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  • by Gary Judd QC

Deflation is good: trying to defeat it has serious drawbacks with potential for danger

[Published in Cuffelinks, October 19, 2016]

Deflation’s evil has become an established fact. I contend the truth is exactly the opposite — price deflation is good and price inflation is bad. What’s more the tools used to defeat deflation and promote inflation are potentially dangerous.

The principle involved is simple. It can be seen from the following imaginary construction.

Assume the money supply available as media of exchange is $100 and goods and services comprise only 100 apples. On average the price of each apple has to be $1. Double the supply of apples and the average price has to be $0.50. Halve the supply of apples and the average price has to be $2.

Keep the apple numbers constant but double the quantity of money to $200. The average price has to go up to $2.

The imaginary construction can be extrapolated to encompass the total quantity of money and the total output of goods and services. Although the price movements will not be uniform, the general principle applies.

Goods and services include everything which may be exchanged for money or for which money may be exchanged. Shares and other securities are included. Land is included. Artworks are included. And so on.

Money is only a medium of exchange. It is what facilitates the exchange of goods and services. In the past it may have had some value as a commodity also, but today it is pieces of paper and electronic entries, with no other use. The ‘value’ of a ‘piece of money’ is no more and no less than that for which it may be exchanged.

Increased output of goods and services increases human prosperity. Constancy in the quantity of money requires prices to decrease with the increased output. Putting new money into the system retards price deflation and encourages price inflation.

Putting new money into the system to encourage price increases does not encourage consumption. It has the reverse effect until the new money is reflected in consumers’ incomes as well as in prices. In the intervening period those who must pay higher prices must consume less and the demand for consumers’ goods and services is decreased. (Of course, after time has passed and most consumers have been able to get higher incomes, there are still some who don’t get the higher incomes and are permanently prejudiced.)

Once the new money has been reflected in consumers’ incomes an equilibrium is restored but on a higher plateau where both prices and incomes are at a higher level than previously.

Nor does consumption come before production. It is self-evident that nothing can be consumed before it is produced.

In a free market prices are set by voluntary transactions between willing sellers and willing buyers: buyers don’t have to buy unless they want to; sellers don’t have to sell unless they want to. What encourages production is the actions of profit-seeking business people wanting to produce more and better goods and services to persuade consumers to buy their goods and services rather than someone else’s. Increasing prices risks deterring consumers from buying their products and encouraging competitors to tap into the same consumer market — so any sensible business will only increase prices if that is judged to be possible without decreasing profit through losing market share.

Bear in mind that producers are also consumers of the goods and services they need for their production purposes. So when we talk of price deflation, it is not just price reductions for the end consumers, but also for the producers to the extent that they are consumers. Deflation, a general reduction in prices, benefits end consumers. It is particularly beneficial to those on fixed incomes who are not or are no longer wealth creators and rely on the wealth they have already accumulated. Retirees are the prime example. Deflation generally benefits poorer people too. Policies which increase prices attack the well-being of these groups.

Deflation is good not just as an intrinsic good because lower prices are good for consumers but also because it is a symptom of increased output of goods and services. The more goods and services available for mankind, the better off mankind is.

Smarter and better methods of production may result in increased output of goods and services. Henry Ford utilised mass production — cars which previously had been available only to the very wealthy because they cost so much to make became universally available. A good example today is the mobile phone which not too long ago was an expensive ‘brick’ available only to the well off. Today it is ubiquitous, affordable even in developing countries — with features which previously would have been unbelievable such as the means to transfer money from workers in the cities to their impoverished rural relatives.

Increasing the output of goods and services tends to push prices down. Increasing the quantity of money tends to push prices up.

New money provides incentives for business people to spend up large on malinvestment or to get into businesses they shouldn’t be in — and then be the first to go broke when harder times arrive. It creates incentives for ordinary people to put their savings (and also borrowings) in places where the increase in the money supply artificially increases the price of the assets — who get burned when those assets decrease in value. It encourages consumers to use the new money (usually received in the form of increased borrowings) to buy things they really can’t afford including houses.

These consequences are all detrimental to human welfare.

It is an immutable law that causes have effects. If effects are detrimental, the rational approach is to remove the causes. Repeating them is irrational. Yet policies designed to increase the amount of money available for the acquisition of goods and services are continuing to be implemented.

Increasing the supply of money by low interest rates forced upon the system by the central banks was the fundamental cause of the GFC. Other factors determined where and how the effects were felt.

Repetition of the causes of the GFC may have had an initial palliative effect, but administering the same medicine will probably be impossible next time because, as the Bank for International Settlements (often described as the central bank of central banks) pointed out in its June 2015 Annual Report, there is no more room to move. See the links for a Daily Telegraph article about the report and the report itself.

Trying new ideas such as negative interest rates are acts of desperation.

One consequence of negative interest rates will be a reluctance to have money on deposit. A rational response to the need to pay your bank to hold your money is to take your money away from the bank. An obvious way for the authorities to deter that from happening is to get rid of cash.

Some say we are already being softened up for that by being told that cash facilitates criminal activity. See linked opinion piece from University of Tennessee law professor Glenn Harlan Reynolds published in USA Today on 29 February last.

Two ways in which the quantity of money may be increased are so-called quantitative easing and through the operation of the banking system.

Whilst quantitative easing is today’s description of the government’s putting more money into circulation, it is not a new phenomenon but has been going on in its present form since the creation of central banks. This is touched on by Professor Reynolds in his USA Today opinion piece.

Then there is the money created through the banking system. Banks making loans create new money. Amongst other places, this is explained in a 2014 article in the Bank of England quarterly bulletin by three Bank of England economists entitled “Money Creation in the Modern Economy”.

Money created in this way can also be destroyed. Benignly by borrowers repaying their loans (which leaves more available for further lending without increasing the money in the system). Often catastrophically when loans go bad as may occur when (amongst other things) the central bank increases interest rates following a period of low interest rates. When this happens the money destroyed may not be able to be replaced by new lending so the amount of money in the system decreases. This was the proximate cause of the GFC — the increases precipitated defaults at that time rather than later.

It also produced recessionary conditions, leading to what some have called the great recession which has persisted in the US — at least until very recently — and continues in Europe and elsewhere.

If the market is allowed to function without obstruction by government interventions the banking system’s creation and benign destruction of money serves an important market function. It acts like a shock absorber evening out demands for and supply of money. Over the whole of an economy and over time a state of equilibrium tends to prevail.

A free market in banking would work to prevent the damage caused by loans going bad. Banking is a confidence business. If they wish to continue in business banks must retain confidence of the public. If there is no government intervention banks which overreach themselves will lose business and in the worst case they will fail. Whilst even in a free market in banking there would still be occasional failures, government interventions have made them almost inevitable (unless the government bails out the failing bank). If they know they will have to take the consequences, banks’ management, directors and shareholders will act to preserve their businesses.

There are three main government interventions. First, bailing out banks which have got into trouble.

Secondly, controlling interest rates, thereby substituting the command of the central bank for what would otherwise be market derived rates.

Thirdly, banking regulation. Controls breed controls. One intervention leads to another, thence to another, and so on. They stop the market functioning properly. They deter bank managers and directors from exercising and taking responsibility and in many cases create perverse incentives to act in damaging ways.

Everyone who takes a close interest in these matters knows that the present aim of government monetary authorities is to get banks to lend more. When more money is pumped into the system by banks lending more, this has the same effect as quantitative easing. It increases the general level of prices (remembering once again that goods and services includes everything for which money may be exchanged, and that prices are also costs of production).

Money created through the banking system will result in prices and incomes reaching a new equilibrium on a higher plateau. This effect comes with the additional danger, already referred to, of money created through the banking system being destroyed. The GFC, still fresh in most minds, shows what happens. It may result in the bailing out intervention (generally financed by freshly minted money). The fear of the need for bailings-out leads to more regulation.

On the one hand, we see the central banks intervening to try to get banks to lend more by pushing interest rates lower. But more lending increases the risk of imprudence, potential losses, failures and bail-outs. More regulation is seen to be the solution for this.

Encouraged by the low interest rates business people, investors and consumers are incentivised to take risks which they wouldn’t otherwise take. The GFC has so recently shown what this sort of behaviour by banks and their customers leads to.

What can be done? Number 1: find a way to ensure constancy in the quantity of money and to prevent its supply being manipulated. Number 2 (which is really part of Number 1): if ever worsening crises are to be avoided, stop repeating the causes.

These measures would allow a natural downward progression in prices as the output of goods and services increases in quantity and quality. This is the solution to a whole raft of problems. To name just two. One is the welfare of ageing populations who are then able to be more easily supported by fewer workers. Another is the amelioration of the impact on people who lose jobs or have to move to lower paying work as a result of the technological innovation which has brought about the increased output and quality of goods and services.

As Cuffelinks is an investments newsletter it is worth concluding with an incidental observation. In the environment of central banks trying to set interest rates and undertaking other money creation activities such as QE, investment advisers and analysts must endeavour to predict the actions of central banks — what’s going to be done at the next review is the overwhelming consideration. It was aptly expressed by Tony Sagami in “Connecting the Dots”.

In the “good old” days, investment professionals used to focus on boring numbers like days sales outstanding, operating margins, cost of goods sold, accounts payable, and paid in capital.

Today, however, what passes for analysis is the dissection of every syllable that comes out of Janet Yellen and Mario Draghi’s mouth. I never thought I’d see the day on Wall Street when linguistics was more important than things like revenues and profits.

However, if you’ve been around long enough, you know that fundamentals do matter and that the current rally based on monetary steroids is doomed to fail. In fact, the warning signs are really starting to pile up.

With a similar thrust, a Reuters report:

Janet Yellen, head of the Federal Reserve, has said economic data will guide interest-rate decisions, but policymakers and their staffs are dismissing large amounts of information as unreliable. Growing doubt about GDP and inflation data within the central bank creates difficulty for businesses and investors to predict the Fed's next step.

That’s just one example of comments with which I am sure readers will be well familiar.

In Julius Caesar, Caesar also had a problem deciding what to do. Shakespeare can have the last word.

CAESAR Cowards die many times before their deaths. The valiant never taste of death but once. Of all the wonders that I yet have heard, It seems to me most strange that men should fear, Seeing that death, a necessary end, Will come when it will come.

The SERVANT enters.      What say the augurers? What do the priests say? 40 SERVANT They would not have you to stir forth today. Plucking the entrails of an offering forth, They could not find a heart within the beast.

Gary Judd QC, a Queens Counsel since 1995, was Chairman of New Zealand’s ASB Bank from 1988 and its associate life assurance company Sovereign from 1998, until he retired from ASB in 2011. He was a prime ministerial appointee to the Apec Business Advisory Council (ABAC) 2009-2012 where he became a co-chair of ABAC’s Advisory Group on APEC Financial System Capacity-Building. He presented around the Asia-Pacific at many seminars and dialogues aimed at improving access to banking, financial and investment services, and understanding between the private and public sectors including as a presenter and panellist at a training program for mid to senior level policymakers and regulators from 15 Asia-Pacific countries. Now without professional involvement he brings a perspective informed by studying the problems with the benefit of his practical experience.

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