A Journal for Western Man

 

The Harms of Inflation

versus the

Benefits of Deflation

G. Stolyarov II

Issue CXVIII - August 14, 2007

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CMFF: Fight Death

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Eden against the Colossus

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A Rational Cosmology

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Implied Consent

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Statement of Policy

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Originally published on GrasstopsUSA.com.        

           When it comes to monetary policy, politicians, economic planners at the Federal Reserve, and public opinion are afraid of entirely the wrong scenario. 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.

            And yet the conventional wisdom has it all wrong. The politicians in fact 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 in individual finances and in entire societies.

            To understand the benefits of deflation, let us consider what it means in a simplified illustration. There is initially 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. Because 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 even 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. What happened there was 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, 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!

            Quite the contrary, 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. Even 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 better yet, 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.

G. Stolyarov II is a science fiction novelist, independent philosophical essayist, poet, amateur mathematician, composer, contributor to Enter Stage Right, Le Quebecois Libre,  Rebirth of Reason, and the Ludwig von Mises Institute, Senior Writer for The Liberal Institute, weekly columnist for GrasstopsUSA.com, and Editor-in-Chief of The Rational Argumentator, a magazine championing the principles of reason, rights, and progress. Mr. Stolyarov also publishes his articles on Helium.com and Associated Content to assist the spread of rational ideas. His newest science fiction novel is Eden against the Colossus. His latest non-fiction treatise is A Rational Cosmology. His most recent play is Implied Consent. Mr. Stolyarov can be contacted at gennadystolyarovii@yahoo.com.

 

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This TRA feature has been edited in accordance with TRA’s Statement of Policy.

Click here to return to TRA's Issue CXVIII Index.

Learn about Mr. Stolyarov's novel, Eden against the Colossus, here..

Read Mr. Stolyarov's new comprehensive treatise, A Rational Cosmology, explicating such terms as the universe, matter, space, time, sound, light, life, consciousness, and volition, here.

Read Mr. Stolyarov's new four-act play, Implied Consent, a futuristic intellectual drama on the sanctity of human life, here.