Poor Definitions of “Deflation” and “Inflation”

To the Editor:

Contrary to Stephen Davies’s March column, “The History of ‘Deflation,’” traditionally and historically, “inflation” referred to a “large” increase in the quantity of money, “deflation” to a “large” decrease. These definitions were not scientifically precise, for what is “large” was always debatable. Moreover, the quantity of money never stands still; it is always changing—gold and silver are constantly being mined, minted, and shifted in and out of the money stock, banknotes are being printed, lost, destroyed, and/or are disappearing from circulation, credit is always being expanded or contracted, and new credit instruments are being invented. On this account, Ludwig von Mises suggested that it would have been more accurate to speak of “inflationism” or “deflationism.”

But the historical definitions of “inflation” and “deflation” in terms of the quantity of money at least helped explain how an increase or decrease leads inevitably and inexorably to changes in purchasing power. As new money is added to the quantity in circulation, whether as metallic coins, banknotes, and/or credit, it enters the holdings of particular individuals at particular times and places. These persons have more money at their disposal than before and start spending more freely, buying more things, and/or offering higher prices for what they want. As the money makes its way from one person to another, the early recipients find themselves competing with others who by then have also received some of the new money. Thus prices will rise.

Language, being manmade, is constantly changing, and so are the meanings of words. In the course of the twentieth century, “inflation” and “deflation” have undergone redefinition. Equating “inflation” with rising prices and “deflation” with declining prices, as Davies does, confuses cause with consequence. The idea that rising prices make for a prosperous economy, declining prices for economic disaster, and the proper control of the quantity of money for economic “stability” is now taken for granted by almost everyone from academician to politician, Chicagoite to Keynesian, bureaucrat to businessman and the man in the street. However, it flies in the face of logic and leads to a tail-wags-the-dog doctrine, like claiming that wet streets cause the rain.

The redefinition of “inflation” has also been responsible for the enactment of inflationary government deficit spending to finance Keynesian full-employment programs. This led to the long-term “age of secular inflation,” on which Davies comments. It also led to widespread distortion of prices, disruption of economic calculations, and malinvestments—as seen for instance in the recent “overexpansion” and then failure of many dot.com firms.

Davies recognizes the factors that contribute to the determination of prices—trade, production, investment, competition, monetary fluctuations, availability of the precious metals, size of population, resources available, and more. But he considers long-term movements in prices “mysterious,” and seems surprised that his study of prices throughout the ages led him to conclude that declining prices need not always herald economic disaster.

Although no one can predict future prices, there is nothing mysterious about the fact that they will be determined by the subjective values, actions, and choices of countless individuals under the circumstances that prevail, as each individual attempts to accomplish his or her various goals with the resources available. When considered in retrospect, prices may be high, or low, depending what is happening with money and how the many price-determining factors come together. But the well-being of an economy depends not on whether prices are higher or lower than prices at other times and places, but on whether the economic climate permits prices to develop in a free and open competitive market. What is crucial for the well-being of an economy is that prices be free-market prices, agreed on by voluntary buyers and sellers in an openly competitive environment. Many trades make many traders better off, and many better-off traders make the economy better off.

—Bettina Bien Greaves

Former member, FEE Board of Trustees

Stephen Davies replies:

I actually agree wholeheartedly with almost everything Bettina Greaves says in her letter. However, I clearly need to clarify my own position somewhat. It is true that for economists “inflation” and “deflation” are the terms for an expansion or decline in the quantity of circulating medium. However the use of these terms to mean an increase or decline in the general level of prices has, as she says, become general since the mid-twentieth century. Since I was responding to current discussion I chose to use the terms in their popularly accepted sense.

I am not in the least surprised that declining prices do not mean economic disaster—that was the point I was trying to make. I was commenting on the surprise that this news would be for contemporary economic and financial journalists. (Among historians the coincidence of stable or falling prices with general prosperity in, for example, the fifteenth century has been a commonplace since the later nineteenth century.) As Bettina Greaves says, it is exchange and trade that ultimately matters, not the prices produced by those trades. However, I do insist that long-term price changes are difficult to explain, given the information and sources we have. Clearly, at any given time the prices for commodities and services are determined by the interplay of the factors that we both mention. However, it is not yet clear why there should be long periods marked by a general trend upwards or downwards in prices. As I say, there are a number of explanations that have been put forward, but none of them fully account for the empirical evidence we can observe. The discipline of history is like that, but we can hope that study will increase our knowledge and understanding.