The Fallacies Behind the Deflation Warnings and the Calls For “Positive Inflation”

The common wisdom these days is that deflation is the enemy – the worst thing that can happen to an economy. Inflation, on the other hand, is the safe promised land, at least until it’s not higher than 2.5% annually. To that end, the central banks all around the world are actively “easing” and printing mass amounts of new money.
The logic behind this myth is that prices going down, aka deflation, is the instigator and biggest contributor to creating downturn and a slowdown of the economy, which eventually leads to a recession, or even worse to the D word: Depression.

In the words of then Governor Bernanke before the National Economists Club, Washington, D.C. November 21, 2002

“The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand–a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending–namely, recession, rising unemployment, and financial stress”

But is this widespread myth really true?

The classic example brought by promoters of this myth is the Great Depression; a time when prices dropped by around 33%, GDP per capita by almost 30% and unemployment rose to 25%. But can this sharp contraction, in a short period of time really prove this claim? Or was the drop in prices in this case an effect, a result of the contraction rather than the cause?

A better answer can be found when examining a long period of time rather than 3 year period. So we checked the real GDP per capita growth over 100 years, in four periods of 25 years each; we also compared the changes in consumer prices during these periods. The results would probably surprise you.

PeriodGDP Per Capita GrowthInflation
1825-1849 24.80% - 10.80% Gold and silver money
1850-187436.71%- 23.10% The three years of the Civil War and greenbacks- excluded
1875-189952.67%- 29.60%The classic gold standard era
1989-201342.15%+78.50%The fiat money era


Source: Inflation: Federal Reserve of Minneapolis. GDP: The Maddison Project 1

What does the data show? Surprise, surprise! Along a 75 year period, GDP per capita grew while prices were constantly dropping. This 75 year data clearly demonstrates that growth and inflation have nothing to do with each other, and the myth portraying wide price drop as an inevitable decline in growth and economic contraction is either a misconception or an outright blunt intentional lie.

As we know, when an economy’s productivity grows significantly, typically thanks to improvements in technology, while the money supply is fixed i.e. does not change significantly, prices will drop. When the same amount of money is chasing more products, the result will be a drop in prices: a mirror picture of classic inflation. This was the case in the 75 years between 1825 and 1900; the huge technology improvements due to the Industrial Revolution increased production output significantly. At the same time, money supply was tied to gold and thus didn’t change significantly. The result was a slow and constant drop in pricing and an increase in purchasing power and standard of living.

Growth and inflation are only connected when prices drop sharply and in a short period of time in response to drops in aggregate demand, commonly a response to the collapse of a financial credit bubble, which was the case in 1929. In the words of the Federal Reserve Chairman at the time, Marriner S. Eccles, “The time came when there were no more poker chips to be loaned on credit.” The result of the credit bubble collapse was a fast and sharp drop in aggregated demand and thus a downward spiral which didn’t stop until the market reached a new balance.

In the 25 years between 1875 and 1900, per capita growth dwarfed even that of the height of the information revolution between 1989 and 2013, totaling 52.7% vs. 42%. Prices simultaneously dropped by almost 30%. By contrast, between 1989 and 2013, prices increased by almost 80%. The reason for that huge decline in the value of the dollar was the massive money creation since 1971. If not for that money creation we could have enjoyed the same economic bounty as in previous times of technological progress.

The data in the above table also disproves a commonly accepted “truth” that money creation and inflation lead to growth while price drop indicates and instigates depression and contraction. This notion mixes steady price drop due to productivity growth with sharp price drop resulting from quick disappearance of “false” demand created by financial credit bubbles.

Nobody can argue that he wants to pay $5,000 for a DVD player as it was 20 years ago, or that an increase in cost of living and diminishing purchasing power is a good idea. However, what does inflation” mean if not exactly that? Let’s remember, “positive inflation” is made of increasing college tuitions, expensive healthcare, higher rent, overpriced consumer electronics and paying more for your next tank of gas and even for food, though the latter two are not part of the core CPI.

So why this myth and the “positive inflation” remedy, are so heavily promoted, as vividly exemplified by Federal Reserve Chairman Ben Bernanke?

“The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.[…]We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”2

The first reason, as sad and strange as it may sound, is the fact that after a generation of Keynesianism and the hailed concept of “positive inflation,” many economists forgot the simple truth that prices can, and have for decades, drop while the economy experiences growth and prosperity.

Another reason for the “positive inflation” myth is that inflation creates a feeling of movement and short-term economic activities, even if at high prices elsewhere, including growth in income inequality and in wealth gap (the Cantillon Effect), or ever existing cycles of booms and bust.

Last but not least is less naïve. When prices go down, even if the underlying reason is an increase in productivity and prosperity, the effective burden of debt goes up. Simply in terms of purchasing power, if prices go down any debt will “cost” more products. Again this is a mirror picture of inflation which reduces the effective burden of debt. For a government that owes 18 trillion dollars and counting, and an economy in debt of almost 59 trillion dollars, a desired outcome is to inflate the debts away and not to increase its relative burden. To that end, even low inflation is a problem as stunningly admitted by Benoît Cœuré, an executive board member of the European Central Bank in a rare TV interview: “Low inflation is as bad as deflation in terms of the capacity of our economy to grow out of debt. We don’t need to meet deflation to be worried. Low inflation is a concern.” 3

The net result of this “positive inflation” policy is that the citizenry are paying with the unneeded reduction in their purchasing power for maintaining the debt balloon, even before the debt itself has to be paid. To that end and with no simple way out of the massive money creation policies of the past 50 years, inflation-constant increase of cost of living-is hailed, while deflation – a reduction in cost of living-is widely denounced.

The writer is the author of the book “A Brief History of Money- How We Got Here and What’s Next” available also in eBook at Apple-iBook and Amazon-Kindle

1 Federal Reserve Bank of Minnesota, consumer price index 1800
Maddison Angus, The World Economy Historical Statistics, Pg. 247
Economic History Association

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