Deflationphobia strikes again!

In last week’s briefing, The Economist magazine worries that current spending on consumption and investment will fall if individuals believe money will be more valuable in the future.

There are several issues with this position. First, focusing on deflation obscures the real concern. Deflation is not a cause, but a consequence. Yes, central banks might fail to adjust the money supply to offset increases in money demand. But, as the Economist admits, deflation might also result from productivity growth. It is only the former monetary deflation that we should fear.

Second, the author fails to distinguish expected from unexpected monetary deflation. Consumption and investment only contract if individuals must reduce spending to maintain desired real money balances. In the case of expected monetary deflation, falling prices allow individuals to maintain real money balances without consuming or investing less. Just as expected money growth merely produces inflation (i.e., without significantly affecting what we are able to produce), an expected monetary contraction merely causes prices to fall. Neutrality isn’t strictly true in either case (see below, for example). But no serious macroeconomist believes the path to prosperity starts at the printing press.

Finally, the Economist ignores the potential benefits of mild monetary deflation. Milton Friedman once argued that we do not hold enough money when the purchasing power falls each period, since bonds and other less liquid assets allow us to avoid the inflation tax. He maintained that we would hold the optimum quantity of money only if the purchasing power were to increase each period at a rate that makes the return on money just equal to the return on other risk-free assets. In other words, mild monetary deflation would promote exchange and production by removing the inflation tax and putting money on equal footing with other risk free assets.

Don’t get me wrong: money matters. Inflation is costly. Deflation is costly. Unexpected nominal shocks (i.e., changes in money supply not supported by changes in money demand) can generate a cluster of errors—unsustainable (and undesirable) booms, in the case of nominal expansions, and unnecessary slumps, in the case of nominal contractions. The effects are real. But we must understand the underlying mechanisms at play so that we can distinguish the consequential from the inconsequential.

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