16 Feb 2009

Two Great Articles on Myths About Deflation

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Here is George Selgin discussing good vs. bad deflation. Selgin says that good deflation occurs when businesses cut unit production costs, allowing them to charge lower prices. If this is what’s driving falling prices, then none of the typical fears will materialize. On the other hand, Selgin says that a “bad” deflation occurs when the money supply contracts as in the 1930s, due to a collapse in bank loans (in the midst of a fractional reserve system). In the big picture view, Selgin says that supply-driven deflation is good (same amount of money chasing more goods), whereas demand-driven deflation is bad (much less money chasing fewer goods).

I have now become so radical (due to my work on the forthcoming Depression book) that I won’t even follow Selgin in calling the price deflation of the 1930s bad. At worst, I think that’s like calling the headache you get when you have a fever bad. I.e. it’s still a symptom of something deeper, and in fact is related to the economy’s attempt to cure itself of the fundamental problem. (And yes yes, you purists, Selgin is using “deflation” to mean falling prices.)

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Now here’s an article that almost lost me in the beginning, but then about halfway into it I decided the guy was a genius. I want to draw your attention to this chart:

Now here’s what the author–Daniel Amerman–has to say about the above chart:

If you’re concerned about a new US depression leading to unstoppable price or monetary deflation because of what happened in the 1930s, let me suggest that you study and remember the graph above. When you get worried about monetary deflation – take another look at March of 1933. Remember as well the one near universal lesson from the long and convoluted history of money: every time the rules governing a currency lead to a problem that causes too much pain for a government to bear – the government just changes the rules….

[W]hat the Great Depression of the 20th century in the United States historically proves is not the unstoppable power of deflation, but the opposite: that a sufficiently determined government can smash deflation at will, virtually instantly, even in the midst of depression, and replace it with inflation.

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