What Causes Deflation? Is Deflation Likely to Occur?

February 2, 2016 – The Money Enigma

deflation

Over the past few years, the word “deflation” has become as popular as the word “inflation” in discussions of financial market risk. But does deflation really represent a risk to the world economy at this time?

The view of The Money Enigma is that inflation poses a much greater risk to the global economy than deflation at this point in time. While severe deflation is a real possibility under a gold standard, such as existed in the 1930s, the fact is that severe deflation is an unlikely outcome under a fiat money regime.

In order to understand why this is the case, we will attempt to answer a few basic questions about deflation.

First, what are the primary causes of deflation? Second, why is deflation more likely to occur under a gold standard than it is under a fiat money regime? Third, what factors are likely to prevent an outbreak of severe deflation across Western economies over the next few years?

Deflation: Why Do Prices Fall?

Let’s begin with some basic microeconomics.

Every price is a relative expression of market value. More specifically, a price measures the market value of one good in terms of the market value of another good. Therefore, at the most basic level, a price can fall for one of two reasons: either, (a) the market value of the first good falls, or (b) the market value of the second good rises.

Think about this in simple terms. Imagine you live in a barter economy with no money and two goods, apples and bananas.

If one apple is three times more valuable than one banana, what is the price of apples in banana terms? Clearly, it is three bananas. If the market value of an apple is three times the market value of one banana, then you will have to offer three bananas in order to buy one apple. The ratio of exchange, bananas for apples, is three to one. Hence the price of apples in banana terms is three.

Now, why might the price of apples, as measured in banana terms, fall?

Well, there are two possible reasons.

First, apples may become less valuable. If apples become less valuable, then it will require fewer bananas to purchase an apple and the price of apples in banana terms will fall.

This much is obvious. What is less obvious is that the price of apples may fall for a second and just as important reason: bananas may become more valuable.

If bananas become more valuable, then it will require fewer bananas to purchase an apple. For example, if there is a sudden shortage of bananas, then we might find that apples and bananas are now of equal value. What happens to the price of apples? It falls. If bananas become more valuable such that one banana and one apple are now of equal value, then the price of apples will fall from three bananas to one banana!

Price as Ratio of Two Market Values

In summary, the basic microeconomic principle is that in any exchange of two goods, the price of the transaction depends upon the market value of both the primary good (in this case apples) and the measurement good (in this case, bananas).

Now, let’s apply this principle to a modern money-based economy.

The price of a good, in money terms, depends upon both the market value of the good itself and the market value of money.

Price and the Value of Money

 

Therefore, in a money-based economy, the price of a good will fall if either, (a) the value of the good itself falls, or (b) the value of money rises.

Let’s think about point (b) for a moment. The price of an apple in money terms depends upon both the value of apples and the value of money. Let’s imagine that today an apple is twice as valuable as a dollar. What is the price of apples? The answer is two dollars.

Now, what happens if, all else remaining equal, money becomes more valuable? For example, one year later the value of a dollar, as measured in absolute terms, has doubled while the value of an apple has remained the same. What is the new price of apples? The answer is one dollar. One dollar is now just as valuable as one apple.

In this example, the price of apples falls, not because apples became less valuable in an absolute sense, but because apples became less valuable in a relative sense, i.e. relative to the value of money.

The key point is that, at a microeconomic level, the price of a good can fall for one of two different reasons: either, (a) the market value of the good falls, or (b) the market value of money rises. Readers who are unclear on this point are encouraged to read “The Measurement of Market Value: Absolute, Relative and Real” and “A New Economic Theory of Price Determination”.

Moreover, we can extend this microeconomic concept to a macroeconomic discussion of deflation.

In simple terms, falling prices across the economy can be caused either by (1) a fall in the market value of goods and services, or (2) a rise in the market value of money.

Ratio Theory of the Price Level

Once again, the first part of that statement is rather obvious. If there were a sudden collapse in aggregate demand, then you would expect good and services to become “less valuable”. In the diagram below, a sudden shift to the left in the aggregate demand curve will lead to a fall in the overall market value of goods (denoted “VG).

Goods Money Framework

However, what most economists and market commentators fail to do is to think about the implications of a weak economy on the right hand side of the diagram immediately above. While a weak economy will almost certainly lead to a fall in the market value of goods (VG falls), a weak economy could also lead to fall in demand for money leading to a lower market vale of money (denoted “VM). Importantly, if the value of money VM falls more than the value of goods VG, then the ultimate outcome is not deflation but inflation!

Deflation: Gold Standard versus Fiat Money Regimes

The problem with most “inflation or deflation” debates is that the participants don’t recognize the simple notion that price is a relative expression of market value.

Any meaningful discussion of deflation must consider not only the forces acting upon the market value of goods (oil price, output gap, etc.), but also the forces acting upon the market value of money (expectations regarding future output growth and base money growth).

More specifically, any genuine discussion regarding the prospect for deflation needs to recognize that while deflation is a real possibility under monetary systems based on the gold standard, widespread and persistent deflation represents a very unlikely event under most fiat money regimes.

Nowhere is this better illustrated than in a comparison of inflationary outcomes in the United States in the early 1930s and the late 1970s.

While economists may debate the exact circumstances surrounding these two different periods, the fact is that both periods where characterized by severe economic weakness, falling economic confidence and rising rates of unemployment. Yet the inflationary outcomes in both periods were vastly different: in the 1930s, prices collapsed; in the 1970s, prices soared.

While many economists may attempt to blame rising prices in the 1970s on OPEC and the oil shock, the view of The Money Enigma is that these two different periods experienced two very different outcomes primarily because of the different nature of the monetary regimes that existed at that time.

In the 1930s, the United States operated on a gold standard. The value of each US Dollar was fixed to a certain amount of gold. In effect, this meant that the market value of each US Dollar was tied to the market value of gold: if the value of gold rose, then the value of the Dollar rose.

In the early 1930s, the “perfect storm” for deflation occurred. First, there was a sudden collapse in aggregate demand, a collapse that was triggered by the excesses of the 1920s. This collapse in aggregate demand led, as one would expect, to a massive decline in the market value of goods and services generally.

In itself, this event was highly deflationary. However, another important factor was in play at that time. As the financial system became increasingly unstable, demand for gold rose: as the market value of gold rose, the market value of the US Dollar also rose! Why? The market value of money rose because the value of money was directly tied to the value of gold.

Now, think about this in the context of our earlier discussion. If the price level is a relative measure of the market value of goods and the market value of money, then what creates the “perfect storm” for deflation? A collapse in the value of goods and a surge in the value of money!

Ratio Theory of the Price Level

In the early 1930s, the gold standard created the perfect set up for a collapse in prices. First, aggregate demand collapsed, leading to a fall in the market value of goods (VG falls). Second, demand for gold rose due to financial instability, leading to a rise in the market value of gold and a commensurate rise in the market value of money (VM rises). The value of goods, as measured in money terms collapsed, and the US economy entered a period of severe deflation.

Now, let’s contrast this with what happened in the late 1970s.

In the 1970s, the US economy experienced both an aggregate demand and aggregate supply shock. In terms of our Goods-Money Framework, the aggregate demand and aggregate supply curves both shifted to the left. The net impact on the market value of goods VG was probably a modest rise.

However, the view of The Money Enigma is that the modest rise in the market value of goods during the 1970s can not fully explain the high levels of inflation that were experienced during that time. Rather, some other factor was at play: a fall in the market value of money VM.

Why did the value of money fall in the 1970s? Well, in 1971, President Nixon ended the convertibility of gold into dollars. Suddenly, the value of the US Dollar was no longer tied to the value of gold and the value of the US Dollar began to decline sharply. As economic confidence in the long-term prospects of the United States declined, the US Dollar began to loss value.

The key point is that in the 1970s, under a fiat regime, economic weakness led to a decline in long-term economic confidence and a decline in the value of money. In contrast, in the 1930s, under a gold standard, economic weakness actually led to a rise in the value of money because the value of money was tied to the value of gold.

This difference explains, more than any other factor, why high levels of inflation plagued the 1970s, while the 1930s experienced severe deflation.

In summary, in order to have a sensible discussion regarding the risk of deflation, we must consider not only the obvious impact of a fall in aggregate demand upon the value of goods, but the nature of the prevailing monetary regime and how economic weakness may impact the value of money under that regime.

The Likelihood of Deflation in 2016 and Beyond

While many market commentators are obsessed by the possibility of deflation, the fact of the matter is that a prolonged period of deflation is a very unlikely under the current fiat money regime that exists in the United States.

As we look ahead into first half of 2016, there is little doubt that economic weakness, most notably a slowing of growth in China and a fall in oil prices, will contribute to a decline in the market value of goods. However, these factors are unlikely to be sufficient to drive a severe decline in prices in the United States.

A prolonged and/or severe period of deflation requires another key factor that is unlikely to occur over the next few years: a rise in the value of money.

As discussed above, one of the primary drivers of the deflation that occurred in the 1930s was a rise in the value of money. In the early 1930s, the value of money was tied to the value of gold. The financial instability of the early 1930s drove up the value of gold and, consequently, the value of money, creating a perfect storm for deflation.

This outcome is very unlikely to occur over the next few years. Indeed, the view of The Money Enigma is that we are much more likely to experience the exact opposite of this, i.e. the US will experience a rapid decline in the value of money and a surge in prices.

The key difference between the 1930s and today is this: in the 1930s, the value of money was tied to the value of gold; today, under the existing fiat money regime, the value of money is directly linked to confidence in the long-term economic future of society.

Over the past few years, the US Dollar has been riding high on optimism regarding the long-term economic outlook for the United States. In essence, most people are optimistic regarding the 30-year economic outlook for the United States, despite the structural weaknesses that were exposed in the 2008 financial crisis and the government credit rating crisis in mid-2011.

However, recent events suggest that optimism in regards to the long-term economic outlook may have peaked. More specifically, the beginning of monetary policy “normalization” by the Federal Reserve has already disturbed the financial markets, despite the fact that this first move by the Fed represents at best what might be described as a “baby step”.

As the Fed continues on its current path, it is almost inevitable that economic disruption will occur and the markets will begin to question the long-term future of the United States. If confidence in the long-term future of the US is damaged, then the value of the US Dollar could decline sharply and prices, as expressed in USD terms, could rise suddenly.

Why is the value of fiat money tied to confidence in the long-term future of society? In essence, the view of The Money Enigma is that fiat money represents a proportional claim on the future output of society. As long-term confidence weakens, a proportional claim on the long-term future output of society becomes less valuable.

Readers who are interested in this general concept should read the “Theory of Money” section of the website and/or a recent post titled “What Factors Influence the Value of Fiat Money?”

Under a fiat money regime, a period of global economic weakness is a necessary, but not sufficient, condition to generate deflation. Therefore, a prolonged period of deflation in the United States is unlikely over the next few years. Rather, it is much more likely that the US Dollar will decline in value over the next few years, at least as measured in absolute terms, and that inflation in the United States will accelerate.