Is Deflation the Enemy, or Is It Inflation?

Like all Keynesian True Believers, Paul Krugman believes that the worst enemy of the economy is deflation. In his view, deflation causes unemployment and inflation reduces it, and he repeats that canard in this recent column.

Not surprisingly, Krugman claims that unless the Fed under Ben Bernanke engages in massive new money creation (and, of course, spending), the economy is doomed:

Today, Mr. Bernanke is the Fed’s chairman — and his 2002 speech reads like famous last words. We aren’t literally suffering deflation (yet). But inflation is far below the Fed’s preferred rate of 1.7 to 2 percent, and trending steadily lower; it’s a good bet that by some measures we’ll be seeing deflation by sometime next year. Meanwhile, we already have painfully slow growth, very high joblessness, and intractable financial problems. And what is the Fed’s response? It’s debating — with ponderous slowness — whether maybe, possibly, it should consider trying to do something about the situation, one of these days.

The Fed’s fecklessness is, to be sure, not unique. It has been astonishing and infuriating, as the economic crisis has unfolded, to watch America’s political class defining normalcy down. As recently as two years ago, anyone predicting the current state of affairs (not only is unemployment disastrously high, but most forecasts say that it will stay very high for years) would have been dismissed as a crazy alarmist. Now that the nightmare has become reality, however — and yes, it is a nightmare for millions of Americans — Washington seems to feel absolutely no sense of urgency. Are hopes being destroyed, small businesses being driven into bankruptcy, lives being blighted? Never mind, let’s talk about the evils of budget deficits.

In response, I will include material from Murray N. Rothbard's America's Great Depression, a recent article by Robert Higgs, and something I wrote for the Mises Institute two years ago. First, we look at what Rothbard has to say regarding deflation:

With the supply of money falling, and the demand for money increasing, generally falling prices are a consequent feature of most depressions. A general price fall, however, is caused by the secondary, rather than by the inherent, features of depressions. Almost all economists, even those who see that the depression adjustment process should be permitted to function unhampered, take a very gloomy view of the secondary deflation and price fall, and assert that they unnecessarily aggravate the severity of depressions. This view, however, is incorrect. These processes not only do not aggravate the depression, they have positively beneficial effects.

There is, for example, no warrant whatever for the common hostility toward "hoarding." There is no criterion, first of all, to define "hoarding"; the charge inevitably boils down to mean that A thinks that B is keeping more cash balances than A deems appropriate for B. Certainly there is no objective criterion to decide when an increase in cash balance becomes a "hoard." Second, we have seen that the demand for money increases as a result of certain needs and values of the people; in a depression, fears of business liquidation and expectations of price declines particularly spur this rise. By what standards can these valuations be called "illegitimate"? A general price fall is the way that an increase in the demand for money can be satisfied; for lower prices mean that the same total cash balances have greater effectiveness, greater "real" command over goods and services. In short, the desire for increased real cash balances has now been satisfied.

Furthermore, the demand for money will decline again as soon as the liquidation and adjustment processes are finished. For the completion of liquidation removes the uncertainties of impending bankruptcy and ends the borrowers' scramble for cash. A rapid unhampered fall in prices, both in general (adjusting to the changed money-relation), and particularly in goods of higher orders (adjusting to the malinvestments of the boom) will speedily end the realignment processes and remove expectations of further declines. Thus, the sooner the various adjustments, primary and secondary, are carried out, the sooner will the demand for money fall once again. This, of course, is just one part of the general economic "return to normal."

In other words, Rothbard says that deflation will help the adjustment process in which the economic fundamentals get back into balance. Given that Krugman operates on the theory that all assets are homogeneous, he is incapable of understanding anything else.

Prof. Higgs notes this about Keynesians and inflation and deflation:

With their great, simple faith in the efficacy of government spending as a macroeconomic balance wheel, vulgar Keynesians disregard malinvestment, past and future, and support government spending in excess of the government’s revenues, the difference being covered by borrowing. Of course, they favor central-bank actions to make such borrowing cheaper for the government. In fact, they chronically prefer “easy money” to more restrictive central-bank policies. As noted previously, they prefer easy money not only because it lowers the cost of financing the government’s deficit spending, but also because it induces individuals to borrow more money and spend it for consumption goods ― such increased consumption spending being viewed as always a good thing, notwithstanding the recent near-zero rate of saving by individuals in the United States. Reflecting on the vulgar Keynesian attitude toward Fed policy, I keep recalling a old country song whose refrain was: “older whiskey, faster horses, younger women, more money.”

Vulgar Keynesians do not spend much time worrying about potential inflation; on the contrary, they are obsessed with an irrational fear of even the slightest hint of deflation. If inflation should become an undeniable problem, we may count on them to support price controls, which, they are convinced on the basis of sketchy knowledge of such controls during World War II, can be made to work well.

In this article, I noted that the current crisis came about because of the Fed's reckless money creation, so it certainly is NOT possible that the Fed can SOLVE the problem with more inflation:

The central issue is that the Fed pushed a policy of inflation, with much of the new money going into the mortgage markets; there is no way to avoid the painful and terrible corrections that must follow such fiscal foolishness. (Now we finally see massive commodity-price increases, which have occurred because there is nowhere for the new money to go but directly into commodities and consumer goods.)

Anyone who believes that the Fed can pretend that heavily damaged mortgage securities are worth more than toilet paper and literally build a $200 billion loan portfolio upon them does not understand finance. Just because Ben Bernanke declares something to be "valuable" does not bestow value upon it.

The simple issue is not lack of liquidity. It is the fact that billions — make that trillions — of dollars were malinvested in markets where the increasing values could not be sustained. To pump near-worthless dollars into this mix does not solve anything; it only ensures that the coming day of reckoning will be even more unpleasant than it would have been otherwise.

So, if the Fed follows Krugman's demands, we can look forward to even more secondary contractions and more malinvestments. The "day of reckoning" won't arrive all at once; it will become a permanent part of our economic landscape.