Saint Louis University – Madrid Campus
Philipp Bagus, In Defense of Deflation (London: Springer. 2015)
While Keynesians attribute deflation to an aggregate demand deficiency, and monetarists are wont to see contractions to the money supply or drops in the velocity of money as the culprit, Bagus takes the reader through a more nuanced view of falling prices. In particular, in chapter 3 he outlines six ways that prices in general may fall, two stemming from a change to the goods’ side of the economy, and four from the money side. Individuals building their cash balances, losses by the fractional-reserve banking system or governmentally decreed deflation all originate from the economy’s money side. Growth deflation and price control deflation all stem from the goods’ side.
In discussing bank credit deflation, Bagus points out the very important yet widely overlooked truism that this particular form of deflation can only occur after a period of credit inflation (p. 77). Those who fear deflation should take note, as this particular form of falling prices is caused directly by inflationary policies, both by accommodative central bank monetary policy and lax lending standards by the fractional-reserve banking sector. Today this possibility may be more acute than at any other time in history given that the U.S. banking sector has built up roughly $12 trillion of M2 money stock from only $1.4 trillion in currency. (Implying that a complete default of the banking sector would necessitate a monetary deflation of nearly 90 percent.)
A particularly interesting section comes in chapter 4, where Bagus outlines five prominent myths of deflation. The discussion on the fallacies of the liquidity trap argument are especially compelling, and Bagus demonstrates that deflation need not lead to any more of an arbitrary or unfair wealth redistribution than inflation.
In the penultimate fifth chapter, Bagus overviews two deflationary episodes – the American growth deflation from 1865 to 1896, and the German bank credit deflation of the 1930s. This reviewer had misgivings as he delved into this lengthy chapter, mostly owing to doubts as to the worth of case studies in an otherwise theory-laden book. My doubts were soon assuaged, however, as Bagus uses the examples to add the reader’s understanding of not only the earlier theoretical aspects of the book, but also these two commonly cited deflationary episodes.
Many economists now view America’s postbellum deflation as due to strong economic growth. This is a particularly important period as it is one of the few data points that illustrate price deflation coexisting with a strong economy. (Elsewhere, Bagus (p. 139-40) explains that the bulk of data points showing deflation as coexisting alongside economic contractions should properly define the causality as going from the latter to the former, and not blame price deflation for the economic malaise.) In addition, Bagus discusses the role of what he defines “qualitative cash building” (p. 130-31). This furthers his previous work on the quality of money (Bagus 2009; 2015), and explains the general cash building that caused price deflation as stemming from the increase in the quality of money as gold convertibility was reinstated after the Civil War. As a result, the growing American population was more willing to hold cash balances as a store of value, meaning less currency circulating as a medium of exchange. As a result the value of money increased to satisfy the needs of the robustly growing economy, or, what is the other side of the coin, the prices of goods in general fell.
The near visceral hatred towards deflation owes its origin back to several politically connected and well-organized groups who were harmed by it during America’s bout of growth deflation. In particular, bankers and farmers – two heavily indebted groups who were strained as they tried to repay their debts as prices, and wages, fell – were able to band together to lobby for a political solution to their economic woes (p. 140-47). While this collective action problem will not strike the reader as overly original, Bagus later revisits the question of why farmers in particular became such a vocal anti-deflation group (as opposed to many other lines of businesses that were mostly silent on the issue). The root issue, at least in Bagus’ mind, is the peculiar way America’s West was won. Land grants given to the railroads (amounting to 242,000 square miles, and area larger than Germany and France (p. 150)) were later sold to farmers. As farmers indebted themselves with mortgages they were placed into a debtor-creditor relation that made them welcoming of price inflation that would diminish their debt burden and increase their receipts from their produce (p. 150-53). This reviewer would have liked to see mention of those farmers who homesteaded their farms and how welcoming of inflation they were. These farmers were typically located at least several miles from the railways and would have faced an entirely different set of financial incentives than those farmers buying land from the railways.
The book is easy to read, and would be a good text for economic students and those trying to navigate the rhetoric concerning the evils of deflation. This brings up, unfortunately, my one real quibble with the book. Since In Defense of Deflation is published by an academic press, few lay readers will have the opportunity to benefit from it. This is a shame, as this reader thinks that, despite his efforts, Bagus will not be overly successful in convincing economists that deflation can be benign. This is not for lack of effort, clarity or facts on the part of the author. The reason, as Bagus also agree based on his introduction, lies in the profession’s wedded position to deflation not only being economically harmful, but morally evil. Most economic discussions never even get the opportunity to discuss the positive or neutral economic impact of deflation since by assumption it is a bad to be avoided at all costs. In this regard, a more ethical based book on money such as Guido Hülsmann’s The Ethics of Money Production (2008) would make a wonderful companion reading to give the reader both sides – ethical and economic – of this funny business of money and prices.
Bagus, Philipp. 2009. The Quality of Money. Quarterly Journal of Austrian Economics 12(4): 22-45.
Bagus, Philipp. 2015. “The Quality of Monetary Regimes”, in (eds.) Per Bylund and David Howden, Essays in Honor of Joseph T. Salerno, pp. 19-34. Auburn, AL: Mises Institute.
Hülsmann, Jörg Guido. 2008. The Ethics of Money Production. Auburn, AL: Ludwig von Mises Institute.