the economy. Deflation of this nature almost always wreaks economic havoc, because people don't see it coming. When the government first starts decreasing the supply of money, individuals and businesses don't realize that it has happened, and act as though the money supply remained stable. With less money in the economy, however, there is less money for businesses to take in as revenue and to pay employees as wages. Since firms haven't yet realized that the currency has appreciated in value, that each dollar is worth more than it was before, resource producers don't initially drop their prices. Faced with constant costs, but a decrease in revenue, business profits drop, and many take severe losses. Some firms go bankrupt, and many will lay off employees. Eventually, faced with a drop in demand at higher prices, resource suppliers cut their prices, and employees will accept lower wages in order to get a job. Business costs drop, and firms stop taking losses. Prices drop throughout the economy. If the government keeps taking money out of the economy, the process will go on, and the recession will continue. Eventually, when the government stops, prices will stabilize at a new, lower level. However, this process takes time. By the time prices stabilize, the damage has already been done, thousands of businesses will have gone bankrupt, and hundreds of thousands, if not millions of people, will have been laid off. This is what happened to America in the Great Depression, when from August 1929 to March 1933 the Federal Reserve decreased the money supply by one third (4). Deflation resulting from an unexpected decrease in the money stock will send almost any economy in to a recession, and is rightly considered harmful and to be avoided. With the Federal Reserve increasing America's money supply by hundreds of billions of dollars every year, however, economists have no reason to fear that deflation of this sort is on America's horizon, and it certainly does not justify printing even more money.

Secondly, deflation can occur naturally, without any intervention by the Federal Reserve, as a result of increased productivity and technological innovation. Computers and DVD players cost less than they did two years ago because of improvements in technology. Walmart can consistently underprice its rivals in the retail sales industry because it has a better supply chain, and can manage its inventory at lower cost. Improvements in productivity and technology lower the costs of producing goods every year, but the steady, gradual increase in the money supply that the Federal Reserve runs prevents most goods from dropping in price. Only in a few sectors of the economy, such as computers, do improvements in technology occur faster than the mild inflation that the government creates, resulting in visible price drops for consumers. If the government held the money supply constant, then every year we would see mild, natural price drops as producers discovered new and more efficient ways of meeting the needs of consumers. As the price of any particular good or service drops, it leaves consumers with more money in their pockets to purchase other goods, or to increase their savings. Such natural, mild deflation is beneficial to the economy.

Understanding what doesn't cause inflation is just as important as understanding what does. Some economists and market analysts claim that excessive, economy wide oversupply, above and beyond the aggregate economy wide demand, forces firms to lower prices in order to sell their excess inventory. Too much supply in the economy, above the level of demand, is said to force the prices of goods and services down (5). However, this theory has one problem - economy wide levels of supply and demand that can be greater or less than each other do not exist. Supply implies demand. The very act of selling a good on the market provides the supplier with the money to demand other goods. The seller can purchase other goods directly, or save the money and invest in projects that will provide a return in the future. In either event the money the producer earns is spent demanding other products in the economy. Selling in the market necessarily creates demand in the market. In economics, this is known as Says law. Economy wide, the concept of oversupply makes no sense. Almost every economy in the world produces far more today than it did fifty years ago, without triggering fifty years of continual global recession. Rather, some sectors in the economy can produce more than consumers desire. These individual sectors, not the economy as a whole, experience over capacity. Consider the airline industry. Consumers have decided that they wish to fly less often, and demand for airline tickets has dropped. The airlines have been forced to respond to the drop in demand by cutting their prices, to induce more people to fly, and by cutting costs. The result has been a drop in prices for air travel, caused by the fact that the airlines were experiencing overcapacity, supplying consumers too much air travel. But that is not the end of the story! Consumers are spending less on air travel, which means that they have more money to spend on other goods and services, such as homes, movie popcorn, haircuts, etc. As consumers increase their spending on other goods and services, as the demand for these products rise, existing firms will see increased profits from the higher prices they can charge, and new businesses and workers will enter these sectors. On the whole, prices are rising in one part of the economy, and dropping in another, which sends signals to workers and investors to shift resources from the areas of the economy that now charge lower prices, to those that charge higher prices. This does not represent oversupply in the economy as a whole, it results from oversupply in some sectors of the economy, sending signals through the market to reallocate resources. It is a mistake to confuse, as some reporters and market analysts have, over capacity in some industries with an impossible, economy wide, oversupply that allegedly causes inflation.

Another phenomenon that some economists, notably the liberal Princeton Professor and New York Times columnist Paul Krugman, believe could cause deflation is a liquidity trap (6). The theory of liquidity traps was first advanced by Keynesian economists during and after the Great Depression. According to the theory, when interest rates drop far enough people will simply stop purchasing bonds and banks will stop loaning money, in the expectation that interest rates will rise and the price of bonds will drop in the near future. Individuals will expect that interest rates have fallen so far that they have no place to go but up. According to this theory, it doesn't matter how much money the government prints when the economy is stuck in a liquidity trap, the money will be remain stranded, unused, in bank reserves, and will not stay in circulation in the economy for very long. In such an environment, the Federal Reserve could print almost as much money as it likes, and inflation would not increase. Under this scenario, as money remained tied up, inactive in bank vaults, the effect on the economy is the same as though the Federal Reserve had decreased the money supply. With businesses forced to cut prices to attract scarce customers in the midst of the recession, and with less money in circulation, prices drop throughout the economy, while businesses and individuals go bankrupt trying to repay loans, set in fixed dollars before the onset of deflation, with the new, deflated, and scarcer dollars.

Fortunately, Americans need not fear the onset of liquidity trap induced deflation on the economy for the simple reason that liquidity traps do not exist. Keynes formulated the idea of liquidity traps in the 1930's without ever doing any research to see if the facts bore out his theory. Beginning with Milton Friedman in the 1960's, economists conducted numerous studies to try and empirically demonstrate the existence of liquidity traps, to try and find evidence that the demand for money alters as interest rates drop. No economist has ever found any solid empirical backing to substantiate Keynes's theory of liquidity traps (7). While the theory might sound good on paper, liquidity traps simply do not exist, and they do not threaten to cause deflation in America today.

Analysts and economists who believe in liquidity traps and fear deflation have one example to point to that appears, on the surface, to justify their concern, Japan (8). The Japanese economy has been mired in stagnation and recession for over twelve years, and has recently experienced deflation. This, despite the fact that the central bank has adopted a policy of providing the Japanese economy with easy money and lowered interest rates to a fraction of a percentage point. On the surface, it appears plausible that Japan could be stuck in a liquidity trap, but this analysis ignores the fundamental problems facing Japan's economy - the Japanese banking crisis. In the eighties and nineties, the Japanese government induced Japanese banks to loan large amounts of capital to government backed business consortiums. The consortiums invested in projects that the government directed them to, in accordance with the national economic plans and goals set by the Japanese state. Some of the technologies and projects that the government directed the consortiums to pursue succeeded, but, unsurprisingly, many others did not. Industrial policies and economic central planning proved no more successful in Japan than it did anywhere else. As many of the consortiums investments turned sour, they were unable to repay their loans and headed towards bankruptcy. Rather than permit the government's partners in industry to go bankrupt, the Japanese government directed banks to continue extending loans to the consortiums in order to keep them afloat. This kept the firms from going immediately bankrupt, but did nothing to alter the fact that they invested poorly, were not profitable, and could not repay their loans. Bad debt piled up upon more bad debt. Today, most Japanese banks are insolvent, with billions of dollars of loans that can never be repaid. They have squandered the deposits of their clients, and cannot redeem many of their depositors savings. Successive Japanese governments have refused to allow any of these banks to actually go bankrupt, propping them up with public subsidies. Instead, most Japanese banks remain in a state of living death, zombie banks incapable of repaying a fraction of their depositors savings, yet kept alive with government bailouts. In such an environment, it is no surprise at all that Japanese banks are not loaning out much of the new money that the Japanese central bank creates, for they are already insolvent and need it to compensate for the hundreds of billions of dollars in bad loans that they issued.

Additionally, the Japanese government has spent trillions over the past decade on programs of mass deficit spending and public works to hire the unemployed and "stimulate" the economy. This has prevented the Japanese economy from reallocating resources and investing in projects and sectors of the economy that could actually create new wealth, the capital and workers are tied up in unproductive public works projects. The Japanese economy is mired in recession and deflation, as a direct result of government actions that crippled the banking industry and redirected capital and workers away from productive uses and towards politically important objectives. The Japanese economy is not caught in a liquidity trap, it is mired in anachronistic governmental command and control policies that fail every time they are tried. For all its faults, the American government has not forced banks to underwrite questionable loans, and is not currently engaging in mass public works projects. While the recent Japanese experience with deflation has caused some economists to believe that deflation must be avoided at all costs to avoid a prolonged recession, deflation did not cause Japan's economic troubles. Japanese deflation, like the recession, resulted from failed government intervention in the marketplace.

Deflation is caused by either a decrease in the money supply, or by innovations in technology and production that lower the costs of production. The theories that excess productive capacity in the economy, or liquidity traps, also cause deflation, are fascinating but wrong. With the Federal Reserve increasing the money supply by over a trillion dollars in the past three years, it can only be increased productivity that has caused the rate of inflation in America to drop to a mere 1.5 percent. Is this harmful? Would natural and mild deflation actually damage the economy? Would an annual drop in prices of two to three percent undermine America's economic growth? Not at all, and the mere hint of deflation is certainly no justification for turning the printing presses on high.

An argument frequently made against the advisability of the Federal Reserve allowing the price level to deflate is that it makes debt harder to pay off (9). In a deflationary environment, debtors must repay fixed interest loans with dollars that have become worth more than they were when the loans were taken out, making individuals and businesses less likely to borrow in a deflationary economy. This argument is incomplete, and fails to understand how human behavior affects the economy.

First, it should be noted that the effect of deflation on debtors is the mirror image of the effect of inflation on lenders, which causes loans to be repaid with dollars that are worth less than they were when the loan was taken out. For every borrower there is a lender, and there is no reason to assume that it is a better policy to hurt lenders than borrowers, to discourage savings rather than taking out debt. The economy, and lenders, have survived just fine in the current climate of low inflation, and borrowers would do just fine in a climate of low deflation. There is a reason for this. People are not mindless sheep, acting irrationally on the basis of animal spirits and incapable of changing their behavior to improve their future. People are intelligent, rational beings who usually act to protect their interest. In the presence of inflation, lenders increase the rate of interest they charge, to compensate for the effects of inflation. If deflation were allowed to occur, the rate of interest charged on loans would naturally drop, to adjust for the fact that future dollars would have greater purchasing power than present dollars. In the presence of deflation, interest rates fall. That is it. No great crisis for debtors, no massive upheavals in the economy. Rational people account for gradually falling prices, just as they now adjust their actions to account for gradually rising prices.

This leads to a second objection to permitting deflation, the concern that interest rates might fall below zero. If people earned more purchasing power in the future by storing their money in their mattress than in the bank or investing in bonds, some economists are concerned they would do so. Saving in a vault, however, only takes more money out of circulation, preventing businesses from obtaining funds to invest and further decreasing the money stock and increasing the rate of deflation. This objection has merit, for this would damage the economy if it actually happened, and it did occur during the Great Depression. However, as long as the rate of deflation is below the pre-deflation interest rate, then even when interest rates drop to account for deflation, they will still remain above zero. People are still better off storing their money in a bank, or purchasing a bond, and earning a lower rate of interest, than taking their money out of the economy by keeping it in their home and earning no interest. It is only in the presence of severe deflation, not mild deflation, that storing money at home becomes more profitable than depositing savings in the bank. Since interest rates on relatively risk-free bonds in the presence of a non-hyperactive Federal Reserve are usually between six and eight percent a year, and since productivity improvements would tend to deflate the economy at a rate of two to three percent a year, there is almost no danger that under a system of natural deflation, people would stop saving in banks or buying bonds. Innovation lowers prices throughout the economy, but not at a high enough rate to cause people to refrain from saving.

A related criticism of deflation is that it causes consumers to increase their rate of savings and put off major purchases today, in the expectation that goods will cost less in the future. Some economists believe that this decrease in consumer spending hurts the economy. Sadly, this analysis remains incomplete. Unfortunately deflation does not have the effect of increasing savings. Increased savings and investments in future productivity benefit the economy. Spending money to eat a hamburger provides far less value to the economy than investing that money in a factory which will produce thousands of hamburgers in the future. America, with a practically non-existent savings rate, could use healthy does of increased individual savings. Alas, deflation does not increase savings rates. As previously explained, deflation lowers the interest rate that banks and other lending institutions charge. Whether inflation or deflation are prevalent in the economy, the effective, the real interest rate that banks charge remains unchanged. Yes, deflation makes future dollars worth more than present dollars, but consumers are no better off saving their money to make future purchases. Deflation causes lower interest rates on savings that provide consumers with fewer of those future dollars than they would have had if there were no deflation and the interest rate remained higher. Consumers remain equally well off saving or consuming in the presence of deflation as they do in the presence of inflation or price stability. The "threat" of increased consumer savings does not justify printing truckloads of new dollars to fight deflation.

Another rationale for the Federal Reserve waging a war on deflation that news articles frequently report is the concept of "sticky wages" (10). This Keynesian theory holds that workers might be willing to accept a freeze in wages, but under no circumstances will they accept a wage cut. In a deflationary environment, with prices falling and the actual purchasing power of the dollar rising, sticky wages would theoretically prevent employers from cutting their employees wages. Instead, they would be forced to merely freeze their employee's wages, providing workers with an effective annual raise equal to the rate of deflation, regardless of their productivity. This in turn would squeeze business profit margins and drive some companies into bankruptcy.

Fortunately, the theory of sticky wages is flawed, resting on the fundamental assumption that workers are irrational and incapable of recognizing that they are as well off after a pay cut in a deflationary economy as they would have been in an economy with no deflation and a price freeze. Workers are perfectly rational, and will accept lower wages in dollar terms, so long as their actual purchasing power does not diminish. Granted, workers will be hesitant to accept a cut in wages if they don't believe deflation will occur. This is a perfectly rational reservation, since the American economy hasn't experienced deflation for nearly fifty years, beyond the living memory of almost all non-retired workers. They would be reluctant to accept a reduction in wages, because they would naturally expect that this would involve a reduction in their actual purchasing power. When employees realized that deflation had truly set in, this reluctance would largely disappear. Furthermore, firms have the option of firing recalcitrant workers and replacing them with workers who recognize that their lower pay did not reduce their effective purchasing power. Recent news reports provide examples of employees who were willing to accept real wage cuts, even in a non-inflationary environment. With several airlines near bankruptcy, workers and their unions have agreed to billions of dollars in wage cuts to prevent mass layoffs. Individuals are not stupid, and will accept a reduction in the dollar amount they are paid, if those dollars will buy more. The Keynesian theory of sticky wages is an interesting, but flawed, concept that does not prove a solid reason for fearing natural deflation.

The term "deflationary spiral," is frequently used in news reports covering inflation, but rarely explained or analyzed. A deflationary spiral is a situation where deflation causes unemployment and bankruptcies, which leads to less money in the hands of workers, who thus purchase fewer goods and services. This forces producers to reduce prices still further to attract more customers, while cutting back on production and laying off more employees, which results in even less consumer demand for goods and services, and so on and so on. If a deflationary spiral occurs, it can wreak havoc on the economy. However, it can only occur if the money supply is decreasing. If one company lowers its prices on its goods, then every consumer who regularly purchases from that company has additional money in their pocket that they can spend somewhere else. If many firms are cutting their prices, then the consumers have a lot more money to spend on additional goods and services. When they do so, they increase demand for these products, causing companies to raise their prices. The net result is a wash. Prices can't fall everywhere throughout the economy at once without increases in productivity. The money has to go somewhere.

If technology lowers the costs of production, in a period of natural deflation, then it frees up resources to create new goods and services that would have otherwise been unavailable, and consumer savings from lower prices are spent on purchasing this increased production. If the economy is in a recession, and production and productivity are not increasing, all businesses won't simultaneously reduce their prices. The savings to consumers from price reductions will be spent elsewhere, putting upwards pressure on prices wherever it is spent. Unless money exists the economy, a deflationary spiral cannot occur. If the government is decreasing the money supply, as it did during the Great Depression, then economists should rightly fear a deflationary spiral. Neo-Keynesian economists argue that an economy stuck in a liquidity trap could also slip into a deflationary spiral, that money could leave circulation in this fashion. Fortunately, this theory faces the fairly significant drawback that no one has found any empirical evidence that liquidity traps actually exist. In the real world, whatever the latter day followers of John Maynard Keynes might argue, the only way for an economy to slip into a deflationary spiral is if the central bank decreases the money supply. The Federal Reserve is not doing so at the moment, and fear of a deflationary spiral is no grounds for inflating the dollar.

Upon close examination, there is no reason to fear natural deflation resulting from technological and productive innovations. As long as lower prices do not occur because the government has contracted the money stock, they are not harmful to the economy. Yet, in the name of fighting deflation, various market analysts, economists, and even some members of the Federal Reserve Board, are calling for the government to lower interest rates still further by turning the printing presses on high. This would be a serious mistake. The true threat to the American economy is inflation. Reason, history, and empirical studies, prove that there is one, and only one, means of causing economy wide inflation - increasing the rate of growth of the money stock, turning vast quantities of paper and ink into currency by government decree. Money has value only as a medium of exchange, as an item that can be traded for goods and services. When the government increases the supply of money relative to the supply of goods and services in the economy, it decreases the purchasing power of every dollar, increasing prices. This is known as the quantity theory of money, and it is demonstrably true. Analyzing America's economic history in the early 1960s, Milton Friedman demonstrated that printing money raises prices every time the government tried it. Ignoring Friedman, and embracing Keynesian theories of liquidity traps that magically allow the government to print money with out causing inflation, the Federal Reserve chose to dramatically cut interest rates in the late sixties and early and mid seventies. The results were as predictable as they were damaging; inflation spiraled and Americans experienced the pain of successive years of annual, double digit price increases throughout the seventies.

Finally, in the late seventies, the Federal Reserve Board under its chairman Paul Volcker accepted the quantity theory of money and dramatically slowed the growth of the money supply. Since the early 1980's inflation hasn't been a serious problem in America, consistently running at low levels of around three percent a year. However, these past twenty years of low inflation are a historical anomaly; economically and politically the government's incentives are to print more money. Economically, the government has the incentive to print money because it spends the money first, before anyone else realizes that the currency has been devalued. It can use the new money to pay off the national debt, fund the salaries of government employees, or anything else it wishes to, before people have the chance to adjust to the inflation and demand higher rates of interest on loans, higher salaries, etc. Politically, inflation is a stealth tax that generates less opposition than normal tax increases. It enables the government to spend money without generating opposition from taxpayers. Since the days of the Roman Emperor Diocletian, governments have found the temptation to devalue the currency impossible to resist. State induced inflation has been a serious problem that has historically only been only contained by the use of the gold standard - gold does not come off the presses quite as easily as paper does. But where government has the authority to issue paper money, it abuses that authority. From the Continental Congress in the Revolutionary War, to the Bank of England during the Napoleonic Wars, from Lincoln's Washington to Davis's Richmond, from Weimar Republic Germany to post-war Japan, from America in the seventies to Brazil in the eighties, to Serbia and Iraq today, governments have proved incapable of controlling the printing presses and inflation. A near invisible stealth tax is destructive enough, but inflation does far more damage to an economy than simply transferring wealth to the state. Variable rates of inflation distort the value of long term contracts expressed in dollars, since the dollars that are exchanged in the future are worth less than those exchanged in the present. If inflation rates were held constant, interest rates would simply rise to account for this, and it would not be a problem, but historically periods of high inflation are also almost always periods of highly variable inflation, preventing individuals who sign a contract from being sure what, exactly, the value of the agreement is. As a result, individuals are less likely to sign long term contracts that could otherwise be mutually beneficial. Inflation transfers wealth towards those who predict it and away from those who do not, causing individuals and especially firms to spend money predicting and avoiding the costs of inflation, resources that could be put to use producing products of value in an inflation-free environment.

Most damagingly, inflation distorts the signal that prices convey in the marketplace to allocate resources. Consumers paying a higher price for a good or service usually indicates increased demand for that good or service. Higher prices signal producers to increase production, even at the expense of higher costs, because the increased production is still profitable at the new and higher prices. A decline in prices for a good sends producers the opposite signal and gives them the incentive to reduce production. Naturally adjusting prices move resources to where they best serve the needs of consumers. In an inflationary environment, producers have difficulty determining whether higher prices result from inflation or from increased demand on the part of consumers. In some cases inflationary price rises cause producers to increase production when consumers demand hadn't risen. In other cases firms won't increase production when higher prices actually did indicate a desire by consumers to purchase more of the good or service offered because the firms believe the increase only resulted from inflation. In either case, inflation caused a less efficient allocation of resources, to the detriment of the economy. Natural price reductions, resulting from innovation, do not scramble price signals because they stem from lower costs to businesses. Firms know exactly how much of the drop in prices results from their lower cost of production, and thus how much of the remainder of the overall price shift occurred because of a change in demand.

Naturally occurring deflation does not damage the economy, government induced inflation does. Throughout human history, including America's history a mere quarter century ago, inflation has proved debilitating. A decrease in the rate of inflation, the merest hint of deflation, is not a sound reason for Federal Reserve Board members to abandon monetary discipline and start printing vast quantities of money. The government is already growing the money supply too rapidly, further interest rate cuts will only guarantee inflation. The printing presses, not innovation and lower costs, are the true threat to America's economic future. . .

Endnotes

(1) "Greenspan's Post-Bubble Economics," The Wall Street Journal, May 8th, 2003.(back)

(2) Federal Reserve Bank of St. Louis, Monetary Aggregates. Available online at http://research.stlouisfed.org/fred/data/monetary/m2ns (back)

(3)"Greenspan's Post-Bubble Economics," The Wall Street Journal, May 8th, 2003. (Back)

(4)"A Monetary History of the United States," by Milton Friedman, © 1963, page 299. (Back)

(5)"Having Defeated Inflation, Fed Gears for War on Falling Prices," Greg Ip and Jon Hilsenrath, The Wall Street Journal, Page One, May 19th, 2003. (Back)

(6)"Fear of a Quagmire," Paul Krugman, The New York Times, May 25th, 2003. (Back)

(7)A Modern Guide to Macroeconomics, Brian Snowden, ©1994, Page 141. (Back)

(8)"Fear of a Quagmire," Paul Krugman, The New York Times, May 25th, 2003. (Back)

(9)"Having Defeated Inflation, Fed Gears for War on Falling Prices," Greg Ip and Jon Hilsenrath, The Wall Street Journal, Page One, May 19th, 2003. (Back)

(10)"Deflation Wouldn't Be Terrible for the Stock Market, if it is Slight,"
Ken Brown, The Wall Street Journal, May 16th, 2003. (Back)