In his response to my article “The Anatomy of Deflation,” Frank Shostak writes: “The problem with this [Reisman’s ] way of thinking is that deflation is presented as an independent destructive force. However, deflation doesn’t have a life of its own - it is always dependent on prior monetary inflation. Consequently, it is not possible to reach any meaningful conclusion regarding deflation without addressing the issue of monetary inflation. (Interestingly Professor Reisman is aware of this yet he only mentions it at the end of his article very briefly and without much discussion of the importance of inflation in activating deflation ).”
The following is what I actually say in my article about inflation as the cause of subsequent deflation:
“Indeed, what creates the need for a sudden, substantial increase in the demand for money for holding is the preceding artificial decrease in the demand for money for holding brought about by credit expansion. Credit expansion leads businessmen to believe that they can substitute for the holding of actual cash the prospect of easily and profitably borrowing the funds they might require. It also encourages a reduction in the demand for money for holding by means of the seeming ease with which inventories can be profitably sold in the face of the rising sales revenues it fuels, which makes it appear better to hold more inventory and less cash. The rise in interest rates that credit expansion serves to bring about in the course of its further progress, as rising sales revenues raise nominal profits and thus the demand for loanable funds, also serves to reduce the demand for money for holding. This is because the higher interest rates serve to make it worthwhile to lend out sums available for short periods of time that it would not have been worthwhile to lend out at lower interest rates. To these factors must be added the influence of any prospect of rising prices that credit expansion may create. And finally, the loss of capital that credit expansion engenders, as the result of the extensive malinvestment that it causes, serves to make credit less available and thus to create a still further demand for money for holding.
“Avoid inflation and credit expansion, let the demand for money for holding be high, let prices and wages be adjusted to that fact, and the economic system will be secure from sudden increases in the demand for money for holding thereafter.
“Similarly, the best reason in favor of an actual decrease in the quantity of money is that suffering it may serve to avoid a greater, more severe decrease later on. This would be the case under a fractional-reserve gold standard that had not departed too radically from a one-hundred-percent-gold reserve. In such circumstances, a reduction in the quantity of money in the form of fiduciary media[6] could bring the quantity of money down to the supply of actual monetary gold and thus both retain the gold standard and avoid the need for a more severe and potentially catastrophic reduction in the quantity of money later on—the kind of reduction that occurred from 1929 to 1933, after decades of expanding the supply of fiduciary media relative to the supply of gold.
“Deflation, which, it cannot be repeated too often, means monetary contraction, not falling prices, is at best in the category of a pain to be endured only in order to avoid greater pain later on. It should never be, and virtually never is, regarded as any kind of positive in its own right. Indeed, opposition to credit expansion, and to the fractional-reserve banking system that makes credit expansion possible, rests for the most part precisely on the fact they are responsible for deflation, which would not exist in their absence.”
I must confess to difficulty in understanding what Mr. Shostak is really criticizing in my article unless it is its support for the quantity theory of money, which he appears to reject. He writes: “It follows then that a fall in the money stock is just a symptom as it were. It doesn’t do any harm as such. The fall in the money stock reveals the damage caused by inflation but it has nothing to do with the damage.
“Furthermore, it is not the fall in the money stock that burdens borrowers but the fact that there is less real wealth.”
Mr. Shostak seems to ignore the fact that the quantity of money is the main determinant of monetary aggregates in the economic system, such as aggregate sales revenues, nominal GDP, and aggregate nominal wages. These magnitudes rise every year not because there is more physical wealth and supply, but because there is more money in the economic system, and they would fall if there were less money.
If I am mistaken and Mr. Shostak does indeed support the quantity theory of money, then the only way I can explain his claim that a fall in the money stock “doesn’t do any harm as such” would be if he accepted the most naive possible version of the doctrine of the “neutrality of money”--naive to the point of ignoring the fact that existing contracts, geared to the conditions of a larger quantity of money and volume of spending are not instantaneously replaceable with contracts geared to the existence of a smaller quantity of money and volume of spending. Indeed, the replacement process may entail bankruptcy proceedings on a mass scale.
Claiming that decreases in the quantity of money are harmless is equivalent to claiming that unchecked increases in the quantity of money are harmless. Both have major destructive consequences. The reason for advocating a hundred percent gold reserve standard is precisely in order to avoid these twin evils.
When I wrote my article, I thought it would make people aware of the vital fact, almost universally ignored, that falling prices caused by increased production have nothing in common with the evil of deflation. Mr. Shostak appears to believe that this point is noncontroversial and has been established by Milton Friedman. At the same time, my view that actual deflation is an evil appears to have led him to the conclusion that I am an advocate of inflation and a supporter of “the popular view.” Mr. Shostak’s response to my article is one that I had never anticipated.
