The Myth of Price Stability

The Myth of Price Stability

There is a myth in mainstream economics that stable prices are necessary for the economy. The idea of price stability became popular in the 1920s, during a period known as the Roaring Twenties. In this article, I take a closer look at the myth of price stability, as well as its origins and reasoning among mainstream economists. Finally, I explain why stable prices are a subtle way of stealing purchasing power from the general public.

Table of Contents

Understanding Inflation and Deflation

The idea of stable prices has its roots in commodity money. For a large part of human history silver and gold were money. This is because silver and gold have a high stock-to-flow ratio.

This means the amount of new gold or silver that can be created compared to their existing stock is low. As a result, gold and silver are relatively scarce commodities, which is one of the attributes that makes them suitable as monies. Human beings cannot arbitrarily create more gold or silver. To do so requires immense effort, improved technology or new discoveries of gold and silver reserves.

When the productivity of the economy as a whole grows at a faster rate than the money supply, prices tend to decrease. In other words, when productivity accelerates we can produce goods and services more efficiently. When the supply of goods and services grows faster than the supply of money, the general price level falls.

On the other hand when the supply of goods and services grows slower than the supply of money, the general price level will increase.

This is due to supply and demand. When more money chases the same number of goods and services there is dis-equilibrium. In order to bring supply and demand back into equilibrium, the price level has to adjust upward.

Deflation in Monetary History

When the world was on a silver or gold standard there were often brief periods of deflation.

Deflation is another way of saying that the general price level is falling. In some cases these periods of deflation happened during times of economic depression. For example, during the Great Depression the general price level dropped dramatically, which was accompanied by a severe economic crisis.

The same coexistence of deflation and economic depression cannot be observed during most other economic crises. A majority of economic depressions in the last 100 years did not coincide with deflation or vice versa, a study by the National Bureau of Economic Research concluded.

Empirically speaking, the link between deflation and economic depression is shaky at best and nonexistent at worst. Nevertheless, the occurrence of occasional periods of deflation and the fear that this may be the cause of economic depressions gave rise to a wide range of theories that called for price stability.

The Great Depression and Price Stability

Given that these theories mostly became prominent during the Roaring Twenties, it isn’t a surprise that the Great Depression further cemented the idea that price stability is necessary to avoid economic depressions.

The Great Depression of the 1930s seems to have confirmed the theory that deflation and economic depressions or interlinked. And this gave a big push to the Keynesian doctrine.

Ever since the Great Depression, Keynesianism became the predominant economic theory and Keynes rose up to become the most influential economist of our time.

A lot of people are misguided by the fact that there wasn’t a lot of price inflation during the 1920s. This led many economists to believe that there was no inflation prior to the Great Depression. But the truth is that the money supply expanded significantly in the 1920s. While there was no price inflation, there was certainly a great deal of monetary inflation. But this was offset by deflationary forces such as increased productivity.

Price Stability and Monetary Inflation in the 1920s

In this sense the Federal Reserve succeeded at maintaining a stable price level during the 1920s. Although there were some mildly deflationary periods during this time, the price level remained stable on average.

But the monetary inflation, which led to artificially low interest rates, distorted the economy. The artificially low interest rates and the increased money supply led to investors misallocating capital. At least this is how the Austrian business cycle theory explains the Great Depression.

The inflationary monetary policy of the Federal Reserve and other central banks around the world, such as the Bank of England, caused an artificial boom during the 1920s. Once the economy and the stock market began overheating, the Federal Reserve began tightening its monetary policy.

This led to the subsequent crash. Credit began deleveraging, the stock market plummeted, house prices fell and the bust spiraled into a full-fledged economic depression.

Did Deflation Cause the Great Depression?

The cause of the great depression was not deflation but the broad misallocation of capital during the artificial boom that took place during the 1920s as a result of inflationary monetary policy and low interest rates. In this particular instance, deflation was only a symptom but not the cause of the depression.

Despite this there is a widespread myth in mainstream economics that central banks must pursue stable prices and prevent deflation at all costs.

But what is so bad about prices dropping? We experienced deflation in different industries all the time, especially in technology. Due to the incredibly fast accelerating productivity in the technology sector, prices of tech products tend to decrease every year.

The first satellite phone was incredibly expensive and could barely do anything. Today, our smart phones can do exponentially more but cost exponentially less. The same is the case with televisions, computers and other technologies. They tend to become cheaper over time.

Deflation As Re-Distributor of Higher Productivity

Why is that the case? It’s because the higher productivity caused by technology is distributed to every member of society through the mechanism of lower price levels. In this case, the price level distributes economic productivity so that all market participants can enjoy the fruits of the higher productivity.

When prices decrease our purchasing power relative to goods and services increases. This means our wealth, or in other words or ability to consume goods and services increases.

This means decreasing prices raises our wealth by distributing the fruits of higher productivity to all participants in the economy. This type of technological deflation is natural and happens to a lesser extent in other industries as well. But the naturally occurring deflation in other industries is offset by monetary inflation that accelerates at a faster rate.

Price Stability Makes People Poorer and Robs Their Wealth Over Time

The prices of houses, clothes and other goods would be gradually dropping over time as our productivity increases.

But since the money supply expands faster than the increase in productivity in these non-technological industries, we do not experience or benefit from this natural deflation. Instead, prices tend to increase mildly year-over-year. This is known as price inflation.

As you can see, deflationary forces and inflationary forces are constantly pulling in opposite directions.

So why do countries pursue the macroeconomic goal of stable prices? The answer to this question has to do with credit.

Price Stability and Credit

Our current financial system and the economy at large is based on fractional reserve banking and credit. Our economy is credit-based and not savings-based.

In a credit-based economy, like the one we currently live in, deflation can have detrimental effects. Inflation tends to punish those that save money and reward those that take on debt. Deflation, on the other hand, rewards those that save money and punishes those that take on debt.

When you take out a loan or borrow money and the purchasing power of your money decreases, you can pay back the loan with money that is worth less. This takes pressure off the borrower because the debt is gradually “inflated away”. Since governments are the biggest borrowers in the world and have the largest deficits, they heavily rely on inflation to lessen their debt burden and inflate away their immense debts.

When there is deflation and the purchasing power of money increases, this hurts borrowers. Anyone that is highly leveraged and has taken on a lot of debt will be under more pressure because the debt load grows.

Natural Deflation and Credit-Based Economies Are Incompatible

Deflation is bad for farmers that borrowed money to purchase farms. It’s bad for homeowners that have taken on huge mortgages to buy homes and apartments. But it’s especially bad for governments that rely on massive amounts of debt to finance government spending.

When there is deflation, all the credit in the system begins unwinding and deleveraging. Apart from increasing the debt load, it also leads to higher interest rates. When the price of debt or in other words the price of credit instruments such as bonds decreases, it means that interest rates go up.

This is simply due to how bonds work. Falling bond prices automatically lead to higher bond coupon rates. When credit starts to deflate interest rates go up, which can bankrupt individuals, corporations and governments.

Let’s say for example that government bond interest rates increase from 2% to 6%. This would mean that governments have to pay three times more money every year just to finance the debt and make interest payments. If interest rates get too high this can lead to a debt death spiral.

Why Deflation Is the Enemy

This is why mainstream economists, central bankers and governments fear deflation.

It’s not because deflation is inherently bad. It’s because in a credit-based system, where borrowing is preferred to saving, the natural distribution of the fruits of higher productivity to all participants in the economy through the mechanism of falling price levels cannot occur.

To keep our credit-based economy afloat, central banks aim for mild inflation. The inflation target is usually 2% year-over-year. This is enough to disincentivize saving and encourage borrowing while simultaneously inflating away government debt.

The problem is when central banks and governments have full control over the money supply, such as in a fiat standard, inflation can quickly get out of hand. When there is no fiscal discipline and governments spend more than they can afford and take in through taxes, they resort to inflation as a source of revenue.

Debunking the Construct of “Stable Prices”

Price stability is an economic construct that’s necessary for a credit-based, highly-leveraged economy to survive. In reality, when economists talk about priced stability today, they really mean mild inflation.

No inflation at all wouldn’t be beneficial for governments because they couldn’t benefit from this “hidden tax” and inflate away government debt.

But when central banks aim for 2% year-over-year inflation, it is the government that benefits from this inflation more than anyone else. The reason for this is because central banks have a monopoly on money and governments have access to central banks in case they need more of it.

This means a country’s central bank can just print money out of thin air and lend it to the government. In a worst case scenario governments have access to an unlimited quantity of money.

The Cantillion Effect

When central banks create new money and lend it to the government, the government and those closest to the central bank can spend this newly created money at pre-inflation prices.

But once this money has circulated enough and ends up in the pockets of the general public, it will cause consumer price inflation. This means once newly created money ends up in the hands of the majority of people it has lost a significant amount of its purchasing power and will buy less goods and services.

But those that were able to spend the newly created money at pre-inflation levels could transfer purchasing power from the general public to themselves through inflation.

This is why many economists, including John Maynard Keynes himself, refer to inflation as a “hidden tax”. Milton Friedman even said that newly printed bank notes should simply be viewed as receipts for taxes already paid.

The newly issued money, which governments can spend at pre-inflation prices, is a hidden tax because it’s financed with the purchasing power of the general public, without their consent, knowledge or any representation.

Price Stability As Theft

In the same way that natural deflation distributes the fruits of higher productivity to all market participants through lower prices, inflation prevents the same market participants from enjoying the fruits of higher productivity.

In other words, when purchasing power decreases people become less wealthy. They can afford less goods and services as their money consistently loses value due to inflation.

When economists talk about price stability, they aren’t talking about 0% inflation. Price stability, today, is the equivalent of mild 2% inflation.

This shows that so-called “priced stability”, while it sounds reasonable and noble, is just another form of hidden taxation. It transfers wealth from the entire economy to a few people. Price stability is simply a good-sounding term that obfuscates the process of mild inflation.

When inflation goes above 2%, this hidden tax becomes more noticeable and painful for people to bear, which usually leads to political pressure and outrage. A return to stable prices simply implies a return to a lower level of inflation, or taxation without representation. But it still creates inequality and prevents a majority of the population from enjoying the fruits of higher productivity.

June 27, 2022