Price Deflation: A Great Idea With Low Probability

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The debate
between those who predict price deflation and those who predict
price inflation has been over two closely related issues:

  1. The likelihood
    of rising U.S. Federal debt to continue to rise;
  2. The ability
    of the Federal Reserve System to continue to purchase as much
    of this rising debt as the Federal Open Market Committee (FOMC)
    decides is appropriate.

The debate
is basically over the debt
vs. the money
supply statistics

Some deflationists
might argue that the debt question is much broader than Federal
debt. It also includes private debt. In response, the inflationist
argues that the source of the debt is irrelevant for monetary policy,
since the FED can legally monetize any asset, including privately
issued debt.

In the 30-year
debate between those forecasters predicting more price inflation
(99.99%) and those predicting price deflation (0.01%), three facts
stand out:

  1. The deflationists
    have been incorrect every year.
  2. There is
    still a tiny niche market for newsletters predicting deflation,
    and approximately three editors have gotten rich by staking out
    this market.
  3. Those few
    subscribers who have actually invested for 30 years in terms of
    deflation have lost most of their wealth.

This niche
newsletter market will continue. There is always a market for newsletters
predicting the opposite of what most experts predict. Those same
three editors will continue to live well and prosper until either
death or Alzheimer’s brings their publishing careers to a close.

One of them
is a second-generation deflationist. I heard his father give a speech
predicting deflation and recommending 100% of investors’ money in
T-bills at the original gold conference in 1967.

After having
heard the man’s utterly preposterous arguments and comparing them
with the other speakers’ case for gold, I phoned my parents and
told them to invest 90% of their liquid wealth in American double
eagle gold coins, which they did the next week. The British pound
was devalued a month later, gold went up and continued to go up,
and my parents made a lot of money.

Those attendees
who invested in terms of the deflationist’s scenario missed out
on a great opportunity. Today, it takes almost $6,000 to buy what
$1,000 bought in 1967. Use the inflation
calculator here.

Still, thousands
of unsuspecting, nave, economically illiterate investors say, “Wow,
this is HOT NEW STUFF!” and send in their subscription money to
get a warmed-over plate full of the dead man’s arguments, which
are re-packaged annually and sold by his son with the same enthusiasm
. . . and also the same results the following year: price inflation.

Like the little
old lady who feeds the slot machine with another quarter, even though
she has fed it for 50 years without a single win, the deflation-predictor
answers: “My odds must be getting better after so many failures.”
No, they aren’t. The machine has been rigged by the house never
to pay off. The casino is owned — lock, stock, and barrel —
by the Federal Reserve System.


The Federal
Reserve System is a government-created, government-licensed, commercial
bank-owned monopoly. The only thing that the government legally
controls is appointments to the Board of Governors: seven members.
This is why the web sites of the 12 regional Federal Reserve Banks
end in .org. Only the Board of Governors’ site ends in .gov. This
is why the 12 regional Federal Reserve Banks must pay for postage,
but the Board of Governors doesn’t. The
legal independence of the FED was announced by the Ninth Court of
Appeals in 1982

reserve banks are not federal instrumentalities for purposes of
a Federal Tort Claims Act, but are independent, privately owned
and locally controlled corporations in light of fact that direct
supervision and control of each bank is exercised by board of directors,
federal reserve banks, though heavily regulated, are locally controlled
by their member banks, banks are listed neither as “wholly owned”
government corporations nor as “mixed ownership” corporations; federal
reserve banks receive no appropriated funds from Congress and the
banks are empowered to sue and be sued in their own names. . . (Lewis
v. U.S., 1982).

The Federal
Reserve System has two primary tools of monetary policy: (1) the
sale (deflationary) or purchase (inflationary) of assets —
mainly U.S. government debt, mainly 90-day T-bills — that serve
as legal monetary reserves for American commercial banking; (2)
control over the legally mandatory ratio of reserves to deposits
— reserves that commercial banks must put on deposit, interest-free,
with the Federal Reserve, unless they hold cash in their vaults.

for most banks are low — about 10%. This applies
to banks with more than $47.6 million. The ratios are lower —
3% or 0% — for smaller banks.

So, there
is not much that the FED can do with respect to altering reserve
requirements that is not deflationary, i.e., raising reserve requirements,
which the FED never does.

The FED can
also set the discount rate: the rate at which commercial banks borrow
short-term money from the FED. Banks almost never do this because
the FED then has the right to do a detailed audit of any banks applying
for these subsidized loans. Instead, banks borrow from each other
overnight: the federal funds market. This is governed by the famous
federal funds rate, which the FED can influence through monetary
policy: buying or selling assets.

Then what
is the FED’s operational tool of monetary policy? Adding (buying)
or subtracting (selling) from the banking system’s legal reserves,
i.e., the monetary base.

The legal
basis of the world’s money supply is debt, i.e., debt owned by central
banks and commercial banks. A central bank increases the nation’s
monetary base merely by adding to its holdings of assets, which
are composed mainly of government debt certificates and, to a much
lesser extent in practice, gold. Gold pays no interest. Government
debt does.

The mindset
of central bankers is tied closely to the interest payments received
from governments. They want to preserve the value of the central
bank’s asset portfolio. But the seven members of the Board of Governors
do not own the central bank or its assets. So, their primary concern
is to provide the American commercial banking system with security
against runs against money-center banks. This is what the senior-level
Rockefeller-employed and Morgan-employed commercial bankers wanted
when they met secretly on Jekyll Island in 1910 to design what became
the FED. The FED has never let them down. No New York City money-center
bank has ever failed.

The 6,000+
small banks, mostly rural, that failed in the Great Depression were
forced to sell their assets to larger banks. The recipient banks
continued to collect interest from the rural debtors. The debtors
had lost all or most of their deposits when their local banks went
bankrupt. (Bankrupt = bank + rupture.) What more could bigger banks
ask for?

central bankers want to preserve the purchasing power of their nation’s
monetary unit, in which government debt is denominated. Politicians
also say they want this. So do commercial bankers. And they really
do. The crucial question is: At what price?

What they
really want is this: general price stability at a discount price.
They do NOT want it at these prices:

  1. An economic
  2. Runs on
    the banks by depositors
  3. The bankruptcy
    of money-center banks
  4. An inter-bank
    payments gridlock
  5. The abolition
    of the Federal Reserve System
  6. A return
    to a market-created monetary system

So, year by
year, the central banks create new money to buy more government
debt certificates. The debt-sellers then spend this money into circulation.
Prices rise.


Central banking
began in the late seventeenth century as a way for the British government
to sell its debt at below-market interest rates. Private investors
agreed to create an institution that would serve as a lender of
last resort, provided that the government grant their bank a monopoly,
which the politicians did in 1694.

The central
banks of the world have the legal ability to buy assets with their
newly created money. Those asset-sellers who receive payment in
this newly created money then spend it, either on consumer goods
or producer goods or loans to people who then buy goods or producer
goods. They do this after they have deposited checks in their bank

The fractional
reserve process takes over as soon as the first deposit is made.
With a 10% reserve requirement, the banking system creates $900
for every $100 that the central bank creates in order to purchase
assets. Economist
Murray Rothbard has described how the procedure works. His is a
useful introduction.

The Federal
Reserve System can create money. It can buy all the debt that borrowers
are willing to sell at a market price, i.e., the prevailing rate
of interest.

Those forecasters
— I hesitate to use the word “economists” — who have predicted
deflation for over three decades have insisted that someday, the
inverted pyramid of debt will collapse.

They never
say why or how.

If cousin
Sam wants to sell a million dollars of debt, nothing legally prevents
a central bank from buying it.

If Uncle Sam
wants to sell a billion dollars of debt, nothing legally prevents
a central bank from buying it.

There are
always people who are willing to issue more debt at some low rate
of interest. The largest issuer of debt on earth is the government
of United States.

argue that the day will come when debtors will not be able to find
lenders. Deflationists do not explain in coherent language why the
central banks of this world cannot buy this debt and lots more just
like it.

The deflationist
scenario rests on the strange supposition that central banks will
not buy debt from insolvent debtors. They do not argue that central
bankers WON’T buy this debt. They argue that the sellers of debt
will use the money to pay off debts. The debt pyramid will collapse.

There is nothing
in modern history to indicate why this might be true. There is also
nothing in monetary theory to indicate why this might be true.

The deflationists
confuse debt paid off by debtors with debt sold by a central bank.
The first transaction does not shrink the money supply; it merely
transfers the ownership of money in individual bank accounts. The
second transaction does shrink the money supply, for it shrinks
the legal reserves by which banks are allowed to issue new loans.

If a man who
has a bad credit rating cannot get a rollover loan, the person or
institution that issued the credit is injured. It may find that
it is holding onto a worthless asset: an IOU that will not be repaid.

The owner
of the IOU will then seek to sell it at a discount. There are market
institutions that allow the pooling of such high-risk debts. In
American real estate, these systems are called Fannie Mae and Freddie
Mac. If they should get into big, politically serious trouble, there
is a market for their debts: the Federal Reserve System.

The FED does
not lend money to the likes of us as individuals. It can at any
time lend money to the likes of us as pooled groups of debtors.

Those predicting
deflation insist that someday, somehow, central banks will not be
able to lend enough money fast enough to keep the fractional reserve
banking system from producing bank failures, thereby producing a
shrinking money supply.

This assumes
that the FED cannot monetize anything it chooses to monetize by
buying ownership. But sellers who are in a squeeze are happy to
sell to anyone who can provide them with enough money to meet their

Such a person
exists: the legally constituted person known as the Federal Reserve


But, the deflationists
insist, when everyone is in debt over his head, there just isn’t
enough money in the world to fund the debt pyramid.

They are correct;
there isn’t enough money in the world to fund it. But there’s more
where that came from.

When it comes
to insufficient money in the world, central bankers have a solution.

It is not
a zero-price solution. The solution could lead to the depreciation
of the monetary unit to close to zero. This has been done in the
past in nations that have lost a major war: Germany and Austria,
1918—23; Hungary, 1945—48. But in industrial nations during
peacetime, this has not taken place. Booms and busts do take place,
but not the complete destruction of the monetary unit. Still, over
time, the erosion of purchasing power continues.

Voters rarely
take much notice this, and don’t much care. They are content to
blame rising prices on greedy businessmen. They never ask themselves:
“If businessmen are greedy, why didn’t they raise prices last year?
Why did they wait until this year?” Voters, you see, are no better
informed than Congressmen. But voters are not paid salaries to recognize
fallacious economic arguments. Congressmen are, officially speaking.

The deflationist
argues that at some point, a central bank cannot create enough money
to save the system from toppling, i.e., to keep the money supply
from shrinking. Yet in over 30 years, I have never read an argument
that shows why a debtor with a bad credit rating isn’t willing to
borrow more money if this alone will save him from bankruptcy.

If the FED
will provide fiat money in a crisis, there will be millions of debt-burdened
takers. When did bad times ever convince a nation of debtors, who
are about to be sent to the bankruptcy courts, that an offer to
roll over their debts at zero interest will not be accepted?


“But what
about Japan?” ask the deflationists. I hear this over and over.
“Japan proves that a central bank can create money, yet prices fall.”

Oh, yeah?

How far have
consumer prices fallen in Japan since 1992? Do you know? Probably
not. You know who else assumes that you don’t know? Any newsletter
promoter who is selling a subscription based on a prediction of
price deflation.

St. Louis Federal Reserve Bank publishes the figures for the major
industrial nations.

Japan is listed
on the page. Click through. See what you find.

You will find
a statistic that the deflationists are either unaware of or prefer
that their subscribers remain unaware of. Fact: in not one year
since 1992 has the rate of price deflation in Japan fallen by as
much as 1%. In half of the years, Japan experienced price inflation.
In 2004, prices were flat.

What does
this tell us? It tells us that the deflationists have neither economic
theory nor modern economic history on their side. They are really
lousy psychologists, too.

In a productive
economy, consumer prices would fall in a non-fractional reserve
banking system. New gold from the mines might increase the money
supply by 1% or 2%. New production might increase by 3%. So, there
would be a steady, predictable fall in prices.

Think of the
production system as if it turned out only computers or other digital
goods. Would we expect to pay higher prices next year? Of course
not. We would expect lower prices plus greater chip speed. Year
after year, this is what we get.

“How awful!”
wail the deflationists. “It’s the end of the world!”

You say they
don’t wail this? Well, why not?

What is wrong
with price deflation? Nothing that I can think of, assuming that
people have correctly forecasted it, and assuming that it is not
the result of prior monetary inflation by the banking system.

What is wrong
with this? In other words, what is wrong with increased production
and a stable money supply — “too many” goods chasing “too little”

Price deflation
can and does come with monetary inflation, i.e., increases in the
supply of gold. It can also come with the increase of fiat money.
Here is the wonderful offer made by the free market: things may
get cheaper, despite mild monetary inflation.

The debt structure,
created in times of monetary inflation and artificially low interest
rates, cannot be sustained in the face of reduced monetary inflation.
Bankers fear deflationary depression through runs on the banks.
This is why central bankers re-inflate again in order to repress
a recession before it becomes a depression. Or, as the Bible says,

As a dog
returneth to his vomit, so a fool returneth to his folly (Proverbs


Here is what
a deflationist is really saying:

the fact that the Federal Reserve System is legally authorized to
monetize any asset simply by creating digital money to buy the asset,
debt will soon — next year, probably — be so large that
millions of debtors will not be able to repay their interest on
time. They will also not accept rollover loans at zero interest.
Then, when they default, the Federal Reserve System will not be
able to create enough digital money to buy up every dime’s worth
of this newly perceived bad debt.

“The worst
debtor on earth is the United States government. This government
— bankrupt — will someday simply refuse to sell any more debt
to the Federal Reserve System. All creditors who hold U.S. government
debt will then refuse to sell this now-worthless debt to the FED,
even though the FED offers them cash on the barrelhead for their
now-worthless debt certificates.”

which I reply: What have these people been smoking?

4, 2006

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 17-volume series, An
Economic Commentary on the Bible

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