We have: Causes of deflation. Now, deflation understood in the, today, conventional sense; a decrease in the price level. So we have here: the first cause is growth. Growth at a constant money supply. Then we have a second cause that is hoarding. The third cause is a decrease of the money supply. So of M-s as we say. And then we have also a fourth cause that is interventionism; monetary interventionism. Okay, we start with the first cause. So, we have economic growth. ..and this allows us to deal with the most widely held misconception about deflation, ..namely that a growing economy requires a growing money supply to operate smoothly. So the idea is.. it’s kindoff a correspondence idea, a correspondence theory. You have here a blob.. ..that is the volume of trade. And this must correspond, somehow, to the money supply. If this grows, then this must grow too, unless it will be impossible to sell all these goods and services, here. ..but that is, ladies and gentlemen, that’s nonsense, because it is very well possible to sell all goods and services as we’ve said before.. ..by simply decreasing the money prices at which these goods and services are sold. So if the quantity of goods and services goes up due to economic growth these will be sold at ever lower prices, ..thus permitting to buy and sell them all with the existing money supply. All that happens is that prices decrease. Now the crucial question is ofcourse: how can this be? doesn’t this put.. How is this possible for entrepreneurs to do this? How can they.. ..operate profitably if they have to pay prices for factors of production now, and only in the future, ..when the greater supplies of goods and services come to the market, prices will go down; how can they operate profitably? And the simple answer can be summed up with the word: anticipation. Anticipation. So one of the essential tasks of entrepreneurship ..you can say *the* central task of entrepreneurship is to anticipate future prices. If entrepreneurs anticipate that prices will go down in the future, well then they can pay only lower prices for factors of production now. And the next problem that appears is: well, what if the factor-owners do not agree? If they say: “Well, I will not sell my labor” or “I will not rent out my land to you at this lower price. I don’t agree with your anticipation.” The answer to this question is: there’s nothing wrong with this. If they don’t go down with their price well it means.. ..that they have a better employment for their property than on the terms offered by our entrepreneur. So we can say, we have an entrepreneur here and we represent an investment project with the time X(-axis). He will sell here, and now he’s wanting factors of production, and if he does not, if he is unable to buy the factors of production.. ..that he needs to complete his project at lower prices here in the present, well it means that the factor owners, ..let’s say, a worker, has a better alternative. For example he can just stay at home. He refuses to work; he has savings, and so on. He will not work for this lower wage rate, or he will work for another entrepreneur that offers him higher wage rates. So the only reason why people would be unwilling to trade with him at the lower prices that he proposes, is that they have better alternatives. And there’s nothing wrong with this. That is so in any business environment. Whether it is inflation or deflation ..monetary stability ..whatever. So there is nothing wrong with it. What is clear however is if this anticipation is correct; if prices will indeed go down in the future, ..well, then sooner or later the factor owners, for example the workers, will be unable to find anybody offering them better terms. So sooner or later then they will be forced to accept the terms offered by our entrepreneurs, ..who offer only lower recompensation in anticipation of the future lower prices. So there’s no reason to anticipate any problems for a growing economy within a deflationary context. There is nothing inherently impossible about arranging ever-lower prices for factors of production in a deflationary economy. Now, as far as the labor market is concerned in particular there the deflationary impact will be lowest. Why’s that? Well, because labor is the most universally usable factor of production. So it can be used in production processes that are very close.. ..to completion. So, first order production processes; companies that produce consumer goods, and also companies that produce producer goods. And in anticipation of a lower price in the future, this will have all the more greater impact on.. ..factors of production used way back here in the production chain. So if we anticipate a price decrease here at the end of the production, ..this will have an ever greater impact on the price that’s paid for factors of production there, ..because we have to discount the prices by the interest rate. So it will have a greater impact here, and so deflation will impact especially raw materials and so on, ..but not so much labor because the laborer has constantly the alternative of working here or here. So you have constant arbitrage processes going on. The same alternative does not exist for raw materials, let’s say iron ore.., ..which can be used only here. So these raw materials, their price will decrease very strongly in a deflationary environment, ..whereas the price of labor, which is universally usable will not decrease that much. That is the reason also why.. ..real wage rates will increase. All other prices will decrease much stronger than the nominal wage rates. So we have a constant increase of real wages, which is exactly what economic growth is all about. And very similar considerations also apply if the money supply decreases. There’s no reason to believe that.. ..entrepreneurs cannot anticipate a decrease in the money supply, if this should ever happen. Empirically this is a very rare circumstance, but there’s no reason to anticipate or to believe that entrepreneurs should be unable to do this. ..and they would adjust to such an expectation exactly the same way as they adjust to secular growth and to increased hoarding. They would simply cut down prices for factors of production, and this could occur quite simply as any other change. I won’t talk about the fourth reason, interventionism, because we are here mainly concerned about the technical argument. So what does this leave us with? It leaves us with the notion that deflation per se is not economically.. ..more harmful than any other change occurring in the economy. It does not put the entrepreneurs before fundamentally different or more serious problems than any other major change occurring in the economy. ..especially if deflation is constant and secular and so on. It’s very easy to adjust to it, just as to any other business environment.

Tagged : # # # # # #

6 thoughts on “Why Deflation Isn’t Harmful | by Jörg Guido Hülsmann”

  1. Deflation isn't depreciation. When the value of the dollar goes up, fewer dollars are required. If you double the quantity of shares as in a stock split (2:1), the market cap of the company remains unchanged. You still have the same purchasing power with the quantity of stock/money as before.

    You can have the same quantity of money and have lower prices. How can this possibly be bad?

  2. It won't go that fast, why would I eat a cake if it will be cheaper tomorrow? I will be in years because they make the cake more efficiently, and if you invest in a company, let's say you make TV's or mobile phones ( both have gone down dramaticly in price ) you actually could make more profit then if they had stayed "expensive" the people who buy it win cheaper products, the owners of the company win ( they sell way more, more profit! ) the people who work there win ( job security, more jobs )

  3. Derived demand effect. If the price is expected to fall by the time the product is sold, the input costs will fall to accommodate it.

  4. Wealth is transferred from debtors to creditors when the prices at the time of repayment are lower than expected. It is transferred from creditors to debtors when prices are higher than expected at time of repayment. Lenders and borrowers should negotiate for an interest rate that cancels out the effects of inflation/deflation.

Leave a Reply

Your email address will not be published. Required fields are marked *