Economic Myths #12 – The Deflation Danger

[First published on Free Life.]

Politicians and mainstream economists are persistent in their warning of the so-called “deflation danger” – the idea that falling prices are calamitous for economic progress and that a perpetual, ceaseless price inflation is needed in order to bring us back to prosperity. Often, a deflation figure as small as 0.6% seems to be sufficient to trigger alarm – something of an hilarious travesty when, regardless of the merits of the deflation thesis, this figure amounts to little more than a rounding error.

The typical argument against deflation runs something like this: with continuous price deflation people expect prices to be lower tomorrow than they are today so that, as a result, they put off their purchases until a later date. This, in turn, causes prices to fall further and further and so we end up in an endless downward spiral of depression and impoverishment. Inflating prices, however, cause people to buy today so that they may insulate themselves from future price rises, thus bringing about economic prosperity and an increase in the standard of living.

The term “deflation” is used, quite confusingly, to refer to two different economic phenomena:

  • Falling prices as a result of increases in productivity – what we might call secular deflation;
  • Falling prices as a result of a decrease in the supply of money, i.e. monetary deflation.

Although the two phenomena are related by the commonality of falling prices, the causes and effects of each are distinct and, as such, they must be treated separately. However, because of the bias of our current monetary system towards perpetual inflation it is usually the case that a general price deflation occurs only during monetary crises – i.e. the second cause of deflation. The supposedly negative effects of such deflations, which are often characterised by sharp, persistent falls in prices, are used, quite carelessly, to demonise the first type of price deflation as well so we end up with the notion that any prices falling for whatever reason are a bad thing.

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