David Howden’s Review of In Defense of Deflation by Philipp Bagus

While Keynesians attribute deflation to an aggregate demand deficiency, and monetarists are wont to see contractions to the money supply or drops in the velocity of money as the culprit, Bagus takes the reader through a more nuanced view of falling prices. In particular, in chapter 3 he outlines six ways that prices in general may fall, two stemming from a change to the goods’ side of the economy, and four from the money side. Individuals building their cash balances, losses by the fractional-reserve banking system or governmentally decreed deflation all originate from the economy’s money side. Growth deflation and price control deflation all stem from the goods’ side.

In discussing bank credit deflation, Bagus points out the very important yet widely overlooked truism that this particular form of deflation can only occur after a period of credit inflation (p. 77). Those who fear deflation should take note, as this particular form of falling prices is caused directly by inflationary policies, both by accommodative central bank monetary policy and lax lending standards by the fractional-reserve banking sector. Today this possibility may be more acute than at any other time in history given that the U.S. banking sector has built up roughly $12 trillion of M2 money stock from only $1.4 trillion in currency. (Implying that a complete default of the banking sector would necessitate a monetary deflation of nearly 90 percent.)

A particularly interesting section comes in chapter 4, where Bagus outlines five prominent myths of deflation. The discussion on the fallacies of the liquidity trap argument are especially compelling, and Bagus demonstrates that deflation need not lead to any more of an arbitrary or unfair wealth redistribution than inflation.

In the penultimate fifth chapter, Bagus overviews two deflationary episodes – the American growth deflation from 1865 to 1896, and the German bank credit deflation of the 1930s. This reviewer had misgivings as he delved into this lengthy chapter, mostly owing to doubts as to the worth of case studies in an otherwise theory-laden book. My doubts were soon assuaged, however, as Bagus uses the examples to add the reader’s understanding of not only the earlier theoretical aspects of the book, but also these two commonly cited deflationary episodes.

Many economists now view America’s postbellum deflation as due to strong economic growth. This is a particularly important period as it is one of the few data points that illustrate price deflation coexisting with a strong economy. (Elsewhere, Bagus (p. 139-40) explains that the bulk of data points showing deflation as coexisting alongside economic contractions should properly define the causality as going from the latter to the former, and not blame price deflation for the economic malaise.) In addition, Bagus discusses the role of what he defines “qualitative cash building” (p. 130-31). This furthers his previous work on the quality of money (Bagus 2009; 2015), and explains the general cash building that caused price deflation as stemming from the increase in the quality of money as gold convertibility was reinstated after the Civil War. As a result, the growing American population was more willing to hold cash balances as a store of value, meaning less currency circulating as a medium of exchange. As a result the value of money increased to satisfy the needs of the robustly growing economy, or, what is the other side of the coin, the prices of goods in general fell.

The rest of the review can be read here.

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