Hülsmann on the Economics of Deflation

The Ethics of Money Production
by Jörg Guido Hülsmann

Chapter 3: Money within the Market Process


This way of presenting things is not fully correct. It is true that an increased money supply tends to bring about higher money prices, and thus diminishes the purchasing power of each unit of money. But it is not true that this process necessarily operates in favor of the debtor and to the detriment of the creditor. A creditor may not be harmed at all by a 25 percent decrease in the purchasing power of money if he has anticipated this event at the point of time when he lent the money. Suppose he wished to obtain a return of 5 percent on the capital he lent, and that he anticipated the 25 percent depreciation of the purchasing power; then he would be willing to lend his money only for 30 percent, so as to compensate him for the loss of purchasing power. In economics, this compensation is called “price premium” — meaning a premium being paid on top of the “pure” interest rate for the anticipated increase of money prices. This is exactly what can be observed at those times and places where money depreciation is very high. 3

3 Late scholastic Martín de Azpilcueta argued that price premiums were not per se usurious, but legitimate compensations for loss of value. See Martín de Azpilcueta, “Commentary on the Resolution of Money,” Journal of Markets and Morality 7, no. 1 (2004) §48–50, pp. 80–83.

A creditor might actually benefit from lending money even though the purchasing power declines. In our above example, this would be so if the depreciation turned out to be 15 percent, rather than the 25 percent he had expected. In this case, the 30 percent interest he is being paid by his debtor contains three components: (1) a 5 percent pure interest rate, (2) a 15 percent price premium that compensates him for the depreciation, and (3) a 10 percent “profit.”

The same observations can be made, mutatis mutandis, for the debtors. They do not necessarily benefit from a depreciating purchasing power of money, and they can even earn a “profit” when money’s purchasing power increases if the increase turns out to be less than that on which the contractual interest rate was based. It all depends on the correctness of their expectations.

Chapter 4: Utilitarian Considerations on the Production of Money


The harmful character of deflation is today one of the sacred dogmas of monetary policy. The champions of the fight against deflation usually present six arguments to make their case. One, in their eyes it is a matter of historical experience that deflation has negative repercussions on aggregate production and, therefore, on the standard of living. To explain this presumed historical record, they hold, two, that deflation incites the market participants to postpone buying because they speculate on ever lower prices. Furthermore, they consider, three, that a declining price level makes it more difficult to service debts contracted at a higher price level in the past. These difficulties threaten to entail, four, a crisis within the banking industry and thus a dramatic curtailment of credit. Five, they claim that deflation in conjunction with “sticky prices” results in unemployment. And finally, six, they consider that deflation might reduce nominal interest rates to such an extent that a monetary policy of “cheap money,” to stimulate employment and production, would no longer be possible, because the interest rate cannot be decreased below zero.

However, theoretical and empirical evidence substantiating these claims is either weak or lacking altogether. 15

15 For recent Austrian analyses of deflation, see the special issue on “Deflation and Monetary Policy” in Quarterly Journal of Austrian Economics 6. no. 4 (2003). See also Murray N. Rothbard, America’s Great Depression, 5th ed. (Auburn, Ala.: Ludwig von Mises Institute, 2000), part 1; idem, Man, Economy, and State, 3rd ed. (Auburn, Ala.: Ludwig von Mises Institute, 1993), pp. 863–65.

First, in historical fact, deflation has had no clear negative impact on aggregate production. Long-term decreases of the price level did not systematically correlate with lower growth rates than those that prevailed in comparable periods and/or countries with increasing price levels. Even if we focus on deflationary shocks emanating from the financial system, empirical evidence does not seem to warrant the general claim that deflation impairs long-run growth. 16

16 See George Selgin, Less Than Zero (London: Institute for Economic Affairs, 1997); Michael D. Bordo and Angela Redish, “Is Deflation Depressing? Evidence from the Classical Gold Standard,” NBER Working Paper #9520 (Cambridge, Mass.: NBER, 2003); A. Atkeson and P.J. Kehoe, “Deflation and Depression: Is There an Empirical Link?” American Economic Review, Papers and Proceedings 94 (May 2004): 99–103.

Second, it is true that unexpectedly strong deflation can incite people to postpone purchase decisions. However, this does not by any sort of necessity slow down aggregate production. Notice that, in the presence of deflationary tendencies, purchase decisions in general, and consumption in particular, does not come to a halt. For one thing, human beings act under the “constraint of the stomach.” Even the most neurotic misers, who cherish saving a penny above anything else, must make a minimum of purchases just to survive the next day. And all others — that is, the great majority of the population — will by and large buy just as many consumers’ goods as they would have bought in a nondeflationary environment. Even though they expect prices to decline ever further, they will buy goods and services at some point because they prefer enjoying these goods and services sooner rather than later (economists call this “time preference”). In actual fact, then, consumption will slow down only marginally in a deflationary environment. And this marginal reduction of consumer spending, far from impairing aggregate production, will rather tend to increase it. The simple fact is that all resources that are not used for consumption are saved; that is, they are available for investment and thus help to extend production in those areas that previously were not profitable enough to warrant investment.

Third, it is correct that deflation — especially unanticipated deflation — makes it more difficult to service debts contracted at a higher price level in the past. In the case of a massive deflation shock, widespread bankruptcy might result. Such consequences are certainly deplorable from the standpoint of the individual entrepreneurs and capitalists who own the firms, factories, and other productive assets when the deflationary shock hits. However, from the aggregate (social) point of view, it does not matter who controls the existing resources. What matters from this overall point of view is that resources remain intact and be used. Now the important point is that deflation does not destroy these resources physically. It merely diminishes their monetary value, which is why their present owners go bankrupt. Thus deflation by and large boils down to a redistribution of productive assets from old owners to new owners. The net impact on production is likely to be zero.

Fourth, it is true that deflation more or less directly threatens the banking industry, because deflation makes it more difficult for bank customers to repay their debts and because widespread business failures are likely to have a direct negative impact on the liquidity of banks. However, for the same reasons that we just discussed, while this might be devastating for some banks, it is not so for society as a whole. The crucial point is that bank credit does not create resources; it channels existing resources into other businesses than those which would have used them if these credits had not existed. It follows that a curtailment of bank credit does not destroy any resources; it simply entails a different employment of human beings and of the available land, factories, streets, and so on.

In the light of the preceding considerations it appears that the problems entailed by deflation are much less formidable than they are in the opinion of present-day monetary authorities. Deflation certainly has much disruptive potential. However, as will become even more obvious in the following chapters, it mainly threatens institutions that are responsible for inflationary increases of the money supply. It reduces the wealth of fractional-reserve banks, and their customers — debt-ridden governments, entrepreneurs, and consumers. But as we have argued, such destruction liberates the underlying physical resources for new employment. The destruction entailed by deflation is therefore often “creative destruction” in the Schumpeterian sense.

Finally, we still need to deal with the aforementioned fifth argument — deflation in conjunction with sticky prices results in unemployment — and with the sixth argument — deflation makes a policy of cheap money impossible. Because these arguments are of a more general nature, we will deal with them separately in the next two sections.


In the past eighty years, the sticky-prices argument has played an important role in monetary debates. According to this argument, the manipulation of the money supply might be a suitable instrument to re-establish a lost equilibrium on certain markets, most notably on the labor market. Suppose that powerful labor unions push up nominal wage rates in all industries to such an extent that entrepreneurs can no longer profitably employ a great part of the workforce at these wages. The result is mass unemployment. But if it were possible to substantially increase the money supply, then the selling prices of the entrepreneurs might rise enough to allow for the reintegration of the unemployed workers into the division of labor. Now, the argument goes, under a gold or silver standard, this kind of policy is impossible for purely technical reasons because the money supply is inflexible. Only a paper money provides the technical wherewithal to implement pro-employment policies. Thus we have here a prima facie justification for suppressing the natural commodity monies and supporting a paper money standard.

This argument grew into prominence during the 1920s in Austria, Germany, the United Kingdom, and other countries. After World War II, it became something like a dogma of economic policy. But this does not alter the fact that it is sheer fallacy, and it is not even difficult to see the root of the fallacy. The argument is in fact premised on the notion that monetary-policy makers can constantly outsmart the labor unions. The managers of the printing press can again and again surprise the labor-union leaders through another round of expansionist monetary policy. Clearly, this is a silly assumption and in retrospect it is very astonishing that responsible men could ever have taken it seriously. The labor unions were not fooled. Faced with the reality of expansionist monetary policy, they eventually increased their wage demands to compensate for the declining purchasing power of money. The result was stagflation — high unemployment plus inflation — a phenomenon that in the past thirty years has come to plague countries with strong labor unions such as France and Germany.


Another widespread fallacy is the idea that paper money could help to decrease the interest rate, thus promoting economic growth. If new paper tickets are printed and then first offered on the credit market, so the argument goes, the supply of credit is increased and as a consequence the price of credit — interest — declines. Cheap money is now available for businessmen all over the country. They will invest more than they otherwise would have invested, and therefore economic growth will be enhanced.

There are actually a good number of different fallacies involved in this argument, and it is impossible for us to deal with all of them here. 19

19 For full detail see Mises, Human Action, esp. chap. 20; Murray N. Rothbard, Man, Economy, and State (Auburn, Ala.: Ludwig von Mises Institute, 1993), chap. 11; Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles (Auburn, Ala.: Ludwig von Mises Institute, 2006), chaps. 4–6.

Suffice it to say that capitalists invest their funds only if they can expect to earn a return on investment — interest — and that they do not seek merely nominal rates of return, but real returns. If they expect the “purchasing power” of the money unit (PPM) to decline in the future, they will make investments only in exchange for a higher nominal rate of return. Thus suppose Mrs. Myers plans to lend the sum of 100 oz. of silver for one year to a businessman in her neighborhood, but only in exchange for a future payment of 103 oz. Suppose further that she expects silver to lose some 5 percent of its purchasing power within the following year. Then Mrs. Myers will ask for another 5 oz. (making the total future payment 108 oz.), so as to compensate her for the loss of purchasing power.

Now the question is whether (1) printing new money tickets will in fact decrease the real interest rate and (2) whether, if it does decrease the real interest rate, this will be an economic boom.

To answer the first question, we have to bring anticipations back into the picture. If the capitalists realize that new paper notes are being printed, they can expect a decline of the PPM and thus they will ask for a higher price premium. If the price premium is an exact compensation for the decline of the PPM, the real interest will be unaffected. In this case, the artificial increase of the money supply would entail merely a different distribution of capital among businessmen, and thus a different array of consumer goods being produced. Some businessmen and their customers will win, whereas other businessmen and their customers will lose. But there will be no overall improvement.

Now suppose that the capitalists overestimate the future decline of the PPM. In this case, the real interest rate would actually increase and many businessmen would be deprived of credit they could otherwise have obtained. Again, the consequence would be a different distribution of capital among businessmen, and thus a different array of consumer goods being produced. But there would be no overall improvement or deterioration.

Yet it is also possible that the capitalists underestimate the future decline of the PPM. This might be the case, in particular, when they are unaware of the fact that more paper notes are being printed. It is this scenario that the advocates of cheap money commonly have in mind. But the hope that tricking capitalists into accepting lower real interest rates entails more economic growth is entirely unfounded. It is true that in the case under consideration the real interest rate would decline under the impact of new paper money being offered on the credit market. It is also true that this event is likely to incite businessmen to borrow more money and to start more investment projects than they otherwise would have started. Yet it would be a grave error to infer that this is tantamount to enhanced economic growth. The case is exactly the reverse.

At any point of time, the available supplies of factors of production put a limit on the number of investment projects that can be successfully completed. What the artificial decrease of the real interest rate does is to increase the number of projects that are launched. But the total volume of investments that can be completed has not thereby increased, because this volume depends exclusively on the productive resources that are objectively available during the time needed for completion. The artificial decrease of the interest rate therefore lures the business community into all kinds of investments that cannot be completed. In terms of a biblical example, they could be said to start building all kinds of towers, only to discover after a while that they just had the resources to build the foundations, but not to finish the towers themselves (Luke 14:28–30). The labor and capital invested in the foundations are then lost, not only for the investor, but for the entire commonwealth. They could have been fruitfully invested in a smaller number of projects, but the artificial decrease of the interest rate prevented this. In short, economic growth is diminished below the level it could otherwise have reached.

To sum up, it is by no means sure that politically induced increases of the money supply will lead to a decrease of the interest rate below the level it would have reached in a free economy. The success of cheap-money policy is especially unlikely when the policy is not adopted on an ad-hoc basis, but turned into a guiding principle of economic policy. But the fundamental objection to this policy is that it is counterproductive even if it succeeds in decreasing the interest rate. The consequence would be more waste and thus less growth.

Additional remarks.

Deflation due to productivity growth is unlikely to increase the burden of indebtedness. While it is true that creditors earn additional income, the debtors also earn additional income in the form of reduced prices. With a growth of their real income, such deflation does not increase the burden of indebtedness.

Also, in contrast with stable prices or inflation, deflation may possibly encourage savings (because of the increased value in the monetary units), which reduce the interest rates to a level lower than it would be otherwise, which in turn facilitate and encourage investments, making the economy more capital-intensive and thus more prosperous than it would be otherwise. Note that the drop in interest rates after the initial increase in savings will tend to discourage the willingness to save. Besides, a drop in prices facilitates the purchasing of products. Overall, individuals will be richer than before.

And if people increase their hoarding, instead of savings, due to uncertainty in the face of a falling wage and price level, the phenomenon would be self-correcting. The rise in hoarding will reduce uncertainty and the needs of putting money under the mattress. In a growing economy, people are becoming richer, which causes uncertainty and hoarding to diminish as real income increases.

A point worth noting is that entrepreneurs could anticipate the secular deline in prices and therefore the decrease of their nominal revenues from sales. In that case, they will bid down the present prices of factors of production to restore their profits. Anyway, success in business does not depend on the price level but on the spread between costs and revenues.

Of course, deflation caused by productivity growth should not be confused with deflation caused by economic crisis. In the latter case, people are indebted and cannot maintain their previous level of consumption.

Keep in mind that historical experience does not necessarily prove, or disprove, the economics of deflation. Economic growth is influenced by numerous factors (to name just a few : IQ, education, freedom). The independent impact of deflation cannot be thought without keeping constant the other and confounding factors. But we could say, for example, that deflation does not decrease economic growth below the rates which would otherwise have prevailed.

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