Why Monetary Policy Should Not Avoid Market Price Deflation

The Center for Market Education (CME) released its Policy Paper No 4, Why Monetary Policy Should Not Avoid Market Price Deflation, authored by Philipp Bagus (Professor of Economics at University King Juan Carlos, Madrid, Spain) and Carmelo Ferlito (CEO of the Center for Market Education, Malaysia), attached to the present message.

The paper notes that the Western world, in general, is experiencing price increases that have not been recorded in decades; in the United States in particular, inflation is now running at a 40-year high of 7.5%, and the Federal Reserve is puzzling over how to exit the inflation tunnel without generating a recession.

With the consumer and producer price indexes recording respectively a 3.23% and a 9.99% annual increase in 2021, led by energy and food items, the debate about inflation finally reached Malaysia too; as happened everywhere else in the world, supply-chain disruptions have been blamed, while the monetary nature of inflation has not been recognized.

The Center for Market Education first warned about inflationary pressures in March 2021 and continued to do so throughout the year. We stressed in particular that inflation is a monetary phenomenon due to the quantity of money rising faster than output. We also explained how the increased quantity of money, generated by expansionary fiscal and monetary policies implemented to address the harms created by lockdowns, created a dichotomy between the real economy and the (over)availability of financial means, a dichotomy that could result in a distortion of the production structure, in a boom-and-bust cycle and, ultimately, in unemployment.

The results of such policies, which were a reaction not to COVID-19 per se, but to the harm created by stay-at-home orders, can be summarized as follows:

  • Excess money supply, generating inflation;
  • Price inflation, while during an economic crisis price deflation should be favoured;
  • GDP still below the 2019 level, despite the expansionary policies;
  • A fragile recovery resting on government consumption and government aid-led private consumption;
  • A non-friendly ecosystem for investments.

CME and the authors stress, once again, the unavoidable need for a plan of government spending cuts in order to contain inflation.

In this paper, Prof Bagus and Dr Ferlito emphasize that another necessary measure is to abandon the fear of deflation which guides many choices in monetary policy. Are falling prices really such a disaster for an economy that they justify a massive liquidity injection, or are they just an excuse to allow welcome money production to benefit those disadvantaged by price deflation?

The authors argue that price deflation in most cases is something natural to the market, or that it is the beneficial – although painful – market reaction to government intervention. Bagus and Ferlito conclude that policies enacted to prevent price deflation lead to harmful consequences for many economic agents.

The general fear of deflation is unfounded. Price deflation can be the natural and welcome consequence of growth, it can bring about real cash building, and it can shorten the recession after an artificial boom. Its most unpleasant form is credit contraction deflation, which decreases the money supply; however, that is only possible in a fractional reserve banking system that has previously created money out of nothing. The main effect is a redistribution of the existing wealth in the economy, rather than a necessary decline in general output, as assumed in various arguments.

The fear of deflation is artificially fed by those who benefit from the creation of new money since they spend the new money first. Banks and government, as well as businesses that depend on a credit expansion boom, fear deflation and profit from the money production they recommend as a prescription against deflation, at the expense of other economic agents who pay higher prices than they otherwise would. By artificially lowering interest rates and distorting the structure of production, it is precisely expansionary monetary policy that triggers the greatest economic disasters and makes credit contraction possible in the first place. In a full reserve commodity money standard, price deflation is completely harmless and the symptom of strong economic growth or successful cash accumulation.

As this paper shows, the inflationary policies in the years following the Great Recession must be considered a policy error, as they delayed recovery and reduced economic growth, and their price-inflationary consequences became more and more visible. This policy error was based on or justified by a faulty theory of inflation, which we have addressed in this paper by offering what CME considers to be a more correct theory.

In a period such as the present one, characterized by strong inflationary pressures, price deflation should not be discouraged. Rather, Bagus and Ferlito suggest the following policy measures:

  • Allow productivity growth deflation by nurturing an environment conducive to innovation;
  • Allow cash-building deflation, as savings are the necessary means for enhancing a process of sound growth;
  • Reduce government spending to reduce the quantity of money in circulation;
  • Reforms should be introduced to reinstate the primacy of balanced budgets.
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