There is a widely held belief these days that deflation is inherently evil and must be avoided at all costs. Deflation is spoken about in association with terms such as 'financial collapse' and 'economic crisis'. However, why does deflation inspire such dread? After all, deflation is simply a name given to an increase in the purchasing power of money that results from a decrease in its supply. Why should an increase in the value of money necessarily be a bad thing?

One common misconception is that money supply growth is related to real economic growth. It is widely believed that inflation and economic growth go hand in hand, as do deflation and economic contraction. However, this could not be further from the truth. To paraphrase the words of John Stuart Mill, written more than 100 years ago, there cannot be a more insignificant thing in an economy than money. It is a machine for doing efficiently what would be done, though less efficiently, without it. Like many other types of machinery, it only exerts an independent influence of its own when it gets out of order. In other words, if a monetary system is working correctly it should not exert its own direct influence on the economy. For example, between 1875 and 1896 the US experienced its greatest period of real economic growth whilst, at the same time, deflation occurred at the average rate of 1.7% per year. On the other hand, the period from 1969 until 1979 saw low real economic growth in parallel with an inflation rate that averaged 7% per year. In the examples sited above it was the rate of increase in productivity that drove the rate of economic growth. During the 1875 – 1896 period the money supply was stable and therefore had no effect on the real economy. During the 1970s the rate of increase in the supply of money oscillated wildly as the government sought to stimulate the economy and bring about full employment by creating large amounts of new money. In this case an 'out of order' monetary system had a detrimental effect on the economy.

Given that deflation is not necessarily a bad thing, let's take a look at the current situation. During the past few years an unprecedented expansion of credit has occurred in the US, leading to 1970's style increases in the supply of money (the supply of US dollars has grown by 11% during the past 12 months, compared with a 1970s average of 9%). The substantial liquidity stemming from the credit expansion has fueled massive speculation in the US stock market which, in turn, has resulted in share prices which bear absolutely no relationship to the intrinsic values of the underlying businesses. It is therefore fair to say that today's monetary system is out of order.

The corresponding increase in wealth resulting from stratospheric share prices has been a catalyst for massive consumer spending, leading to impressive GDP growth rates (5.6% during the final quarter of 1998). The importance of rising share prices to the US economy was highlighted by Alan Greenspan during testimony before the House of Representatives on 20th January this year : "…all else equal, a flattening of stock prices would likely slow the growth of spending, and a decline in equity values, especially a severe one, could lead to a considerable weakening of consumer demand."

In a monetary system such as we have today, new debt means new money and new money stimulates rises in asset prices which, in turn, provide the security for the creation of more debt. The whole process can continue until the repayment burden on the debt increases to the point where borrowers are no longer able to take on new debt, or risk premiums widen such as occurred during August to October 1998, or asset prices stop rising (and perhaps start to fall), or some event occurs which shakes confidence (as happened when Russia defaulted on its debt in August 1998). Credit expansions are inevitably followed by credit contractions, the only question being the timing of the transition. What we can be certain of, at the moment, is that we are at a very advanced stage of the expansion, a time when the level of indebtedness has reached dire proportions.

During a period of deflation, money becomes more valuable over time and hence the cost of debt repayment becomes greater. Therefore, in today's financial environment where the entire monetary system is based on debt and that same debt has been expanded at astronomical rates, deflation would be a catastrophe. In other words, the amount of debt and, by definition, the amount of money must continue to be increased. Failure to continue the expansion would lead to a reduction in consumer spending due to the burden of servicing the existing debt. Such a reduction in spending would cause a serious decline in economic growth which would have a corresponding adverse effect on company profits, causing a sharp drop in equity values. As confirmed by Mr. Greenspan, stock market valuations have become so important to the overall economy that a drop in equity values will, of itself, lead to a weakening of consumer demand. Therefore, if the expansion stops, the US economy would be in danger of imploding.

The dilemma in which the major central banks of the world find themselves is indicated by their dramatic actions following the first signs of a tightening in the credit markets during the second half of 1998. Since October 8th 1998, there have been 79 cuts in official interest rates throughout the world, thus flooding the major economies with money and re-igniting the stock market boom. It has been alleged, in some quarters, that the three cuts in official US interest rates initiated by the Federal Reserve during this period were designed, at least in part, to support the stock market. Mr. Greenspan has flatly denied this whilst, in the next breath, confirming that asset prices have become so important to consumer spending that they must be taken into account when framing monetary policy.

Alan Greenspan is now in the position where he will never be able to increase interest rates, irrespective of how over-heated the US economy becomes, due to the danger of such an action bursting the stock market bubble and causing a severe depression. This is possibly why the US Federal Reserve recently advised that they would, in the future, announce changes in interest rate 'bias'. Since they no longer have the option of raising rates they will choose, instead, to announce a change to a 'tightening bias' in the hope that this will have a cooling, but not freezing, effect on the markets.

Returning to the initial question, is an increase in the value of money necessarily a bad thing? Well, if you have fostered a giant credit expansion the answer is a resounding YES

Milhouse
Hong Kong
19 February 1999

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