The ECB has finally launched its own open-ended Quantitative Easing (QE) planning to buy securities worth of €1.1tr euros. This unprecedented move requires a convincing justification. One argument in favor of QE is the low rate of price inflation in the Eurozone which allows the ECB to sell its program as countering a slide into deflation. Deflation is widely considered as the worst case scenario. The Economist claimed that deflation is “the world´s biggest economic problem”. Christine Lagarde called deflation an “ogre.”
But is the deflation phobia really justified? Is price deflation a problem for the economy as a whole?
To answer the question it is important to take an unbiased look upon the phenomenon of decreasing prices. A price is simply a historical exchange relationship. In every exchange there are two parties, a buyer and a seller. Of course, when prices fall, buyers benefit. It is true that falling prices cut the sales revenues of companies. Yet, essential to companies are not the sales but profits, i.e. the difference between revenues and costs. Companies can earn profits at higher and at lower price levels, depending on what happens on the cost side.
In fact, decreasing sales prices lead to pressure to reduce costs. Companies will replace workers with machines. More machines must be produced, which increases the demand for labor in the capital goods sector. Workers who lost their jobs in the consumer goods sector will find new employment in the capital goods sector. The capital stock grows without leading to mass unemployment. A problem arises when the government impedes certain prices to fall, i.e. by enforcing minimum wages. The resulting unemployment is, however, not caused by falling prices as such, but by government interventions that prevent the necessary fall in other prices (in this case, the price of labour).
A related argument against deflation holds that not falling prices per se are the problem but the expectation thereof. Consumers would delay consumption expecting lower prices leading to losses for companies, even lower prices, a further reduction of consumption, and so on.
Yet, next to no one will stop to fill up the gas tank for a year, because one expects that gasoline prices will be 10% cheaper next year – not to speak of voluntary starvation in expectation of falling food prices. Even if we go to the technology sector where consumers expect practically indefinitely falling prices, we see no crisis or falling investments. The opposite is true. Even though consumers know that new devices will be offered at cheaper prices in the future, smartphone sales increase. Consumers and companies do not wait for prices to fall, because they want to use these products rather sooner than later.
Another argument against price deflation states that some costs are fixed in the short run resulting in losses for otherwise sustainable business models. Most prominently debts are fixed nominally. The real debt burden increases in a price deflation. Consequently, the demand for goods and services by debtors falls. But what is generally overlooked is that creditors profit from price deflation. Creditors have more buying power. Creditors win what debtors lose.
The real debt burden may increase to such an extent that the debtor goes bankrupt. But even this extreme case does not imply an overall problem for the economy. Society is not made worse off by the bankruptcy and the following change of ownership. The old owner loses control over the property to the creditors that better anticipated the price evolution. In the aggregate the productive capacity of the economy is unchanged. When a factory owner goes bust, their factory and their machines do not disappear. Bankruptcy merely implies a redistribution and change of ownership. When the business model is sustainable, the new owners may continue the production without debt. Indeed, the increase in the real debt burden that comes with price deflation has a salutary effect. It reduces the incentive to borrow and thus stops the march towards artificial credit expansion and indebtedness.
Unfortunately, the cause of falling prices is often neglected in the debate on deflation. Falling prices may well be the cause of increasing productivity. It is one of the most harmful economic myths that a growing economy needs an at least equally fast growing money supply. The production of more and better products simply causes a tendency for prices to fall, which is the most natural and healthy process in an economy. In the second half of the 19th century in the US falling prices and economic growth were the rule. Today in countries such as Spain prices are (finally) falling, while new jobs are created and the economy is growing. Such a price deflation is a blessing.
There is yet another destructive myth which is frequently employed to justify QE. The myth created by Milton Friedman states that the Great Depression endured for so long because the Federal Reserve did not sufficiently increase the money supply. Currently, commentators are afraid to repeat the errors of 1937 when after 4 years of apparent economic growth, the US economy fell back into recession. Yet, the root of the Great Depression lies in the expansionary monetary policy of the 1920s that led to an artificial boom. When the bubble burst in 1929, credit contraction ensued. The deflationary process of correcting the investment errors committed during the boom was inevitable. Credit deflation is only a consequence of the boom revealing investment errors faster. What made the Great Depression so intense and long were the monumental policy errors committed by President Hoover and President Roosevelt, both of whom pushed for higher wages, raised taxes and public spending, made the economy more rigid and increased tariffs. Furthermore, as economic historian Robert Higgs convincingly argues, the downturn of 1937 was caused by growing regime uncertainty over Roosevelt’s term. Business confidence in the New Deal policies eroded. Businessmen feared a regime change. Private investment collapsed due to the uncertainty of property rights.
But if all these arguments against price deflation fail, why is there such a strong opposition against it? As shown, price deflation implies a redistribution. The losses of debtors in a price deflation explains their resistance. The finance industry, highly indebted companies and especially the state as the largest debtor in our economies have a strong interest in avoiding deflation and present price deflation as a catastrophe. Not coincidentally these actors are the first ones who profit from the prescribed remedy: inflation. Yet, inflationary measures cannot undo past investment errors. Unfortunately, the ECB´s measures may allow old malinvestments to struggle along, prevent the necessary austerity of the public sector, slow down reform efforts in the Eurozone, foster new distortions and create new bubbles. That is the real danger we are facing. Deflation is not.
Jesús Huerta de Soto is Professor of Economics at the Universidad Rey Juan Carlos in Madrid.
Philipp Bagus is Professor of Economics at Universidad Rey Juan Carlos and author of “In Defense of Deflation”