Deflationary booms

This post was first published on Nov 16, 2009.  We decided to push it through again in case you missed it the first time around.  This comes as Jim Rickards’ interview on CNBC this week echoed our view on deflation to the tee.  Find the interview in our media section.

While the majority of economists today perceive deflation - that is to say, a contraction in money supply (in the broader sense) which tends to declining asset and consumer prices – to be bad for an economy, history shows this is not necessarily true. You can have strong economic growth with a stable money supply, while experiencing declining consumer and asset prices. This is what we call a deflationary boom.

The second half of the 19th century was a time of a powerful deflationary boom (see chart below). Immense productivity gains stemming from new technologies and inventions (such as efficient trans-ocean steamships) opened international markets such as Australia, America, and Africa, which led to a rapid rise in supply of agricultural products and other commodities in the industrialised world. New supply growth outstripped demand growth, and the net effect was declining prices globally. By 20th century standards, money supply in the broader sense remained unchanged, with the exception of a few wars.

The growth of broad money does not need to rise with the pace of economic growth and/or population growth. When the supply of broad money remains unchanged relative to economic and population growth rates, the general price level will decline. This means the purchasing power of the currency rises. Gold has established its place as money throughout human history, owing to its steady supply growth of around 2%-3% per year which kept track with both population growth and real GDP growth (along with other qualities such as divisibility, durability, convenience, consistency, and intrinsic value - qualities of money described by Aristotle). At the end of the day, money is only a medium of exchange, increasing the supply of it artificially can bring no economic benefits and/or productivity gains. There is no reason why broad money supply growth should be running at over 20%, as it did for much of the 1990’s in South Africa. Creating money at such a pace causes the business cycle, and creates problems with monetary calculations.

During deflationary periods such as the second half of the 19th century and during the Great Depression, real wages rise. When prices are falling, a specific amount of money will in the future buy more goods.

People still need to consume a certain portion of their income on a day to day basis, so declining prices won’t force the economy into a deflationary spiral from which it can never escape. This is a very popular argument against deflation, but it is plain to see that declining prices of Hi-Fi, TV and PC’s haven’t stopped people from buying them. As a US National Bureau of Economic Research (NBER) paper recently pointed out, “historically, the negative view of deflation may be attributed to the fact that deflation had been largely unanticipated,” and that “these economists find that, contrary to conventional wisdom, deflation may well be more positive than negative.”

To find why the outcry against deflation and falling prices and rising purchasing power of money is portrayed as absolute anathema to a growing economy by the financial media, we need to look elsewhere. In a deflationary environment, lenders profit as their capital is repaid with money of a higher purchasing power. The R1,000 repaid is worth more than the R1,000 initially lent. Borrowers suffer a loss, and have to settle their debts with money of a higher purchasing power. The burden falls on the borrower, had a negative interest premium not been priced into the transaction.

As Irving Fisher taught us in his book Booms and Depressions, published in 1932, over-indebtedness was responsible for the Great Depression: “debts are out-of-line with, are too big relative to other economic factors.” It’s not the bust that’s the problem, it was the boom in credit and hence debt that was the problem. Either way, when the correction takes place, somebody must take the pain, either through default, bankruptcy, or other associated losses. The malinvestments cannot be made to disappear, but the burden can be shifted from one group to another.

Today, governments – and particularly those of developed economies – are the biggest borrowers in the world. They would never be able to afford to repay their debts if there were to be any significant deflation. By firing up the printing presses, the value of debts are inflated away, which eases the burden of all debtors. The debts are literally papered over. The reasons given for doing so in the press are propaganda or pure ignorance. The burden of this papered-over-debt falls squarely and arbitrarily on the middle and working classes, and others with a fixed salary or pension. As the inflated money falls in value, the middle and working classes have no way of firstly diagnosing the situation, and secondly once they realise it’s an intentional policy by the government, the wealth destruction has already taken place.