During the current recession a number of commentators have made various comparisons to the Great Depression, mostly because of the dramatic decline in the stock market and ongoing troubles in the financial industry. When oil prices also began a dramatic decline in the autumn of 2008, pulling the overall consumer price level downward for the first time in a very long time, yet another fear of the Great Depression era came to the forefront of the public’s consciousness: deflation. Many observers pointed out, quite correctly, that the deflation that followed nearly immediately after the stock market crash in 1929 was a major reason that what would have been a serious, though likely short-lived, recession was transformed into the Great Depression. With these fears of deflation, and the damage it did decades ago, now part of the discussion, it is a good idea to remind ourselves just what we should and should not fear about deflation, and how deflation can be, and was historically, a major contributor to economic catastrophe.

The key to understanding deflation is to realize that it comes in three forms: the Good, the Bad, and the Ugly. To make sense of these three forms we need to be clear on some terminology and definitions. First, the word “deflation” itself requires additional clarity. Normally, the definition is something like “a sustained decline in the average level of prices.” That definition immediately raises the question of why anyone would think deflation is bad. After all, what could be bad about things getting cheaper? For one thing, “prices” are normally understood to include “wages” (although in the Ugly version we’ll see what happens when this isn’t the case), so whatever gains one gets from lower prices are likely to be offset by lower wages. For another, that definition says nothing about whether the process by which prices fall is a painful one. (Could not one say of inflation: “What’s the big deal? Sure, prices are going up, but your wages will too, so aren’t you just even?” We know enough about the process by which prices rise to know it’s not that simple and the same is true of the process by which they fall.)

With that common definition in mind, we then need to make a further distinction about the cause of falling prices. A decline in the general level of prices can come from two broad sources: improvements in economy-wide efficiency (the decreased relative scarcity of some large number of goods) or a deficient supply of money. We might further distinguish between these two by referring to the first as “price deflation” and the latter as “monetary deflation.” Price deflation, as it turns out, is the “Good” of the Good, the Bad, and the Ugly. Monetary deflation is the “Bad” and can lead to the “Ugly.”

Price deflation, sometimes called “benign deflation,” is, or at least should be, the normal by-product of a growing economy. To see why, we need one last digression, this time into monetary theory. Understanding both inflation and deflation requires that we recognize that the demand for money is a demand to hold real cash balances: We demand money when we hold balances in our wallets or our checking accounts. When we spend money we actually reduce our demand for money as we shift how we hold our wealth from money to whatever we buy. Think of a wallet or checking account as part of a larger portfolio of assets we choose to hold at any given time. We want a certain portion of our wealth in the form of housing, some in the form of food, some in the form of clothing, and some in the form of money. Thus our demand for money is a demand to hold money balances, and we care about the real purchasing power of those money balances—what they are capable of buying, not just what number is stamped on the bills.

A correct understanding of the demand for money helps us to understand why sometimes people can have either more or less money than they would prefer. For example, during inflation the monetary authority has created more money than people wish to hold at current prices, so they spend those “excess” money holdings on goods and services, driving up their prices. During a monetary deflation, as we shall see, a deficient supply of money means that people do not have large enough money balances and will act to get more.

All of this implies that a good monetary system is one that supplies exactly the amount of money the public wishes to hold at the current level of prices. It is worth noting that this view, called “monetary equilibrium theory,” implies that not every increase in the supply of money is inflationary. Should the demand for money rise, it is the appropriate response of the monetary system to increase the supply to match it. In our discussion of monetary deflation below, we will see why monetary equilibrium theorists make this argument. This argument also distinguishes those Austrian economists who work from the monetary equilibrium tradition from those who work from a more Rothbardian tradition, in which any increase in the money supply not matched by an increase in the quantity of gold is necessarily inflationary and the ideal monetary system is not one that matches changes in money demand with changes in the money supply.

The Good

If the monetary system is doing its job and matching changes in money demand with changes in supply, the long-term trend of the price level will be gently downward as economy-wide productivity rises. Put differently, increased productivity will cause benign price deflation as the real cost of goods and services falls. This sort of deflation is not only not harmful; it is beneficial because the cost of living is lower. In the United States this is precisely what happened to the price level during the last few decades of the nineteenth century, since the pre-Federal Reserve banking system based on gold was reasonably effective at getting the money supply right much of the time and productivity gains caused a steady, slow fall in the price level. Over the last few decades the same downward pressure on prices from productivity gains has been taking place, but it has been outweighed in the aggregate by the inflationary policies of the Fed, so the price level continues to climb in spite of these productivity-induced deflationary pressures.

One implication of this last observation is that consumer price index figures may well understate the real degree of monetary inflation in a given economy. For example, if productivity increases are pushing prices down 3 percent per year, but excesses in the money supply are pushing prices up by 3 percent per year, the common measures of inflation would show stable prices. However, on the monetary equilibrium view, that stable price level is disguising underlying inflation of 3 percent, as prices should have fallen by 3 percent. Austrian economists have long argued that something like this may well have been at work in the 1920s, where relatively stable prices concealed a multiyear inflationary boom that culminated in the recession and then the stock market crash of 1929.

To the extent that a fall in the overall level of prices reflects increased productivity, it is Good. Similarly, a decline in the price level caused by the decreased relative scarcity of key goods is not problematic. The dramatic fall in oil prices in the autumn of 2008 was enough to cause the average level of prices in the United States to fall, which is the source of much of the concern about deflation. However, this sort of deflation is not the type to be concerned about, and certainly does not warrant the comparisons to the Great Depression. In fact, falling oil prices in this case probably did much to prevent the early months of the recession from being any worse than they were, as lower gasoline prices eased financial pressures on many households.

The Bad

The “Bad” sort of deflation arises from an insufficient supply of money. When people do not have as much of their wealth in the form of money as they would like, they will make attempts to increase those money balances. Assuming that in the short run additional income is not possible, people have essentially only two other options: sell off other assets or reduce their expenditures. Either one will work, but selling off assets is problematic for two reasons. First, it is not totally under the individual’s control since it requires a buyer, and second, if everyone is short on money, finding a buyer will be especially difficult because everyone else is looking to sell. Therefore, the most likely result of a deficient money supply is that people will restrict their expenditures to allow more of their income to build up as checking account or currency balances.

As everyone reduces spending, firms see sales fall. This reduction in their income means that they and their employees may have less to spend, which in turn leads them to reduce their expenditures, which leads to another set of sellers seeing lower income, and so on. All these spending reductions leave firms with unsold inventories because they expected more sales than they made. Until firms recognize that this reduction in expenditures is going to be economy-wide and ongoing, they may be reluctant to lower their prices, both because they don’t realize what is going on and because they fear they will not see a reduction in their costs, which would mean losses. In general, it may take time until the downward pressure on prices caused by slackening demand is strong enough to force prices down. During the period in which prices remain too high, we will see the continuation of unsold inventories as well as rising unemployment, since wages also remain too high and declining sales reduce the demand for labor. Thus monetary deflations will produce a period, perhaps of several months or more, in which business declines and unemployment rises. Unemployment may linger longer as firms will try to sell off their accumulated inventories before they rehire labor to produce new goods. If such a deflation is also a period of recovery from an inflation-generated boom, these problems are magnified as the normal adjustments in labor and capital that are required to eliminate the errors of the boom get added on top of the deflation-generated idling of resources.

Over the course of U.S. history the economy has been subject to a number of deflationary episodes, all of which were the consequence of a variety of government interventions in the monetary system. In each of those cases before the Great Depression, policymakers largely allowed the economy to repair itself by standing by and doing little to nothing while prices and wages fell sufficiently to get the demand for money back into alignment with the supply. No doubt these were painful recessions that could have been avoided by having a banking system that responded to changes in money demand by more quickly adjusting the money supply, rather than allowing the price-level adjustment process to cause the problems noted above. However painful they were, these recessions did not become the “Ugly” version of deflation precisely because policymakers allowed the necessary downward adjustments to take place, which was the correct thing to do given the monetary system’s errors that caused the monetary deflation in the first place.

The Ugly

During the Great Depression, what should have just been a Bad deflation became an Ugly one. This deflation was unlike earlier ones for two reasons. First, the scale of the deflation was unmatched. The U.S. money supply fell over 30 percent between 1929 and 1933, a period in which the demand for money was actually rising as a consequence of the stock market crash and the bank failures that followed it. The combined effect was a massive downward pressure on prices. The Fed did not actively reduce the money supply during this period; it failed to react strongly enough to actions the public and banks were taking, such as the public’s holding more currency rather than bank deposits, which caused a multiplied reduction in the total money supply. As Milton Friedman and Anna Schwartz’s A Monetary History of the United States describes it, there was a great deal of internal debate within the Fed over whether it had the power to respond as we now believe it should have and whether, even if it had the power, such a response was the right one. Those who argued in favor of doing nothing won the day and substantially worsened the depression in the process.

The second difference from earlier recessions was that policymakers adopted the view that the key to recovery was to “maintain” prices and wages at their pre-deflation levels. Both Presidents Hoover and Roosevelt strong-armed business leaders into keeping prices and wages up and pushed laws that directly or indirectly did the same.

The effects of these misguided attempts at price and wage maintenance were devastating. Firms continued to pay unjustifiably high wages, while watching sales slacken because prices also stayed high; they covered their losses out of their profits, causing some firms to fail and others to see severe declines in their stock prices. This contributed to the low levels of private investment that prolonged the depression since firms did not have profits to recycle back into their own activities. More brutally, keeping wages so high led to the horrific unemployment rates of the Great Depression, which peaked at around 25 percent in 1933. Only by around 1934 did prices and wages fall enough to start bringing unemployment rates back down. However, unemployment remained at historic highs because even with the declines in prices and wages, private investors were hesitant to take risks in light of the policymakers’ earlier mistakes and the constantly shifting political environment. During the Great Depression, unemployment stayed above 14 percent from 1931 through 1940.

Current observers are quite right to point to the Great Depression as an example of what can go wrong from deflation. There is no doubt that the very large monetary deflation of the early 1930s made the recession that began in the summer of 1929 much deeper and more severe than it would have been otherwise. But even so, had prices and wages been allowed to adjust, that recession would have been Very Bad, but not Ugly. Attempting to keep prices and wages high during the monetary deflation prevented the cleansing price adjustments from taking place and forced sellers to make “quantity” adjustments in the form of reduced production and historic levels of unemployment.

Avoiding the Last Big Mistake

The price level declines seen in the fall of 2008 and early 2009 do not seem to be harbingers of significant deflation. As noted earlier, the decline in oil prices is the leading factor pushing down the overall price level, and this is the benign price deflation that we have labeled Good. In fact, the Fed’s initial response to the troubles in the banking system in the fall of 2008 was to flood the system with reserves, remembering the mistakes the Fed made at the onset of the Great Depression. Given the worries about a cascade of bank failures and the major deflationary effects this would have had on the money supply and the economy as a whole, injecting some additional reserves was probably the right reaction at the time. Two key questions remain, however:

1) Did the Fed overreact and create too many reserves? A look at the Fed’s balance sheet suggests it may well have done so, especially given how many of those new reserves are just sitting in the banks right now (helped along by the Fed, now paying interest on such reserves).

2) Will the Fed be able to withdraw those reserves as the economy recovers and thereby avoid a potentially massive and damaging inflation? If it cannot do so, we will face a much bigger threat in the near future from inflation than from deflation.

All of that said, we do not know for certain what is going on with the demand for money. We know that expenditures are down, which suggests that people are quite possibly increasing their demands for money. But in the absence of the thousands of bank failures that characterized the 1930s and with evidence that banks, on the whole, are continuing to lend (despite scare-mongering media and government stories to the contrary), the concern that any increase in money demand will translate into significant monetary deflation seems remote. As Milton Friedman once said, central banks are always trying to avoid their last big mistake. In this case, that big mistake was the Great Depression, and the Fed has clearly shown a willingness to err on the side of inflation rather than deflation, even at the cost of putting itself in a difficult position once the recovery starts.

What all of this goes to show is that the best way to avoid both Bad and Ugly deflation and to generate the Good kind is to minimize the role of government intervention in both the monetary system and the regulation of prices and wages. A competitive banking system—one without a central bank but with fractional reserves—would avoid both deflation and inflation. Even under a central bank, the effects of a monetary deflation can be minimized by restricting government’s involvement in the setting of prices and wages. In a free economy the only deflation we would see is the slow, long-run decline in prices that results from the productive powers of competitive capitalism. That deflation would be just another Good produced by truly free markets.

Steven Horwitz

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.