We’re All Talking About Inflation, But Deflation May Also Be On The Way – Analysis


By Frank Shostak*

Most recent data continue to show a visible acceleration in “price inflation,” with the yearly growth rate of the US Consumer Price Index (CPI) rising to 6.2 percent in October from 5.4 percent in September and 1.2 percent in October of last year—its highest level since December 1990.

Most experts seem to be surprised by the massive increase in the momentum of the CPI in October. Based on the definition of inflation as increases in the money supply and not increases in prices, the sharp increase in the yearly growth rate of the CPI is predominantly on account of past massive increases in money supply.

Note that the yearly growth rate of our monetary measure for the US stood at 79 percent in February 2021 against 6.5 percent in February 2020. Given the time lag between changes in money supply and changes in the CPI, it is quite possible that the yearly growth rate of the CPI will strengthen further.

However, on account of the sharp reversal in the momentum of money supply, the momentum of the CPI might also follow suit. A sharp decline in the yearly growth rate of the Austrian money supply (AMS) measure to 17.9 percent in September 2021 from 60 percent in September 2020 raises the likelihood that the momentum of the CPI will visibly weaken ahead. We suspect this outlook could emerge in the latter part of next year (see chart).

If this were to eventuate, then the likely decline in the yearly growth rate in the CPI ahead raises the likelihood that most commentators will start warning about deflation, i.e., a general decline in the prices and the threat that this will pose to the economy.

A general decline in the prices of goods and services is regarded as bad news since it is seen to be associated with major economic slumps such as the Great Depression of the 1930s.

In July 1932, during the Great Depression, the yearly growth rate of industrial production stood at –31 percent while the yearly growth rate of the CPI bottomed at –10.7 percent in September 1932 (see charts).

According to commentators the possibility of deflation is a major worry. That is because when prices fall it is harder for borrowers to pay down existing debts, leading to growing defaults, while banks become reluctant to extend credit. The logic runs that these two factors combined generate a downward spiral in credit creation and resultant economic activity. Furthermore, most experts regard a general fall in prices as always “bad news” because it slows down people’s propensity to spend, which in turn undermines investment in plants and machinery. These factors are further argued to set in motion an economic slump. Moreover, as the slump further depresses the prices of goods, this intensifies the pace of economic decline.

It is for these reasons that most economists are of the view that it is the duty of the central bank, the Federal Reserve System, in the US, to prevent deflation. In his 2002 speech before the National Economists Club, in Washington, DC, on November 21, 2002, entitled “Deflation—Making Sure ‘It’ Doesn’t Happen Here,” Ben Bernanke, then a Fed governor, laid out measures that the central bank could use to combat deflation, such as buying longer-maturity Treasury debt. He also mentioned Milton Friedman’s “helicopter money.”

For most experts the key reason for the need to pump money into the economy is to boost the demand for goods and services. For them all that is required to fix things is to strengthen aggregate demand. Once this happens the supply of goods and services will follow suit. But why should an increase in demand result in an increase in supply? Without suitable production infrastructure, no amount of expansion in supply is going to result from an increase in demand.

Also, to suggest that consumers postpone their buying of goods because prices are expected to fall means that people have abandoned any desire to live in the present. However, without the maintenance of life in the present no future life is conceivable.

Furthermore, in a free market the rising purchasing power of money, i.e., declining prices, is the mechanism that makes a great variety of goods produced accessible to many people. On this Murray Rothbard wrote, “Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.”

Even if it were accepted that declines in prices in response to an increase in the production of goods promote the well-being of individuals, what about the argument that a fall in prices is associated with a decline in economic activity? Surely, this type of deflation is bad news and must be countered.

Why Monetary Pumping Makes Things Much Worse

Whenever a central bank pumps money into the economy this benefits various individuals engaged in those activities which sprang up on the back of that loose monetary policy at the expense of wealth generators. Through loose monetary policy, the central bank gives rise to a class of people who unwittingly become consumers without the prerequisite of contributing to the pool of wealth. The consumption by these recipients of newly created money is made possible through the diversion of wealth from wealth producers. They only take from the pool of wealth without contributing anything in return.

Observe that both consumption and production are equally important in the fulfillment of people’s ultimate goal, which is the maintenance of life and well-being. Consumption is dependent on production, while production is dependent on consumption. The loose monetary policy of the central bank breaks this relationship by creating an environment where it appears that it is possible to consume without producing.

Not only does the easy monetary policy push the prices of existing goods higher but the monetary pumping also gives rise to the production of goods or assets which are demanded by non–wealth producers.

As long as the pool of wealth is growing, however, the various goods and services that are patronized by non–wealth producers appear to be profitable to provide. But once the central bank reverses its loose monetary stance the diversion of wealth from wealth producers to non–wealth producers is arrested.

This in turn undermines the demand of non–wealth producers for various goods and services, thereby exerting downward pressure on their prices.

The tighter monetary stance that undermines the various activities that sprang up on the back of previous loose monetary policy halts the bleeding of wealth generators. The fall in the prices of various goods and services comes simply in response to the arrest of the impoverishment of wealth producers and hence signifies the beginning of economic healing. Obviously, to reverse the monetary stance in order to prevent decline in prices amounts to the renewal of the impoverishment of wealth generators.

As a rule, what the central bank tries to stabilize is the so-called price index. The “success” of this policy however, hinges on the state of the pool of wealth. As long as the pool of wealth is expanding, the reversal of the tighter stance creates the illusion that the loose monetary policy is the right remedy. This is because the loose monetary stance, which renews the flow of wealth to non–wealth producers, props up their demand for goods and services, thereby halting or even reversing the decline in prices.

Furthermore, since the pool of wealth is still growing, the pace of economic growth stays positive. Hence the mistaken belief that a loose monetary stance that reverses a fall in prices is the key in reviving economic activity.

The illusion that through monetary pumping it is possible to keep the economy going is shattered once the pool of wealth begins to decline. Once this happens, the economy begins its downward plunge. The most aggressive loosening of monetary policy will not reverse this plunge. The reversal of the tight monetary stance will further eat into the pool of wealth, thereby deepening the economic slump. Even if loose monetary policies were to succeed in lifting prices and inflationary expectations, they could not revive the economy while the pool of wealth is declining.


Contrary to the popular view, as a rule deflation is always good news for the economy. Thus when prices are declining in response to the expansion of wealth, this means that people’s living standards are rising.

Even when prices decline because of the bursting of a financial bubble created by money creation, it is also good news for the economy, for it indicates that the impoverishment of wealth producers is finally being stopped.

*About the author: Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

Source: This article was published by the MISES Institute


The Mises Institute, founded in 1982, teaches the scholarship of Austrian economics, freedom, and peace. The liberal intellectual tradition of Ludwig von Mises (1881-1973) and Murray N. Rothbard (1926-1995) guides us. Accordingly, the Mises Institute seeks a profound and radical shift in the intellectual climate: away from statism and toward a private property order. The Mises Institute encourages critical historical research, and stands against political correctness.

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