Is deflation a threat to our prosperity? Part 2

28 September 2008

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Hello,

In my previous video message, I explained that contrary to what we hear or read every day since the beginning of the financial crisis, an overall decline in prices does not necessarily lead to an economic depression. This thesis is entirely based on the exceptional case of the Great Depression and it doesn’t fit with historical facts.

I concluded my message by asking if deflation was not instead a positive economic phenomenon. This is what I want to discuss with you today.

We all know that there is a sustained rise in prices when the quantity of money circulating in the economy increases faster than the quantity of goods and services. It’s easy to understand why. Something that is scarce is generally more valuable. But when it becomes a lot more abundant, it loses its value.

So, the more money there is, the more it drops in value, and the more consumers need to pay for the available goods. In other words, they have to give up more of these worthless dollars to obtain the goods.

This is precisely what’s been happening in most countries for the past decades. That’s because central banks never cease to create more money out of thin air, which causes prices to constantly go up. For example, they have gone up by 42% in Canada since 1990.

An overall drop in prices will occur when the opposite is happening. That is, when it is the quantity of goods and services that increases faster than the quantity of money. Also, logically, if both rise at the same rate, prices will stay more or less stable.

So, imagine a situation where central banks don’t manipulate the money supply anymore. And instead of continually rising at a rate of between 6 and 12% per year, as we’ve seen in Canada in recent years, the quantity of money in the economy stays the same.

Every year however, we become a little bit more productive. We create new goods and services. We find new methods to produce them more efficiently. Technology gets better. And if there is population growth, there’s also more people working.

So there are always more and more goods and services available in the economy, but we have the same quantity of money to buy them. Prices will obviously have to adjust by going down. If the economy grows, let’s say, by 3% a year, while the money supply grows by 0%, then we will necessarily get price deflation.

This is not just theory. It is what happened several times in the 19th century, in an era of rapid economic development. At a time when there were no central banks and when money was calculated as a certain quantity of gold or silver.

Note again the difference. Most economists and media commentators tell us that if prices go down, this will lead to some economic catastrophe. But in reality, the decrease in prices that I have just described happens precisely because we produce more things.

Deflation is not a threat to our prosperity. On the contrary, in a situation where the money supply is stable, it is the manifestation of prosperity!

Prosperity has nothing to do with the quantity of money that we have in our pockets, but rather with the quantity of goods that we can buy. And if we can buy more goods with the same amount of money because prices are lower, then we are more prosperous.

This is why there is no reason to fear a drop in prices. And why the interventions by central banks to prevent prices from going down may cause more harm than good to the economy.

The real debate that we should be having is about the constant creation of new money by central banks. Is this really necessary? Doesn’t it destabilise the economy? Who does it benefit? Don’t we get poorer when the goods that we buy always get more expensive?

I’ll have other occasions to raise these issues in future messages.

Until then, thank you for listening and talk to you soon.