The Two Kinds of Deflation

People say deflation caused the Great Depression, so deflation must be bad. But deflation just means falling prices, and falling prices sound like good news for you and me. So how can it be bad when the things you buy get cheaper? It depends why they got cheaper. Prices can fall for two opposite reasons. In the Depression, prices fell because the money itself was being destroyed, which is what happens when too many people can’t pay their debts. The other reason is that things are getting cheaper to make. The first leaves a society poorer. The second is what getting richer looks like.

Two different events that share a symptom

To see how money can be destroyed, start with where it comes from. Most money is loaned into existence.¹ When a bank makes you a loan, it creates the money it hands you, so the new money and the debt appear together.² And when too many loans go bad and the banks that made them fail, that money disappears again.

That’s what happened in the 1930s. In the United States, people and businesses borrowed far more through the 1920s, some of it just to buy shares.³ When the boom broke, borrowers couldn’t pay back what they owed, and their losses became their banks’ losses. Banks failed, and when a bank failed, the money people had in their accounts vanished with it. Thousands of banks went down, and the amount of money in the economy shrank by roughly a third.⁴ With a third less money around, buyers couldn’t pay the old prices. A seller with stock on the shelf and bills to pay couldn’t wait for money that wasn’t coming. So sellers cut their prices to get the money that was left, and prices fell by about a quarter.⁵ None of that fall came from anyone getting better at making things. The money side of every price was collapsing.

Falling prices then made everything worse, because the amount you owe on a debt is fixed. It stays the same whether prices rise or fall. Your wage falls with prices, but your mortgage payment doesn’t, so the same debt takes a bigger bite out of a shrinking income. More people can’t pay, more banks fail, more money vanishes, and prices fall further. That loop has a name, debt deflation, and it’s real.⁶ But a fever is a symptom of an infection. The falling prices are the fever. The debt that can’t be paid is the infection. Blaming the Depression on falling prices is blaming the fever for the infection. You’d still treat a fever that high. What the treatment can’t do is cure the infection. It works by making the debt easier to carry, not by clearing it, so the next fever comes with more debt under it and needs a bigger dose.

The other reason prices fall has nothing to do with any of that. When a business finds a way to make the same thing with fewer hours, less energy, and less material, competition pushes the price down toward the cost of making one more of it, because any business that keeps the old price loses customers to a rival who passes the saving on. No money is destroyed. Nobody has to go bust for the price to fall. Where prices are allowed to fall like that, your wage buys more year after year. Photographs used to cost real money, in film, developing, and postage. Today taking a photo and sending it around the world costs almost nothing, and people take and share more photos than they ever did.

So the two reasons prices fall are opposites in everything that matters. When prices fall because the money is being destroyed, none of the fall comes from things getting cheaper to make. When prices fall because things are getting cheaper to make, no money is being destroyed. On a price chart the two falls look the same. For your life they mean the opposite.

History has even shown both at the same time. In the last decades of the 1800s, prices in Britain and America drifted gently down for years, while output grew and wages bought more. Money then was tied to gold, and nobody could make more of it at will, so nothing pushed prices back up when things got cheaper to make. But banks still created money by lending, and the painful episodes inside those same decades were America’s banking panics of 1873 and 1893, when too many of those loans went bad and the money vanished.⁷ You can only make sense of those years if you tell the two reasons apart.

Why people lump them together

The first reason people lump the two together is what the numbers show. Inside a money system that can create money at will, the falling prices that show up in the numbers mostly come from money being destroyed. A system like that can take a slow fall that comes with better tools. In that fall it’s the cost of making things that drops, and pay drifts down slowly behind it, so the money to meet a fixed payment is still there. What it can’t take is a sudden fall in the prices credit pushed up, houses first, because then the losses spread through the banks. In that fall it’s the lending that has stopped, so incomes and the house fall together and at once, and the fixed payment is hit from both sides in the same year. And where the loan was written against a house, the house is worth less too, so the bank stands to lose more on that loan. So every time a sudden fall in those prices threatens, the system is rescued with new money, and the rescues keep getting bigger. In between, the aim is for prices to rise a little every year, for the reasons the central banks publish.⁸ Either way, when technology pushes prices down, the government and central bank create more money and credit to push them back up, and the fall is cancelled out before it can spread across a whole economy. That power was taken on to stop crashes like the panics of 1873 and 1893, and at first it had a hard limit, because the money was still tied to gold. Once that tie was cut, the power buried the good kind along with the bad. That’s why every deep, economy-wide deflation of the past century came with a crash. An economist who says “deflation means depression” is reading the record in good faith. But the record was produced by a system built to stop the good kind before it spreads.

The second reason is that the economics was worked out from inside that system. If you just accept that money is always loaned into existence, then a sudden broad fall in prices is dangerous, and the models say so correctly. The mistake is the starting assumption. What’s true inside that system gets treated as a law about falling prices, whatever the cause.

The third reason is the word itself, and it’s the only one of the three where anyone’s interests come in. One word, deflation, covers prices falling for either reason, and as long as it does, “we need 2% inflation” sounds like a law of nature.⁹ Governments that fund themselves by creating more money have a strong reason not to split that word in public. Split it, and the target shows as what it is, a decision made by people that prices will rise 2% a year.¹⁰ At 2% a year, prices double about every 35 years. We call that “price stability”.¹¹

And there’s a test you can run yourself. In the corners of the economy where prices have kept falling anyway, you won’t find a depression. Electronics have got cheaper, for what they do, for fifty years, and the industry making them is thriving.¹²

Wouldn’t people delay every purchase?

The objection is that people would just wait to buy, if they knew prices would keep falling. You already live inside that experiment, and your own behaviour answers it. You know next year’s phone will be better and cheaper for what it does. People queue overnight to buy this year’s anyway. For fifty years the price of computing power has fallen year after year, predictably, and the world keeps buying more of it, not less.¹³

Why do people buy anyway? Because you buy things to use them, and waiting has a cost, which is living without the thing. You buy the coat because winter is now. You buy the phone because of what it does for you, starting today. Computing is where you’d most expect people to wait. Prices there fall fast, buyers know it’s coming, and they still buy.¹⁴ Across a whole economy prices would fall far more slowly than that. Even if prices fell at 5% a year, waiting a full year to buy something for £1,000 would save you £50, and the price of that £50 is a year without the thing. Set against a coat you need this winter, that isn’t a trade people take.

What people do put off is the purchase that can wait. Sometimes that’s the impulse buy or the fourth gadget, the thing you bought partly because money sitting in the bank loses value today, and sometimes it’s a big one, like a car. What gets cut is the borrowing that would have paid for it, and life carries on. The other change is that more people save up for big purchases instead of borrowing for them, because saving finally works. Wait six months, pay less, owe nothing. Some people will still borrow, for houses and cars above all. But people borrow less, borrowing costs more, and it’s kept for the cases where it beats simply holding your money.

Turn the objection around and it claims people will only spend if their savings are quietly drained. That’s a claim that the economy runs on a kind of theft, and it fails its own test. If inflation made people spend their way to prosperity, the countries with the highest inflation would be the richest on earth. What you actually see in those countries is people desperately swapping their pay for anything solid the day it arrives. The careful version of the objection says a little inflation is needed, so that there’s room to cut interest rates in a downturn and pay doesn’t have to be cut. The comparison between countries doesn’t reach that version. But it still asks savers to lose a little every year on the money they hold, so the charge of theft stands against it too. And both of its worries have answers. Dearer credit means less borrowing and more careful borrowing, and the economy keeps going. Pay that resists cuts buys more as prices fall.

What about businesses with debts?

The strongest version of the objection to falling prices is about businesses and their debts. When prices fall, a loan gets harder to pay back, because the money you pay back buys more than the money you borrowed. And a business whose selling prices fall faster than its own costs gets squeezed. That’s true. In an economy running on borrowed money, a squeezed business ends up unable to pay what it owes, which is exactly why you can’t switch today’s economy over to falling prices overnight. The pile of debt has to shrink first, or be built differently.

When the price falls because the business got better at making the thing, the order runs the other way round. It found a way to make the same thing with fewer hours and less material, so its cost per item has already come down by the time its price does. In an economy built from the start on money that nobody can create more of, wages hold roughly steady while most of what they buy gets cheaper, so workers gain without asking for a rise, and businesses make their profit through efficiency rather than by raising prices. Investment carries on, disciplined, funded more by savings and ownership stakes than by cheap credit. Innovation doesn’t need cheap credit.

The fever and the infection

Follow the Depression argument to its end and it’s an argument against building an economy on debt, with money made of debt, because that structure can’t take a sudden fall in the prices credit pushed up. The same money that holds incomes and house prices up also cancels the overall fall in shop prices. The infection is the debt. Prices falling because things got cheaper to make is what getting richer looks like, when nobody is creating money to hide the fall. Only a money that nobody can create more of, and that no bank creates by lending, lets prices fall as we get better at making things. It doesn’t stop a new pile of debt being built on top of it. But when that debt goes bad, nobody can create more of that money to cover the losses, so the rescue is harder and the failure faster. That’s the job bitcoin applies for. Bitcoin comes at the end of that story, once you can tell the two reasons apart.