Price Deflation: A Great Idea With Low Probability

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

The likelihood of rising U.S. Federal debt to continue to rise; 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 clock 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:

The deflationists have been incorrect every year. There is still a tiny niche market for newsletters predicting deflation, and approximately three editors have gotten rich by staking out this market. 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, naïve, 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.

Federal 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.

Reserve requirements 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?

Secondarily, 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:

An economic depression Runs on the banks by depositors The bankruptcy of money-center banks An inter-bank payments gridlockThe abolition of the Federal Reserve SystemA 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 accounts.

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.

Deflationists 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 debts.

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


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.

The 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” money?

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 26:11).


Here is what a deflationist is really saying:

“Despite 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.”

To which I reply: What have these people been smoking?

January 4, 2006

Gary 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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