Perpetual Deflation

Blogger “Lord Keynes” (LK) posts on inflation, savings, and Keynesian stimulus.  There are a lot of different things I could say — and then I would have to agree with his criticism of “Rothbardians” who oppose fractional reserve banking on the basis of fraud or instability —, but I want to focus on one particular argument he makes in his post,

The alternative system favoured by some Rothbardians – a system of perpetual deflation – would impose a “tax” on producers and businesses that take on debt to expand output and increase employment: the deflation tax would penalise productive businesses and individuals who must pay back their debts with money of higher purchasing power. The economy would also experience debt deflationary effects.

There is no theoretical basis for this, and there is no empirical basis for this.  There are two types of deflation that free bankers like to talk about: secular and monetary.  The first they consider benign, and it results from output increasing at rates faster than the supply of money (the second free bankers consider malign, and I disagree, but this is a topic I have discussed elsewhere).  A free banking system “deals” with monetary deflation, not secular deflation.

We actually saw a period of secular deflation between 1879–94 (what a lot of economic historians like to term the “long depression”), and none of the problems that LK describes came up.  In fact, this period was amongst the most productive in the history of the United States (if not the most productive).

One of the best histories of this period is provided by Robert Higgs, in his book The Transformation of the American Economy — I review the book here.  As I note in the review, during this period, moneylenders actually allowed for a dynamic interest rate, which would let the rate on loans fall with prices.  So, it turns out that the market, through competitive forces, deal with that “issue” (an “issue” we must be neutral on, because there are always costs on the market — is it fair to call these “penalties?”).  EDIT: It seems to pertinent to remind that the supposed problem with interest and a rising value of money is not with producers, who do not see a fall in profits (since they are selling more output).

I feel that LK is confusing deflationary “problems.” The issue with monetary deflation, as best described by Leland Yeager in A Fluttering Veil, is a fall in the price of outputs before the price of inputs adjust.  This, according to the theory of monetary disequilibrium, would lead to a disruption of entrepreneurial action, since it would throw production into disarray.  I disagree, and I have voiced my opinions in an article published at the Cobden Centre, and reproduced on this blog.

But, let one thing be clear:  there is no problem with secular price deflation, and a free fractional reserve banking system would not stop secular deflation from occurring.

16 thoughts on “Perpetual Deflation

  1. Lord Keynes

    “The first they consider benign, and it results from output increasing at rates faster than the supply of money “

    (1) then why wouldn’t this deflation force debtors to pay back money in higher purchasing power terms, effectively making the burden of their debts higher? You have not, in any way, demonstrated why this would not happen.

    “none of the problems that LK describes came up. In fact, this period was amongst the most productive in the history of the United States (if not the most productive).”

    You couldn’t be more wrong:

    (1) there was a great deal of business pessimism in this period, negatively affecting their expectations. If one bothers to look at contemporary accounts in the business press in both Europe and America, one finds numerous complaints of reduced profits and pessimism. Unless you think shocked expectations do not affect the level of investment, then there is a clear case that investment levels fell below what they could have been.

    (2) there were clear debt deflationary effects in this period. Above all farmers were pressing for relief from debt deflation. The burden of the debts rose. This was not simply caused by industrialization of agriculture, nor by the fall in the size of agricultural employment in the labour force.

    (3) In this period, the deflation from 1873-1896 caused a popular movement to demand a increased money stock by free silver, often backed by debtors.

    “as I note in the review, during this period, moneylenders actually allowed for a dynamic interest rate, which would let the rate on loans fall with prices. “

    What you say is:

    “Interestingly, many moneylenders included the option for a dynamic interest rate, allowing the rate on loans to fall with deflation.”
    http://mises.org/daily/5466/Americas-Greatest-Industrial-Transformation

    Yet there were clearly considerable numbers who did not – otherwise there would not have been significant complains about the burden of interest. Unless you were to legislate to make bankers take account of deflationary effects, there will not be an evasion of debt deflationary effects.

    Reply
    1. Jonathan Finegold Catalán Post author

      (1) then why wouldn’t this deflation force debtors to pay back money in higher purchasing power terms, effectively making the burden of their debts higher? You have not, in any way, demonstrated why this would not happen.

      Did you look at David Hewitt’s link? The argument posed there works in reverse, as well. A fall in prices does not occur neither simultaneously or proportionally amongst all goods; they affect certain goods (namely, those which are increasing in quantity). A businessman who produces Widget A and increases his output by two, therefore halving the price of Widget A, only sees an increase in purchasing power if the price of the goods he purchases also fall.

      Anyways, the price of consumer electronics are consistently falling. Why are we not seeing a fall in competition in the electronics industry?

      (1) there was a great deal of business pessimism in this period, negatively affecting their expectations. If one bothers to look at contemporary accounts in the business press in both Europe and America, one finds numerous complaints of reduced profits and pessimism. Unless you think shocked expectations do not affect the level of investment, then there is a clear case that investment levels fell below what they could have been.

      This couldn’t have been the prevailing attitude, though, because we know (objectively) that this period in American history was the most productive. Real investment increased at its highest rate (barring, perhaps, the 80s and 90s, but we don’t know what the real rate of growth during these years was, yet [see stories of the “great stagnation”]).

      Indeed, falling prices were the result of increased investment, and therefore increased output.

      there were clear debt deflationary effects in this period. Above all farmers were pressing for relief from debt deflation. The burden of the debts rose. This was not simply caused by industrialization of agriculture, nor by the fall in the size of agricultural employment in the labour force.

      I’m not near my bookshelves, but Robert Higgs disproves this. I mention some facts related to this in my review. Farmers were mostly complaining against the falling price of their product, related to the costs of production (i.e. rail transportation). He has a much more compelling story, with the proper empirical evidence (the book was published during his years as an econometrician), but he shows how your story (the popular myth) is wrong. You also have to consider that most farmers were seeing a decline in profit, because higher agricultural productivity meant that less and less farmers were required to produce sufficient output to satisfy demand. So, of course those who were not profiting sufficiently were seeing problems in repaying debt.

      In this period, the deflation from 1873-1896 caused a popular movement to demand a increased money stock by free silver, often backed by debtors.

      This is true, and it was mostly agitation from farmers, who were seeing a declining industry.

      I think you’re not really considering all the facts, and when you look at “contemporaneous accounts” you aren’t considering the biases involved in issuing complaints. There were a lot of factors involved in businessmen’s inability to repay debt. They could blame falling prices, but the real cause was probably a fall in profitability due to increased competition.

      Reply
      1. Lord Keynes

        “This couldn’t have been the prevailing attitude, though, because we know (objectively) that this period in American history was the most productive. “

        (1) This does not refute what I have said.

        (2) I dispute your statement. The 1870s had quite high real output growth, yes (maybe 6.32% by Romer’s figures). But the subsequent rates show a severe fall in growth rates:

        Romer:
        Average real GNP growth rate, 1871–1880: 6.32%
        Average real GNP growth rate, 1881–1890: 2.72%.
        Average real GNP growth rate, 1891–1900: 3.79%

        (calculated from Romer, C. D. 1989. “The Prewar Business Cycle Reconsidered: New Estimates of Gross National Product, 1869–1908,” Journal of Political Economy 97.1: 1–37 )

        Balke and Gordon:
        Average real GNP growth rate, 1871–1880: 5.10%
        Average real GNP growth rate, 1881–1890: 2.96%.
        Average real GNP growth rate, 1891–1900: 3.85%.

        (calculated from Balke, N. S., and R. J. Gordon, 1989. “The Estimation of Prewar Gross National Product: Methodology and New Evidence,” Journal of Political Economy 97.1: 38–92)

        Real output slowed down considerably in the course of 1873-1896, from high rates in the 1870s, to comparatively low rates in the 1880s, and only slightly better in the 1890s.
        The 1880s had quite poor real output growth, actually – right in the middle of this period of this deflation.

        Moreover, there was also unusually high unemployment in both the 1870s and 1890s:

        Year | Unemployment Rate
        1873 | 3.99%
        1874 | 5.53%
        1875 | 5.83%
        1876 | 7.00%
        1877 | 7.77%
        1878 | 8.25%
        1879 | 6.59%

        1880 | 4.48%
        1881 | 4.12%
        1882 | 3.29%
        1883 | 3.48%
        1884 | 4.01%
        1885 | 4.62%
        1886 | 4.72%
        1887 | 4.30%
        1888 | 5.08%
        1889 | 4.27%
        1890 | 3.97%
        1891 | 4.34%
        1892 | 4.33%
        1893 | 5.51%
        1894 | 7.73%
        1895 | 6.46%
        1896 | 8.19%

        1897 | 7.54%
        1898 | 8.01%
        1899 | 6.20%
        Vernon, J. R. 1994. “Unemployment Rates in Post-Bellum America: 1869–1899,” Journal of Macroeconomics 16: p. 710.

        http://socialdemocracy21stcentury.blogspot.com.au/2012/01/us-unemployment-18691899.html

        And note that Vernon’s estimates are the lowest – other estimates put unemployment at much higher rates.
        Another point about the 1870s: if this was part of the “most productive” period in US history, then why did unemployment rise from 1874-1878?

        This doesn’t support out your idea “that this period in American history was the most productive”.

        Reply
        1. Jonathan Finegold Catalán Post author

          I don’t think that data takes into consideration several important contributory facts. I don’t have my books to second-look this, but this my dates are generally correct.

          From 1873 to 1879 there was industrial stagnation, which is why I start with 1879. 1873 is an important date because it is around the time that the greenback was no longer used as a means of exchange — there was a severe monetary deflation which came from dropping use of the greenback. This also explains why there was “unusually high” unemployment between 1874 and 1879, where it finally fell during periods of industrial growth.

          The period of industrial growth ended in 1894, with the financial crisis of that year. Following that crisis, there were gradual changes to the monetary system, which contributed to the growth of the supply of money (related to the silver agitation that you mentioned before).

          I’ll have to look at Romer’s paper. I don’t know how she comes up with RGDP, because from industrial data it’s clear that between roughly 1873 and 1878 there was no notable increase in investment.

          EDIT:

          Another point about the 1870s: if this was part of the “most productive” period in US history, then why did unemployment rise from 1874-1878?

          Please check the dates I use, above.

          Reply
          1. Lord Keynes

            “This couldn’t have been the prevailing attitude, though, because we know (objectively) that this period in American history was the most productive.”

            So I take it you here refer to the entire 1873-1896 period or 1878-1896?

            But that can’t be the case, as the decadal real GNP rate slumped in the 1880s, and wasn’t much better in the 1890s.

            Regarding the 1870s, if we take out 1873-1876, the average GNP growth rate:

            The estimates of Balke and Gordon (1989: 84):

            Year | GNP| Growth Rate
            1879 | $123.1 | 12.31%
            1880 | $137.6 | 11.77%
            1881 | $142.5 | 3.56%
            1882 | $151.6 | 6.38%
            1883 | $155.3 | 2.44%
            1884 | $158.1 | 1.80%
            1885 | $159.3 | 0.75%
            1886 | $164.1 | 3.01%
            1887 | $171.5 | 4.50%
            1888 | $170.7 | -0.46%
            1889 | $181.3 | 6.20%
            1890 | $183.9 | 1.43%
            1891 | $189.9 | 3.26%
            1892 | $198.8 | 4.68%
            1893 | $198.7 | -0.05%
            1894 | $192.9 | -2.91%
            1895 | $215.5 | 11.7%
            1896 | $210.6 | -2.27

            Average: 3.78%

            The average real US GNP growth rate from 1947–1973 was 3.86%, higher than 1878-1896.

            So the assertion that 1878-1896 was a “… period in American history [sc. that] was the most productive” isn’t true, at least in terms of real output growth in Balke and Gordon’s estimates.

            More analysis here:

            http://socialdemocracy21stcentury.blogspot.com.au/2011/12/real-us-gnp-growth-rates-18701900.html

          2. Jonathan Finegold Catalán Post author

            I will have to come up with a more substantive response later (if you still haven’t gotten my point), but I’m basically doubting those GNP figures.

      2. Lord Keynes

        “Indeed, falling prices were the result of increased investment, and therefore increased output.”

        Partly, yes.

        But the other major factor was that money growth did not match growth in the real economy:

        See Capie, F. H. and G. E. Wood, 1997. “Great Depression of 1873-1896,” in D. Glasner and T. F. Cooley (eds). Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York. 287-288.

        S. B. Saul, The Myth of the Great Depression, 1873–96, London 1969.

        “Real investment increased at its highest rate (barring, perhaps, the 80s and 90s, but we don’t know what the real rate of growth during these years was, yet [see stories of the “great stagnation”]).”

        (1) The key are your words “barring, perhaps, the 80s and 90s” – yes, as the deflation continued growth rates fell quite sharply. That strongly supports what I argued originally about expectations, deflation and the volatility of investment.

        (2) “we don’t know what the real rate of growth during these years ”
        Of course, we will never know what the real growth rates were – all we can have are estimates.

        The 2 good estimates I cite above support my case..

        Reply
        1. Jonathan Finegold Catalán Post author

          But the other major factor was that money growth did not match growth in the real economy:

          One in the same thing. The growth in the real economy came from an increase in output.

          The key are your words “barring, perhaps, the 80s and 90s”

          Sorry, I wasn’t clear enough. I was making a comparison to the 1980s and 1990s.

          Of course, we will never know what the real growth rates were – all we can have are estimates.

          You misunderstand what I write. I’m doubting those estimates for the reasons I gave — the period between 1873 and 1878 was one of productive stagnation.

          Reply
          1. Lord Keynes

            “I will have to come up with a more substantive response later (if you still haven’t gotten my point), but I’m basically doubting those GNP figures.”

            OK. I can accept that.

            One other point. Matters aren’t helped if you look at the 1873-1896 period for a real output growth average, but I suppose you already agree with this.

            The estimates of Balke and Gordon (1989: 84) for 1873–1896:

            Year | GNP| Growth Rate
            1873 | $96.3 | 5.01%
            1874 | $95.7 | -0.62%
            1875 | $100.7 | 5.22%
            1876 | $101.9 | 1.19%
            1877 | $105.2 | 3.23%
            1878 | $109.6 | 4.18%
            1879 | $123.1 | 12.31%
            1880 | $137.6 | 11.77%
            1881 | $142.5 | 3.56%
            1882 | $151.6 | 6.38%
            1883 | $155.3 | 2.44%
            1884 | $158.1 | 1.80%
            1885 | $159.3 | 0.75%
            1886 | $164.1 | 3.01%
            1887 | $171.5 | 4.50%
            1888 | $170.7 | -0.46%
            1889 | $181.3 | 6.20%
            1890 | $183.9 | 1.43%
            1891 | $189.9 | 3.26%
            1892 | $198.8 | 4.68%
            1893 | $198.7 | -0.05%
            1894 | $192.9 | -2.91%
            1895 | $215.5 | 11.7%
            1896 | $210.6 | -2.27

            Average real US GNP growth rate: 3.60%
            The average real US GNP growth rate from 1947–1973 was 3.86%,

  2. Jonathan Finegold Catalán Post author

    It’s interesting to note that the experience of 1879-93 caused Friedman and Schwartz to reevaluate their position on secular price deflation.

    Reply
    1. Meng Hu

      I know this post is from 3 years, but I think I have some important information on this subject. There are at least two reasons as for why unemployment is not as low as we can expect, and growth is lower than what it could be. I read Higgs’ book, and at pages 123-124, he writes :

      Though inventions led to increased efficiency in production, they often meant bankruptcy for those employing older processes. David A. Wells, despite his pervasive optimism, was perceptive enough to recognize that “nothing marks more clearly the rate of material progress than the rapidity with which that which is old and has been considered wealth is destroyed by the results of new inventions and discoveries.” Though migration allowed young people to obtain higher incomes, it often left their parents lonely and unhappy in the old home. Though the settlement of fertile Western lands provided cheaper food for urban dwellers, it often meant ruin for Eastern farmers. And similar contrasts might be recited at great length. We could say that people did adjust; ultimately everyone was better off. But such an interpretation is incomplete and ignores the costs imposed on people by the disruptive transformations that inevitably accompanied economic growth.

      The inescapable fact is that economic growth hurt many people. Some recovered their losses, but others did not. Economic growth meant Progress from a social point of view because it created more wealth than it destroyed, but the distribution of the gains and losses was quite unequal. If we are interested in individual welfare, the answer to the question “Was progress worth its price?” must necessarily be that for some it was, and for others it was not. It will hardly do to say that individuals “freely chose to have economic growth,” because growth was a social process; the actions of a single individual simply did not matter one way or the other. An individual could determine his own program of saving and investment, but he could neither foresee nor control the future development of the market system. He could not know that the investments made in such hopeful expectations and based on the most reliable available information were often destined to become reductions in his wealth.

      I have no doubt that the U.S. economy has experienced what he calls an industrial revolution (see pages 47-48 and Table 3.2 of the book).

      But I also think there is another big factor that explains both the “high” unemployment that accompanied the economic crises at that time and the lower-than-could-be-expected growth. It’s due to its weak banking system. Beckworth (2007; read at page 205) has explained there are three factors; I found two of them significant. The first is that the imposition of a tax on state bank notes made banking under a state charter unprofitable. The second is much more annoying because there was no branch banking. As free bankers emphasized many times, the absence of branch banking makes the banks very unstable and much more exposed to external shocks. Generally, when there is no branch banking, it’s the sign that the banking system is (still) not very developed. But in the case of the U.S., such argument does not apply. In fact, branch banking were simply not allowed. Now the third argument made by Beckworth is obscure : “The National Banking System consisted of a tiered system of banks across the country that effectively kept most of their reserves in New York City banks. The New York City banks, in turn, invested the reserves in the call loan market at the New York stock exchange. Call loans were made to parties who bought securities on margin—the securities served as collateral—and were payable on demand. Since most of the reserves were tied up in the stock market, the liquidity of the National Banking System was made susceptible to external shocks that created volatility in stock prices. The frailty of the National Banking System was especially consequential since the state banking system, the alternative venue for chartering a bank, declined after the Civil War and would not fully recover until the late 1800s (Atack & Passell, 1994; Sylla, 1972; Wilson, Sylla, & Jones, 1990).”. There is no reason why such investments are risky if banks were operating under a free banking system (no binding laws or legal tender laws or any other things that push banks to make risky actions and cause malinvestments). So, the weakness of the banking system is mainly the result of government’s interventions.

      It’s clear to me that if the banking system was more robust, unemployment will be lower, and growth stronger. It has obviously nothing to do with deflation, as I have no reason to believe, theoretically, that deflation is harmful. Selgin’s book “Less than Zero” is by far the best you can read on deflation. I have a brief summary here. And if you really need empirical evidence, I can also say there is no proof that deflation lowers economic growth; see Ryska (2014).

      Concerning the data on unemployment, I think Vernon’s (1994) estimates should be trusted. He pointed out that Lebergott’s data has many problems. Based on Vernon, I can say that unemployment wasn’t not very high (but not very low either). In any case, the portrait that the U.S. economy of 1873-1896 is one that can be described of being one of great depression is inaccurate, for anyone who has read Beckworth’s paper.

      Reply
  3. rob

    “The alternative system favoured by some Rothbardians – a system of perpetual deflation – would impose a “tax” on producers and businesses that take on debt to expand output and increase employment: the deflation tax would penalise productive businesses and individuals who must pay back their debts with money of higher purchasing power.”

    The reason there is deflation is that more goods are being produced (due to increased productivity) but the same amount of money is available to buy them. Business will be borrowing money to invest in more productive techniques and part of their business plans will likely be to undercut their competitors by selling cheaper. Thus it is invalid to believe they will be “penalized” by the very deflation that they are partially responsible for. In fact the opposite s true since their costs will fall as other lines of production also reduce prices.

    Reply
  4. Leonardo IHC

    The sentence “The alternative system favoured by some Rothbardians – a system of perpetual deflation – would impose a “tax” on producers and businesses…” is simply wrong as stated as a general law. First of all we must point that “deflation” here means just “price deflation” i.e. “lowering prices”.
    You must distinguish two cases: 1) I am an entrepreneur, I know how to produce with lower costs per unit, and I know I must do it before other entrepreneurs do, so I decide do lower the price of my goods while maintaining profits, I better say while hoping to attract more demand a the expenses of my competitors. Is this a problem? Is it a problem if all entrepreneurs do the same so prices fall? It is their profitable choice to do so, the purchasing power of money increases so – maybe – even nominal wages will start lower in nominal terms while standard of living remain the same or improve… I can see no tax here (neither anything specificly Rothbardian).
    2) Central Bank cuts money supply, so forces interest rates to rise, forces MV to reduce (if V is already at its full expression and no mere credit circuits of payment exists), forces spending to decrease, thence prices to lower. Here is sort of a tax, as entrepreneurs decision has to adapt on external will like part of their profits get dragged away so they receive a lower net price per unit. I admit that a sudden 100% reserve imposition works this way one-shot.

    Reply

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