As the recession deepens in Hawaii and across the nation, academics and journalists have joined in panic chorus to warn of the dreaded economic monster: DEFLATION! What's this? Falling prices. Is it bad? An army of lobbyists will try to persuade the Legislature and Congress that it is very bad. They will press lawmakers to prevent deflation with price controls, subsidies, and regulation.

Under the title "The Growing Threat of Deflation," Chris Isadore explained the alarm on CNNMoney.com saying, "The biggest problem with deflation is that when businesses need to continually cut prices to spur sales, they eventually respond by cutting production. That results in growing job losses, and could, in the worst case scenario, even cause a depression." (12-18-08)

I don't buy it.

Increasing Wealth
Suppose retail prices are cut in half. Do we stop buying? No. We buy more because we are wealthier. Our income can buy twice as many products. And producers have an incentive to hire more people and to buy more materials to make more products. It is easy for producers to do so because their money also buys twice as much!

But if people see prices fall, moans journalist Robert Krulwich on ABC , they will stop buying because they will wait for prices to keep falling further. Really? Then what was going on when a consumer stampede killed a Wal-Mart store clerk on Long Island during the Black Friday discount sales last fall? Was that crowd at the door waiting passively for prices to fall still further?

No. People respond to lower prices. People buy more when prices fall. Economists who say otherwise are defying what they teach as "The Law of Demand" and "the wealth effect." A good example of prices falling over the long run is in the computer industry. Prices have always been going down, but people still buy more computers and related stuff. Why? Most people buy computers when the trade for paper dollars seems worth it to them—all the time!

The Deflation Monster of 2009?

The Politics of Prices
Why all this hand-wringing about falling prices? To understand the alarm, one must first understand the politics of prices in Washington, D.C. People are affected differently by broad changes in prices and they have different levels of political influence. Some are winners and some are losers. If the quantity of money increases faster than increases in the quantity of products, we experience rising prices. This general rise in prices is inflation. During inflation, people with fixed incomes are losers because their income buys fewer products. They are less wealthy.

The same holds for savers and pensioners who earn a fixed income from interest. Savers and pensioners are the ultimate creditors who use banks as middlemen to loan their money on to debtors. Years later, debtors pay off their loans with "cheap" money, money that can't buy as much because of rising prices. So savers and pensioners may get repaid in money that can't buy as many products as before the loan. Thus creditors are big losers from inflation and debtors are big winners. Who is the biggest debtor in every country of the world? The government.

Winners & Losers
People with low incomes usually spend their dollars on daily living. Higher income people who don't spend their dollars on daily living don't care to hold or save a lot of paper that is losing value. Those with a lot of extra dollars trade for things that increase in value, i.e. gold and precious metals, real estate and raw materials, museum collectibles, etc. The more demand, the more those prices rise.

Who is the biggest holder of gold, real estate, and museums in every country of the world? The government. Who collects more taxes as incomes rise to higher brackets and as property values rise? The government. And who prints the dollars and spends them first? The government.

If Joe the Plumber prints a few hundred dollars, the officials arrest him for "counterfeiting." The counterfeiter has taken products from society while simultaneously devaluing everyone's currency. When the government prints a few hundred billion dollars, these officials are applauded for "stimulating the economy with monetary policy." Whether accomplished by counterfeiters or monetary officials, the effect is much the same: a redistribution of wealth from the losers of inflation to the winners of inflation. In this manner, monetary policy has robbed 95 percent of the purchasing power of the dollar over the past 75 years.1

"By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens." –John Maynard Keynes

Property and Debt
My house in Waipahu nearly doubled in value over three years. It increased in value by more than I earned as income in the same period of time. The house was the same, except for wear and tear. Good for me. So where did the extra value come from? It didn't fall out of the sky and I didn't do anything to earn it.

No, much of this "value" came from the losses of everyone holding dollars. Thank you very much inflation. I was a big winner and I don't deserve any tears if the price of my house should fall again later. Deflation does the opposite of inflation by reversing the winners and losers. During deflation people with fixed incomes, savings, and pensions all become wealthier as their dollars buy more products. They are winners from falling prices.

Losers from deflation are the debtors who must pay off debts with more valuable dollars. Other losers are the holders of precious metals and real estate that decline in value during deflation. The losers include many influential people, but the biggest loser in all categories is the government—it holds more debt, gold, and land than anyone else. In addition, the government faces falling tax revenues and a loss of newly printed money to spend. And politicians don't want that.

Japan's Lost Decade
We are told that deflation is the great horror facing our nation because debtors will find it increasingly difficult to pay off their debts. We are told this condition plagued Japan in the 1990's and led to a "lost decade" of near zero growth. I don't buy it.

Deflation isn't the cause of defaults and economic collapse. Default and collapse are the consequence of extraordinary inflation and a reckless credit expansion bubble. There's no reason to have more sympathy for debtors during deflation than the debtors have for their creditors during inflation. Both sides are responsible for the risks, not just the creditors. An inflationary bubble was created in Japan, leading to soaring real estate, stock, and credit markets. Land prices in Tokyo were so inflated that the value of the Emperor's Palace grounds was estimated at greater than the value of all the land in California.2 That inflationary bubble had to crash, and it did. There was no stopping it—but they tried.

Inflation preceded the crisis in Japan and the winners from inflation were not going to give up their gains by permitting lower prices to restore normalcy. Instead, massive monetary infusions and price manipulations continued to interfere with, and delay, necessary economic adjustments. The economic crisis in Japan was the creature of inflation. This is the same in the U.S. today following decades of inflation and the subsequent bubble in real estate, stocks, and credit markets. Deflation is an inevitable restoration of real economic value.

All Bubbles Pop
Is growth impossible during deflation? Not at all. Modest deflation was normal from 1865 to 1911, one of America's great periods of growth. The quantity of products increased faster than the quantity of money. So what? People built this into their planning.

Deflation rewarded those who saved money and invested wisely. It rewarded fixed-income workers with increasingly valuable dollars. And it penalized those who borrowed recklessly. All of this was good for growth.

Then the Federal Reserve Board was created just in time to print money and expand credit for World War I and to generate the real estate, stock market, and credit bubbles of the Roaring 20's. RCA stock soared from a couple dollars a share to over $600 a share.3

This bubble had to collapse, and it did with the Great Depression and America's "lost decade" of the 1930's. It is more than coincidence that the Great Depression followed the creation of the Federal Reserve Board.

Was the Great Depression cured by more government spending? Not at all. Federal spending increased by 49 percent under President Herbert Hoover in the three years from 1929 to 1932, the greatest peacetime increase in U.S. history. President Franklin D. Roosevelt increased federal spending by another 49 percent in the five years from 1933 to 1938, and the economy was still deep in depression with nearly 18 percent unemployment.

What Spending Matters: How Much or On What?
How did Hoover and Roosevelt spend that money to prevent deflation? Both of them spent millions trying to make food scarce in order to raise prices. While consumers across the nation were suffering widespread unemployment, historian Eugene Barker recounts that FDR "made contracts with farmers to plant less land than usual in wheat, cotton, corn, rice, tobacco, and a number of other crops…farmers who entered into the contract ‘plowed under' millions of acres of growing cotton…"

"In order to reduce the supply of hogs and cattle, so that the price of bacon, hams, and beef might go up," says Barker, "the government bought and destroyed several million pigs and beeves." 4

Roosevelt's advisors said this was good for the economy. Well, all this spending was good for farmers, bureaucrats, and generous politicians. But it was not good for the economy. It was disastrous for most folk because it meant there would be less food and clothing amidst higher prices and higher direct and indirect taxes. More important than how much money is spent locally or nationally, is how wisely money is spent. And massive government spending typically redirects wealth from productive investment to unproductive malinvestment.

Virtue and Vice
Inflation now seems inevitable to anyone who grew up after World War II. Few people alive today can remember a time when prices were actually stable or going down. The result is that inflationary monetary policy always punishes savers and rewards debtors with perverse incentives.

Thus, Americans have become addicted to spending and debt. Americans don't save enough for their own retirement, for their own education, for their own health care, for their own unemployment or other emergencies. Instead, Americans have become dependent on politicians and the government to provide for their retirement, education, health care, unemployment and other emergencies.

And where does government get the money to do all of this? They print dollars and they borrow dollars from those who do save a lot, i.e. the Asians of rapidly emerging markets abroad. Is it time for the government to reverse these incentives—to reward savers and punish debtors with deflation? No.

It is time for the government to get out of the business of manipulating the value of "legal tender" as a way of increasing its power and manipulating people. Officials with fine hats are neither smart enough nor virtuous enough to rule us in this manner. We have been the toys, the broken and abused toys, of politicians and elitist monetary officials long enough.

The government monopoly on currency through legal tender laws should end. Americans should be free to choose alternative currencies to work for and to save.5 Governments are not good at running monopolies. When there is competitive choice, people will look for quality alternatives, and the government will finally have a motive to stop ruining the dollar by inflation.

-GIR-

Professor Ken Schoolland teaches Economics and Political Science at Hawaii Pacific University and is the author of Jonathan Gullible: A Free-Market Odyssey. He is a member of the Grassroot Institute of Hawaii's Board of Scholars.

Footnotes:
1. Rockwell, Lewellyn H., "The Blessings of Deflation," Ludwig von Mises Institute, 5-30-03.
2. Emmott, Bill, The Sun Also Sets, Page 118.
3. de Aenlle, Conrad, "Is Frenzy for Internet Stocks a Bubble Waiting to Burst?", International Herald Tribune, 9-25-99.
4. Barker, Eugene, The Building of Our Nation, Row, Peterson & Co., Evanston, Illinois, 1948, p. 776.
5. Paul, Ron, "Ron Paul on Legal Tender Laws," RonPaul.com, Sept. 28, 2008.