Why Deflation Is Not Inevitable (Sadly) Part 1: John Exter's Mistake

Recently by Gary North: Keynes and Bernanke on Bubbles and Manias: Blame the Free Market

There is a debate going on within pro-gold circles: inflation or deflation. The deflationists predict that price deflation is inevitable and imminent. The inflationists insist that mass inflation is inevitable, but maybe not imminent.

Deflationists rarely speak of mass deflation, let alone hyperdeflation. Just deflation. They do not say by what percent prices will fall each year or for how many years.

A newcomer to this debate may imagine that this is a hot new topic. It is in fact an old topic in which one side — the deflationists — have been wrong every year since 1955. When World War II broke out, deflation ended all over the world. It has not returned.

The main promoter of the deflationist position in the hard-money camp after 1970 was John Exter, a free market economist who had been a senior banker with Citibank and an economist with the Federal Reserve. He had been the senior economic advisor to the government of Ceylon when it set up the central bank of Ceylon (Sri Lanka). He was a member of the Council on Foreign Relations. He died in 2006 at the age of 95. He had been invisible for thirty years, making no public appearances and granting only one interview that I can locate on the Web, in 1991.

Exter is forgotten today, yet all of the forecasters of inevitable price deflation who are part of the hard-money, pro-gold movement rely on arguments originally developed by Exter. They rarely cite him, but they never escape his ideas.

This is not true of the deflation predictors in the camp of the Keynesians. Almost all academically trained economists who worry about the possibility of deflation are Keynesians. They deny that deflation is inevitable. They believe that the national government can stop deflation if it runs a large enough budget deficit. They have faith in the so-called stimulus.

Keynesians today rely on Milton Friedman and the monetarists to assist them in their policy objective of avoiding price deflation. They recognize that the central bank must inflate in order to fund the government’s deficits and to lend to consumers to buy their way into prosperity. I am aware of no academic Keynesian who says that the world is facing inevitable deflation, meaning massive deflation. They also do not believe that mass inflation or hyperinflation is likely.

So, when I say “deflationists,” I have a specific group in mind:

Non-economists who predict that there inevitably will be price deflation on a massive scale, no matter what the government does and no matter what the central bank does.

Why do I say “non-economists”? Because there are few if any academically trained economists who predict inevitable price deflation.

Austrian School economists insist that hyperinflation is always an option, leading to the destruction of capital markets, the breakdown of the division of labor, and a switch to a new currency unit when money dies. They also say that if the Federal Reserve System ceases to inflate and also refuses to intervene to save the banks, there will be a banking collapse leading to monetary deflation and price deflation. Most of them think this is politically unlikely.

I am one who thinks the Federal Reserve will attempt to stabilize the money supply in order to avoid hyperinflation. I say, “mass inflation, yes; hyperinflation, no. Then deflation.” I hope. But all Austrians argue that the outcome is a matter of central bank policy. Deflation will not take place unless the central bank stops creating new money. All Austrian economists therefore reject Exter’s scenario.

Non-Austrian School economists insist that the government and the central bank can always get the economy out of any crisis that previous laws and central bank policies have created. All that it will take to avoid the crisis will be “prudent” economic policies — “prudent” being defined as “what I would recommend if anyone ever asked me.” They say that there need not be price deflation. The price of avoidance is mild monetary inflation — a small price to pay, they all insist.

Austrians believe that price deflation is preferable to price inflation, but think we will get price inflation. The others believe that price inflation is preferable to price deflation, and are confident that we will get price inflation.

Exter thought otherwise.


In the early 1970s, Exter offered a theory of an inevitable collapse of prices. I have not been able to locate anything on the Web that he wrote in that period. There are only summaries. The archive of his speeches and papers are housed in the Hoover Institution. You can read his basic ideas in a 1991 interview conducted by Franklin Sanders.

He offered a forecast of a rush for liquidity during an inevitable financial crisis. He said that the ultimate form of liquidity is gold.

He proposed an inverted pyramid of increasingly liquid assets. Gold is at the bottom: the most liquid. His chart of the inverted pyramid of liquidity is all over the Web. Here is the one I have downloaded.

Pay close attention to what is immediately above gold: paper money — dollars. Above paper dollars are Treasury bills.

This raises a crucial point. There is an enormous advantage of paper money in a time of deflation. You don’t have to make money to get richer. You just sit on a pile of paper money and wait. When prices fall, you are richer, but you pay no income tax on your profits. You can buy everything cheaper. You don’t have to report the “sale” of your investment assets: dollars. You just spend them — no muss, no fuss, no IRS Form 1040.

Anyone who really believes in Exter’s scenario should recommend paper money rather than gold for investors with less than $10,000 to invest. The investors with more money should buy T-bills. Why? You don’t have to pay taxes on your capital gains with paper money and T-bills. Legally, there are no capital gains. In fact, there are: everything costs less, and you have cash to spend.

Any investment advisor who predicts inevitable price deflation who does not recommend T-bills and paper money is faking it. He doesn’t really believe his position.

According to Exter, gold is more liquid than anything else. This is wrong conceptually. Gold is not money today. Therefore, you must pay a commission to buy or sell it. If you pay a commission, the asset is not truly liquid. One of the three characteristics of liquidity is the absence of any commission. This means money. Any asset that can be exchanged only by paying a commission is not money.

Gold’s price will fall in a time of deflation. It will fall because gold is not money except for central banks, and they hold it mainly for show, as I shall explain. It is a mass inflation hedge. It is not a deflation hedge.


Exter said that the debt burden of the financial markets would soon get so large that nothing could stop a collapse of these markets. He said that central banks do not have the power to create money fast enough to keep this mountain of debt from collapsing.

As I recall — but am not sure — he also argued that central banks can create reserves that commercial banks will not use to make loans. The bankers will be too fearful. So, the money supply will not rise proportionally to the increase in the monetary base. If he did not argue this, today’s deflationists surely do.

This scenario pleased gold investors in the early 1970s, who at long last had a theory that would let them get rich in both inflationary times and deflationary times. Gold is supposedly both an inflation hedge and a deflation hedge — the only asset possessing this virtue.

The problem is, this theory rests on the idea that gold is money. It isn’t. It is a legal reserve for central banks, but anything central banks buy serves as a legal reserve. In the United States, this reserve is kept on the books at $42.22 per ounce. This is an accounting fiction. Everything a central bank does is an accounting fiction. This fiction undergirds all modern monetary policy.

In 2008, the Federal Reserve Bank of New York, a private agency, swapped Treasury debt at face value for toxic debt owned by the biggest American banks, mostly headquartered in New York City. That exchange at face value was a legal fiction that kept the biggest commercial banks solvent.

The Federal Reserve System is always legally solvent, not because of the marketability of the assets it holds, but because the Board of Governors of the Federal Reserve is an agency of the United States government. That legal covering removes the Federal Reserve Bank of New York from having to submit to an independent audit.

The entire system is a legal fiction — one highly favorable to the largest banks, which can tap into the government for money by way of the Federal Reserve Bank of New York, a private agency.

We have never had an opportunity to test Exter’s theory of gold as a hedge against price deflation, because there has yet to be a single year in which the CPI has fallen.

Exter’s theory of price deflation applies only to the credit markets, not consumer prices. Consumer prices are governed overwhelmingly by the money supply, specifically M1. I have provided the evidence here.

Exter thought his theory applied to the CPI, but he was wrong, given the existence of central banks. The money supply does not shrink merely because capital markets’ various price indexes fall. His theory has to do with the capital markets, not retail consumer markets.

Allow me to explain the difference.


Say that you buy a share of stock at the market price. Let us call the company Madoff, Inc. You buy it for $100. You write a check for $100 to your broker. The $100 goes from your bank account to the broker’s bank account, and most of that money then goes to the bank account of the person who sold you the share.

Then bad news hits regarding your stock. The company has cooked the books. It turns out that the company is an empty shell of debt. The share price immediately falls to zero. You take a 100% loss.

You are a big loser. The person who sold you the share is a big winner: he got out in time.

The money supply has not changed.

What is the effect of the collapse of Madoff, Inc. on consumer prices? Nothing.

Why not? Because the price of Madoff, Inc. was an imputed price based on a few sales. Until the bad news hit, not many people bought or sold Madoff, Inc. There were millions of shares outstanding, but only a few thousand traded on any day. The price at which the latest share traded was imputed by the market to all the others. The money involved was limited to the handful of actual trades.

You lost the $100 on the day you wrote the check. You received an asset that you thought was worth $100, which it was, very briefly. Then it wasn’t.

You say “I lost $100 when the stock fell to zero,” but this is a mistake conceptually. You are applying the loss to the value of the share. You lost your expected future value on the share.

Yes, you lost money. You lost your money on the day you bought the share. You gave up money for a dream. The market value of your dream then collapsed. You did not lose money at that point. You lost it when you wrote the check. What you lost when the stock’s price collapsed was value. You did not lose money. The asset was not money.

The person who sold you the share made money. How? By selling you the share. He made $100. I am not talking about his personal profit or loss on the expected future value of the share. I am talking about money.

The stock market — meaning an index, with all the problems of every index — can go up, based on imputed prices across all shares because of the prices of a few shares being traded. Stocks can go down for the same reason. Investors neither make money nor lose money when their stocks rise or fall. They make psychological profits or losses, but they do not make money.

You make money when you sell. How much money do you make?

Whatever you sell for.

You lose money when you buy. How much money do you lose?

Whatever you buy for.

Don’t confuse money with dreams. Yes, you can spend dreams. How? By persuading people to buy them. But they will pay a broker’s commission. The dreams are not money. You cannot buy anything at Wal-Mart in exchange for one of your dreams.

Neither the deflationist nor the inflationist should regard the movement up or down of a stock market index as unquestionable evidence of either deflation or inflation.

The same is true of a bond market index.

The same is true of a commodity futures market.

All of these markets are markets for dreams. People pay money to buy them. The dream-seller gets the money.

Then what does count, or should count, when economists develop a theory of consumer prices? They should consider only those prices that are related to goods and services that are consumed rapidly. The goods in a supermarket should be counted. Why? Because people’s expectations about the benefits of consuming these goods are confirmed rapidly.

I would tell the statisticians: “Do not look at the loss-leader goods, whose prices are low for one week to lure shoppers into the store. Look at the day-to-day goods with high turnover — the goods that most consumers buy because the products are used up steadily, come rain or come shine.” This is what statisticians do.

For these high-turnover goods and services, money’s purchasing power is relevant. When these goods and services are rising in price, year by year, we know that the money is being debased by the central bank through monetary inflation. That is to say, when any consumer price index is rising, the money is being debased even more.

Why more? Because, in a free market economy, output is increasing most of the time. There are “more goods for money to chase.” A capitalist economy produces falling prices, year by year. Think “computers.” Think “phone calls.” So, if the price index is flat, the central bank is inflating. This means it is debasing the currency. This is what central banks do, year by year, decade by decade. They do not deflate.


Housing prices rose rapidly after 1996 because of the FED’s policies of monetary inflation under Greenspan. After 2000, they soared.

Rents did not soar. They rose, but not nearly so rapidly as housing prices. Keep this in mind.

A house’s price performs more like a stock than like a roll of toilet paper. Prices are imputed to a house. Lenders lend lots of money to buyers to buy a house. Most houses do not sell in any given year. The prices paid for houses are imputed to other houses in the neighborhood.

Who loses money on a house? The lender, who lends the money to a borrower, who signs a series of documents. The lender buys a dream: repayment. But he loses money.

The borrower buys a house with borrowed money. He loses his down payment, if any. He does not lose any additional money. That was what the lender lost.

Part of this house is like toilet paper. It gets used regularly. But most of the house is a dream. “Housing prices never go down. I’ll get rich.” Or “nobody will be able to evict me, because I will pay my mortgage and taxes.”

When housing is bought on the basis of “I’ll get rich,” the market begins to resemble a stock market. When it is bought on the basis of “I can live here for what I can rent,” it is more like the toilet paper market.

The government’s statisticians use an imputed rent to estimate the appropriate number for evaluating the price of shelter. This is the correct procedure conceptually. This is “house as toilet paper,” not “house as an investment.”

When “house as an investment” took over people’s thinking, we got a housing mania. We got house-flipping. We got a cable show called “Flip This House.” We got greed. Now we have fear.

The skyrocketing price of housing under Greenspan was not reflected in the consumer price index. Rents were. This was as it should be.

The collapsing price of housing under Bernanke has not been reflected in the consumer price index. Falling rents have been. This is as it should be.

What went up came down. Housing prices rose rapidly. Rents didn’t. That was why the housing boom under Greenspan was a bubble. He denied that it was a bubble. He was either lying or else he did not understand the economics: specifically, the pricing of capital. The price of a capital asset is based on its expected stream (dream) of income, discounted by a risk factor (default) and the prevailing rate of interest.

“Flip this house” has become “jingle mail”: send the lender the keys and walk away.


Everyone uses indexes. We cannot think without them, even when we make them up, based on our experiences.

If an economist says “there will be rising prices,” his prediction is relevant only in terms of a price index. If he says that “monetary inflation produces price inflation,” he must have two statistical concepts in mind: (1) a definition of money (there are several); (2) a price index (there are several).

When I say “monetary inflation produces price inflation,” I have two indexes in mind: (1) M1; (2) the Median CPI. The Median CPI is published by the Federal Reserve Bank of Cleveland. It is less volatile than the CPI. Most analysts use the CPI.

What interests me most is the trend of the index, not the numerical indicator. Is the trend accelerating or decelerating?

All indexes must be revised from time to time. All indexes are based on what experts think is important in a particular sector of life at a particular time in history. Over time, tastes change, wealth changes, technology changes.

It is not useful to stick with an old index whenever society changes significantly. What indexes from fifth-century B.C. Athens would have retained analytical value from then until now? Life expectancy. Height. Weight. Number of mistresses per husband in a lifetime. These are social indexes, not economic ones. They are indicators of stability more than change.

Think of public health statistics. “Public health” is itself an aggregate. Should officials still include polio statistics? What about statistics on scurvy? You get the point.

Think of the consumer price index. If there had been such a government-funded index in 1900, buggies would have been included. Automobiles would not. Today, there are no buggies in the CPI. People pay no attention to the price of buggies, except for the Amish. Buggies have zero weight in the CPI because they have close-to-zero importance in the economy.

Someone has to decide: (1) items to be sampled, (2) sampling techniques, (3) relevance for each category, (4) relevance for whom? These are issues of representation. There is broad agreement on food, clothing, and shelter. There is less agreement on which kind of food, clothing and shelter.

Some items are removed from an index when they become marginal to the society. This is true of the Dow Jones Industrial Index, too. Time produces changes. These changes mandate alterations in indexes. All indexes.

The fact that there are debates over how an index is created is not a valid argument against all indexes. If it were, then this statement would make no sense: “Monetary inflation produces price inflation, other things remaining equal.”


Exter believed that the debt load in the capital markets will eventually become too great to bear. Borrowers will not be able to make payments to lenders. There will be a wave of selling of these assets. The prices of these assets will fall.

I respond: “Even if this is true, which I doubt, this has nothing to do with consumer prices.”

The U.S. stock market indexes have all fallen, 2000 to 2010. Consumer prices have risen. There is no correlation in economic theory. There has been no correlation in practice.

The move up or down in the imputed price of a capital asset does not affect the money supply. Causation is the other way around. The money supply affects the imputed price of the asset, but so do the business cycle, the rate of interest, and people’s expectations.

The money supply affects consumer prices, meaning an index compiled through samples of specific prices of consumer goods and services, assembled through a theory of the proper weighing of these sample prices.

Exter’s logic would be valid if the collapse of asset prices led to bankruptcies of banks. These collapsing banks would take digital money with them, but only on this assumption: the central bank does not intervene to save the banks with a huge increase of money. It also must assume that the government does not intervene to provide money for these banks.

Exter’s theory does not hold up if the central bank can create new base money by purchasing assets, thereby injecting new money into the economy. If the central bank creates reserves, and if the commercial banks lend all that these reserves allow them to lend, the money supply will not change much.

If the commercial banks do not create money by lending it, but instead hold it at the FED as excess reserves, the FED can start charging a fee to hold excess reserves. The commercial banks will withdraw the money and lend it. It will then flow into the economy. Result: monetary inflation, then price inflation.

In a financial meltdown, the people holding the money will change. The amount of money held in individual bank accounts and in currency in individual wallets will not change. Neither will the price of toilet paper — no matter what hits the fan in the capital markets. This was demonstrated in 2008. Consumer prices did not fall. That was because the money supply did not fall.

Exter, a Citibank banker, did not understand big banking. Exter, the designer of the Bank of Ceylon, did not understand how central banks work. He offered a theory of falling asset prices that had nothing to do with falling consumer prices. It has never come true. It will not come true. The theory is wrong.

The fact that a rich person put his money with Bernie Madoff did not affect the money supply or consumer prices in general. He is still buying toilet paper. So is any person who got some of the money that Bernie spent.

The people who wound up with Bernie’s investors’ money did not go to jail. Bernie went to jail.

Exter was hypnotized by what I call “Madoff economics.” He never figured out that the Madoffs of the world are only middlemen for money, not the creators of money. Madoff’s corruption had no effect on most of the public — only on the schlemiels who let him invest their money. They lost their money the day they turned it over to him. They bought dreams with their money. The dreams are gone. The money isn’t.

The deflationists point to the dream indexes and say, “They cannot survive. They will crash.” They probably will, but that will not affect the price of toilet paper.


John Exter’s theory of inevitable falling asset prices as the trigger that creates widespread price deflation does not make sense in a world of central banking and massive government deficits. As long as the money supply does not shrink, there will be no mass deflation, let alone hyperdeflation.

The money supply will not shrink in any country unless the government and the central bank jointly pull back and refuse to bail out the banks, either by redefining what constitutes solvency or by creating more fiat money.

Keep your eye on the money statistics. The rest is irrelevant. I post them here: Federal Reserve Charts.

January 9, 2010

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 © 2010 Gary North