Why the Deflationist Argument Is Wrong in Both Theory and Practice

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Ludwig von Mises wrote this in Human Action (1949).

At any rate, a monetary expansion results in misinvestment of capital and overconsumption. It leaves the nation as a whole poorer, not richer. These problems are dealt with in Chapter XX.

Continued inflation must finally end in the crack-up boom, the complete breakdown of the currency system.

Deflationary policy is costly for the treasury and unpopular with the masses. But inflationary policy is a boon for the treasury and very popular with the ignorant. Practically, the danger of deflation is but slight and the danger of inflation tremendous.

A debate has gone on for over 35 years: Austrian School economists and analysts who predict price inflation vs. non-Austrian School analysts who claim to be Austrian and who predict price deflation.

For the entire period, the consumer price index, January to January, has never declined. This goes back to 1955. This fact has had no effect on most deflationists. They remain deflationists.

The deflationists argue that the size of America’s debt — private and government — is too large for Federal Reserve monetary policy to keep from collapsing in a wave of uncontrollable defaults and price deflation.

Their central argument has not changed ever since a self-proclaimed Austrian School (he wasn’t) former central banker (he was: Ceylon), John Exter, began pushing the following argument in the early 1970s. They argue as follows: no matter how much the Federal Reserve adds to the monetary base, it cannot get frightened commercial bankers to lend money. This will keep the increase in the FED’s balance sheet — the monetary base — from being translated into M1: real money. Therefore, debt will “implode,” forcing down prices at Great Depression-era rates of decline. From 1930 to 1933, they argue, the money supply fell by a third. So did prices. This or worse will happen again.

The deflationists do not understand these crucial facts:

The FED is 100% in control over the size of M1.The FED has chosen to imitate post-1990 Japan.Japan has has never had a year since 1990 in which consumer prices went negative by as much as 2%.The money supply shrank in the Great Depression because 9,000+ banks failed.The government passed the FDIC law in 1934.The money supply has not shrunk since then.

Let us look at these facts. (Note: they are facts. They are not theories.)

1. The FED is 100% in control over the size of M1.

The deflationists argue that the FED can pump up the monetary base by purchasing assets, but it has no control over the size of M1, which is the real money supply. This is because M1 depends on commercial banks making loans, thereby taking advantage of all those extra reserves that the FED’s newly created reserves make available. The commercial banks instead deposit the money with the FED as excess reserves. So, M1 has not grown to match the more than doubling of the monetary base. The FED therefore has no control over M1. It cannot control what bankers do with available reserves.

This is the deflationists’ bottom line: “The FED cannot force bankers to lend money.” This is so utterly nonsensical that it boggles the imagination. The FED could get every banker in the country to pull back all excess reserves ($1 trillion these days) tomorrow and lend the money. It does not have to issue an edict. It does not have to take over the banks. All it has to do is charge 10% per annum on all excess reserves. Probably 1% would do the trick.

Banks are paid zero interest on these excess reserves today: whatever the federal funds rate pays. Federal funds are overnight bank-to-bank loans: the shortest of short-term loans.

Banks must make their money from lending, and a trillion dollars are not making banks any money today. If the FED imposed a fee (a negative interest rate), the banks would all lose money — big money — on their excess reserves.

The FED could experiment at the rate required. It could keep raising the “digit-storage fee” until the banks had no more excess reserves on deposit. This would double M1. This would double most prices. Simple. No compulsion. No directives. Just raise the price of not lending until banks are fully lent out.

This is so obvious that only a self-blinded deflationist refuses to see it, acknowledge it, or reply to me. I have been pointing out this out potential strategy for months. On September 18, I wrote:

The FED can get banks lending again simply by charging banks a storage fee on their excess reserves. Put differently, the FED pays negative rates. At some point — probably around 1% — the banks will pull their money out of their excess reserves account and lend it to the Treasury at 0.1%. That’s a better rate than negative 1%.

There is no problem with getting banks to lend — nothing that a 1% negative interest rate would not cure in 24 hours. If I am wrong, then the FED can hike the fee to 2%.

The FED’s problem is this: as soon as the banks pull out their money and start lending, the fractional reserve process takes over. The doubling of the FED’s monetary base, September to December, 2008, will lead to a doubling of M1 and a move of the M1 money multiplier into positive territory.

We would get mass inflation, then hyper-inflation. The FED has no intention of getting either one. So, it pays banks 0.1% on their excess reserves, leaving Keynesians to get all in a dither over the liquidity trap and zero-bound interest rates.

They refuse to respond . . . all of them. That is because, logically, there is no answer. So, all of them are playing “Let’s pretend.” Let’s pretend there is no economic logic. Let’s pretend that no one has mentioned this obvious policy. Let’s pretend that an increase of the Federal Reserve balance sheet has nothing to do with the money supply. Let’s pretend that Murray Rothbard was pathetically shortsighted when he wrote his textbook on money and banking in 1983, The Mystery of Banking. He just did not understand that deflation is inevitable. Poor Rothbard. All that brainpower, so little understanding!

Here is my advice:

Until a deflationist responds specifically to my argument, using both the logic of profit and loss (commercial bankers’ self-interest) and the logic of fractional reserve banking as presented by Rothbard and all other trained economists, you should dismiss the entire deflationist position as crackpottery.

The deflationists can run, but they can’t hide . . . from basic economic logic.

2. The FED has chosen to imitate post-1990 Japan.

The Japanese government and central bank allowed the largest banks to keep bad loans (toxic assets) on the books for almost two decades. The banks have not lent. They have hoarded reserves. This has protected them from bankruptcy. Sound familiar? Of course. This is what the FED has done. It swapped Treasury debt for toxic assets at face value in late 2008 — a subsidy of hundreds of billions of dollars. This was for big banks only. It is letting small banks fail, to be absorbed by larger banks, with the FDIC absorbing the losses.

3. Japan has has never had a year since 1990 in which consumer prices went negative by as much as 2%.

Prices in Japan have not risen or fallen much in any year. They have remained close to flat, overall, for over 17 years. Some years slightly up; some years slightly down; but no overall change. See for yourself. This chart is published by the Federal Reserve Bank of St. Louis.


“Wait,” you say. “This isn’t what the deflationists have said. They told us that Japan has suffered from deflation for years.” They have, indeed. They lie. That’s right. Lie. As in “let’s put the shuck on our readers, who will not look up any of this. Let’s scare them with the bogeyman of price deflation. We’ll sell subscriptions!” And they have.

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December 2, 2009

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2009 Gary North