"Falling prices aren’t necessarily bearish for jobs, profits or growth."

Financial Post
The deflation myth
By Richard Salsman

Financial Post‘Fears of “deflation” are widespread. By one account, “the scare word whispered around Washington these days is deflation, which means a falling price level and sometimes implies a stagnant if not collapsing economy.” The “scare word” also spooks the U.S. Federal Reserve, which is now planning to print US$600-billion in more paper money, even though it has already tripled its balance sheet since 2008, and even though currency-gold prices, the world’s most sensitive inflation indicators, have skyrocketed by 16% to 41% in the past year (depending on the currency), and by an average of 26%.

In the past, gold-price jumps of such magnitude, which always mean a depreciation in the real purchasing power of paper money, i.e., inflation, have been bearish for equities and growth.

The current anxiety over “deflation,” that is, an increase in money’s purchasing power, causing a declining price level, is ridiculous, for two reasons: (1) there’s no actual deflation to speak of (nor is it likely to occur in the coming few years, given prevailing public policies), and (2) even if some deflation were to take hold, it wouldn’t necessarily be bearish for equities, profits or economic growth.

Financial PostDeflation is an increase in the real purchasing power (or value) of money, i.e., an increase in what a certain sum of money can buy in terms of actual goods and services. This entails a decrease in the cost of living (and the cost of doing business), as reflected in a decline in the general level of prices and costs. In contrast, inflation is a decrease in the real purchasing power (or value) of money, i.e., a decrease in what money can buy in terms of actual goods and services. This entails an increase in the cost of living (and in the cost of doing business), as reflected in a rise in broad-based prices and costs.

Many economists presume, falsely, that deflation necessarily coincides with (or causes) a contraction in economic output. In fact, deflation by itself in no way curbs the motive to produce, because it doesn’t preclude the maintenance of business profit margins. During the Industrial Revolution, deflation was common. It was also a bullish phenomenon in the second half of the 19th century, the period of the fastest economic growth in human history. Consider the empirical record during the three to four decades between the U.S. Civil War (1861-65) and the First World War (1914-18). There was a huge increase in output (and profits) in the world’s major economies during this period, even as price levels increased only marginally or even declined (“deflation”).

This was a period of widespread political-economic freedom. Contracts were respected, governments (and their debts) were minimal, taxes were low and money was sound (the classical gold standard lasted from 1870 to 1913). In the U.S. during these remarkable decades, there was no federal income tax, no central bank, no deposit insurance and no morass of regulatory agencies.

The table above shows how, despite stable or declining price levels, worldwide economic growth (real GDP) was quite rapid from 1880 to 1913 and inversely related to prices (with a negative correlation of -27%). Average annual “inflation” was only 0.3% in these nations from 1880 to 1913, while growth averaged 3.5% a year — a pairing that hasn’t been matched in any 33-year period since.

This rebuts the myth that falling prices must coincide with a stagnating or contracting economy. Price levels declined in fast-growing nations such as Britain and Denmark, and increased only minimally amid robust economic growth rates elsewhere in the world. The “worst” inflation in 1880-1913 occurred in Portugal, so it suffered the second slowest rate of economic growth, but notice how its price level increased by just 22% in 33 years, an annual average inflation rate of only 0.7%. During these decades the U.S. price level increased only 10%, a mere 0.3% a year.

If we consult an even longer U.S. track record during the 44 years between 1869 and 1913, we find that real GDP skyrocketed by 461%, for an average growth rate of 10.5% a year, while the price level actually declined by 12%, or -0.3% a year.

Today’s anxiety-ridden Keynesian economists would have to concede that this was a long-term “deflation” in prices; worse (for them), they’d also have to admit what their theoretical “models” don’t even permit them to conclude: that these deflationary decades coincided with stupendous rates of economic growth (indeed, sustained rates of high growth that haven’t been matched since). The only subsequent, long-term stretch of robust U.S. growth occurred during the “Roaring Twenties,” when the general price level declined yet again. From 1920 to 1929, real GDP in the U.S. expanded by 43% (or 4.7% a year), while the general price level declined by 17.7% (-2% a year). Profits and stock prices also zoomed during the decade. Again, deflation was no impediment to robust prosperity.

That deflation and economic depression seem to have coincided during the Great Depression of the 1930s has caused generations of economists to improperly indict (and fear) deflation. In fact, that debacle was instigated and prolonged not by “deflation” per se, but by a series of wealth-destroying public polices: (1) a deliberate inversion of the treasury yield curve by the Federal Reserve in 1928-29, (2) huge tax hikes on a broad array of imports, starting in 1930 (the protectionist tariffs imposed by the Smoot-Hawley Act), (3) a massive hike in the federal income tax rate on the rich, from 25% in 1930 to 66% in 1932 (which slashed in half their incentive to produce income, since it cut the after-tax retention rate from 75% to 34%), and (4) a 41% devaluation of the U.S. dollar, in March 1933 (i.e., a one-time massive inflation).

By devaluing the dollar, the FDR regime made it worth less in real terms; it raised the gold price from US$20.7 per ounce to US$35, which reduced the dollar’s gold content (real value) from roughly 1/21 of an ounce of gold to just 1/35 of an ounce of gold. This deliberate debasement in the dollar’s real value, a value which had been steady over the prior four decades constituted inflation, not “deflation.”

Although broad U.S. price indexes (and costs) declined sharply from 1930 to 1934, this was an effect of punitive public policies (yet another symptom), not itself a “cause” of the Great Depression. Punitive policies, each in their own perverse way, invited banks, business and the general public to hoard liquid and lower-risk assets, to raise their demand for cash balances, especially in the form of gold, due in large part to FDR’s devaluation of the dollar, which boosted the gold price, and his threats to abandon the gold standard and seize private gold holdings. A rising demand for money, in the face of a declining supply of money (given bank failures and the extinction of chequing deposits, which comprise most of the money supply), necessarily raises the value of money (i.e., deflation), as reflected in falling prices.

As in the past, under the classical gold standard, businesses today could easily survive and even flourish under a mild, slowly drawn-out deflation, so long as their costs also declined and their profit margins were preserved. But the deflation of the early 1930s was quick and severe, leaving little scope for careful, rational adjustments in commercial-contractual relations among dislocated creditors and debtors.

Worse, the Hoover-FDR regimes strong-armed businesses into not cutting their main cost — labour. Obtuse, Keynes-inspired policymakers in Washington insisted that consumers and labourers (not investors or businesses) drove the economy, and, as such, they said wage rates and income levels shouldn’t be allowed to fall but instead should be maintained at pre-1930 levels, even though this policy would necessarily sabotage profits, cause widespread losses and generate mass unemployment. The Keynesians certainly got what they asked for in the 1930s (not a recovery, but stagnation), yet instead of blaming themselves for the market carnage, they blamed “deflation” — the same phenomenon that, when mild and prolonged, was a direct boon to economic prosperity in 1880-1913 and 1920-29.

The only genuine danger from deflation is that faced by over-indebted, would-be deadbeats. When money gains value over time (as under deflation), the over-indebted face a larger repayment burden. They must repay their debt with ever more valuable money, compared with the (lesser) value of money initially borrowed. In a deflation, the prices (and incomes) one receives necessarily decline, but the face amount of the debt owed does not decline. This is the “pinch” that deflation ultimately exposes and makes transparent. Joblessness only worsens the debt burden, but joblessness itself follows from excessively high real wage rates (see the 1930s). The real danger (and difficulty) in economic depression lies not in “deflation” per se, but in two fatal choices: (1) to incur excessive debt (often made with the hope of repaying in cheaper money, as under inflation), and (2) to demand excessive wage rates.

At root, unanticipated deflation really only hurts speculators in leverage — hardly the kind of people (or businesses) who drive a genuinely productive and entrepreneurial economy. It is creditors (i.e., savers, lenders and investors) who benefit from deflation, all else being equal and so long as their clients aren’t over-leveraged. The so-called “fear of deflation” is nothing but disguised sympathy for over-leveraged deadbeats (or high-cost firms), coupled with a thinly veiled disdain for greedy lenders, bankers and investors.

It’s not coincidental that in 1936 the Jack Kevorkian-sounding John Maynard Keynes called for the “euthanasia of the rentier and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity value of capital.” In 2009 the Obama government jettisoned the U.S. Bankruptcy Code so as to cheat the bondholders of General Motors and Chrysler, and favour the United Auto Workers. The “rentier” is the presumed dastardly bondholder who lives on his earned interest.

In any case, deflation is currently hardly a risk. Over the past half-century in the U.S. (July 1960 to July 2010), there hasn’t been a single one-year period when retail prices actually declined. Not one.

The U.S. retail-price inflation rate has been relatively low lately, especially compared with the double-digit inflation rates of 1975-82. But does that mean today’s low inflation rate is poised to move lower still, until it tips “inevitably” into the deflationary zone? Not necessarily, especially since at no time in the past 50 years did a U.S. inflation rate ever tumble into a deflation rate. There’s been no annual deflation in the U.S. since 1960, only different rates of inflation — periods of faster rising or slower rising prices.

The U.S. economy has had a declining rate of inflation in the past year, but history says that’s good for economic recoveries and expansions. The thing to have feared in the past few years was accelerating rates of inflation, as in 2006-08, since that signalled trouble for the economy, profits and stocks.

But investors never hear much from printing-press Keynesians about the potential dangers of a rising inflation rate. All they seem to hear about is whining and worrying about the alleged dangers of deflation. This Keynesian media bias tends to prompt Fed policymakers into taking actions and adopting quantitative easing schemes that threaten to boost the inflation rate — the real menace.

Richard Salsman is president of Intermaket Forecasting Inc. in Durham, N.C.