All Commentary
Wednesday, May 1, 2002

The Dreaded D Word

Deflation Is Largely Misunderstood

Deflation is a much-feared economic phenomenon, perhaps because it is most often associated with the Great Depression of the 1930s or with the recent troubles in Japan. and yet deflation has not always been coincident with periods of depression.

The general record of the nineteenth century, in sharp contrast to that of the twentieth, was one of falling prices, which Murray Rothbard called a “wonderful long-run tendency of untrammeled capitalism.”1

The gold standard had the effect of suppressing large sustained increases in the money supply. Therefore, even after inflationary spikes, such as during the War of 1812 and the Civil War, deflationary busts soon followed, which checked long-term increases in prices.

Furthermore, as economist Marc Faber noted in a recent essay, “while the entire 19th century was characterized by a deflationary trend (commodity prices and interest rates in 1900 were half those of 1880), it was a century during which enormous economic progress took place accompanied by strong population growth.”2 Real wages rose dramatically during the nineteenth century, global trade flourished, and manufacturing capabilities improved.

Deflation, it seems, is largely misunderstood. What causes it? Is it happening now? A brief exploration into the nature of deflation might be helpful.

Deflation, like its sibling inflation, is properly defined as a monetary phenomenon. Yet rather than fight that battle over semantics here, the popular definition will suffice for purposes of this piece. Deflation is popularly defined as a condition where prices are generally falling. It can also be defined as a contraction of the money supply, which tends to lower prices as well. Stated another way, in a deflationary environment the purchasing power of money generally increases. This is the opposite of inflation, where the purchasing power of money generally falls, a condition post-World War II generations know well.

As Ludwig von Mises insightfully observed, there is always either inflation or deflation.3 The purchasing power of money is not stable, but responds to the tugs and pulls of economic forces constantly acting on it. There are unavoidable continuous fluctuations, sometimes small and subtle.

Just as inflation punishes some (savers) and benefits others (banks), a deflationary environment likewise produces winners and losers. For example, deflation will inevitably make it tougher on some businesses that are unable to lower their expenses as quickly as their selling prices are falling. Contractual obligations—debt contracts, rents, labor contracts—all become a greater burden and make the downward adjustment hard on profits. As debts are extinguished and credit contracted, bank profits are slashed. (As Mises wrote “credit expansion is a boon for the banks, contraction is a forfeiture.”4) But, on the other side of the ledger, savers gain as their pool of savings increases in purchasing power. Fixed-income groups also benefit. And, as happened during the nineteenth century, real wages rise. Deflation does not automatically mean unemployment, as long as wage rates are not kept artificially high by government or labor union interference.

Which brings us to an important point. Deflationary forces can be either voluntary or compulsory. A voluntary deflationary push arises from the actions of free individuals and private firms in an economy. There are three ways that a free-market economy drives down prices.

First, there is the deflationary effect of increasing productivity and innovation.
For example, as Faber points out, the “emergence of efficient trans-ocean steamships” and the opening of canals reduced transportation costs dramatically, which also had the wide-ranging effect of saving money and time, thereby improving the standard of living.5 Other innovations in our own time also have deflationary effects; the power available in a desktop computer far exceeds what was available for similar money even ten years ago. This can sometimes be forgotten in a world where continuously expanding fiat money smothers these felicitous market outcomes.

Demand for Cash

Second, deflationary effects may arise from an increase in the demand for cash. Thinking back to basic supply-and-demand economics, if the demand for something increases (in this case, money), its price (in this case, the purchasing power of money) will tend to rise, all else being equal. This form of deflation is particularly vilified among contemporary economists who believe that the best way to achieve prosperity is to spend money.

Finally, deflationary effects could be unleashed by a contraction of the money supply (including credit). Because the banks have inflated their assets during the boom, the natural process during the bust is to contract as businesses and consumers stop borrowing and pay back or default on debts, and as banks become more cautious, slowing or halting altogether the credit-creation process. Even so, this deflation has a limit. And that limit is, as Rothbard pointed out, “the eradication of all previous credit expansion.”6

These deflationary causes are benign and corrective of previous excess. It is the compulsory or forced deflation that is the most damaging. The most popular way governments attempt to combat deflation is essentially to print money. Governments also attempt to create deflationary forces as a tool to combat rampant inflation.

Recently, Argentina froze more than a third of its people’s savings to protect its banks and to attempt to salvage the purchasing power of the peso. “Since early December,” a Washington Post article notes, “depositors have faced limits on withdrawals from savings and checking accounts.”7

The government of Argentina, in an effort to curb the inflation it created by printing fiat currency, is now denying its people access to their savings. It is yet another abominable violation of property rights by a government, an outright theft perpetrated under the guise of saving the Argentine economy.

Freezing savings accounts is basically a way to force people to hold greater cash balances, a way to artificially prop up the demand for cash. As noted, an increased demand for cash is a deflationary force. In this case, Argentina hopes to harness it to defeat its opposite, inflation.

It is a story told countless times in the history of human affairs. As pointed out by Rothbard in his essay “Deflation, Free or Compulsory,” such measures failed President Collor de Mello of Brazil in 1990 and they failed President Mikhail Gorbachev in the Soviet Union. It is hard to see anything but failure for such a policy in Argentina.

Deflation Now?

Some economists believe the global economy is susceptible to experiencing widespread deflation. Morgan Stanley economist Stephen Roach recently wrote, “for the world as a whole, I would judge the risk of deflation to be higher than at any point in 70 years.”8 Other observers already believe deflationary forces have kicked in, and point to the decline of commodity prices around the world.

Not everyone is on that bandwagon, however. James Grant’s piece in Forbes, “What Deflation?,” pointed to a rising median consumer price index and the continued expansion of the Federal Reserve’s balance sheet.9

The inflation/deflation debate will probably continue. Part of the problem is, as Mises noted long ago, that the terms inflation and deflation lack “categorical precision” because whether a change in purchasing power is large enough to be called inflation or deflation involves some personal judgment.10 Certainly, the measurement of such phenomena is a difficult if not impossible task.

Whether deflation occurs (or is occurring) is not the point of this essay. Deflation, as with all economic phenomena, will create opportunity for some and hardship for others. For perspective, however, we should not associate deflation only with periods of economic bust. Moreover, deflationary currents that arise from benign market forces created by the actions of individuals are corrective of a previous inflationary boom. Any hindering of this process can only cripple and delay a recovery.

Christopher Mayer is a commercial loan officer and freelance writer.


  1. Murray Rothbard, “Deflation, Free or Compulsory,” reprinted in Making Economic Sense (Auburn, Ala.: Ludwig von Mises Institute, 1995), p. 238.
  2. Marc Faber, “Long Live Deflationary Shocks, and Down with the Central Bankers Who Want to Prevent Them,” Strategic Investment, December 12, 2001, p. 10.
  3. Ludwig von Mises, Human Action: A Treatise on Economics (Scholar’s Edition) (Auburn, Ala.: Ludwig von Mises Institute, 1999), p. 419.
  4. Ibid., p. 565.
  5. Faber, p. 9.
  6. Murray Rothbard, Man, Economy, and State (Auburn, Ala.: Ludwig von Mises Institute, 1993), p. 866.
  7. “Argentina Freezes CDs,” Washington Post, January 11, 2002.
  8. Stephen Roach, “Deflationary Perils,” US and Americas Investment Perspectives, Morgan Stanley, November 7, 2001, pp. 15–16.
  9. James Grant, “What Deflation?,”, December 24, 2001.
  10. Mises, p. 420.

  • Paul Milstein Professor of Real Estate at Columbia Business School, where he is also the Research Director of the Paul Milstein Center for Real Estate. In addition, he has also been a Visiting Scholar at the Federal Reserve Bank of New York, and Research Associate at the National Bureau of Economic Research.