 Good afternoon, everyone. I will talk on the economics of deflation. So what we will do is, first we will try to find out what is deflation, the definition of deflation. Then we will look on the courses of deflation and then on the consequences. So the basis is naturally the question, what is deflation? We have some indications from the economist, the magazine, it says it's a pernicious threat. It's not only a problem, it's actually the world's biggest economic problem. Another definition, and this comes from Christine Lagarde. Christine Lagarde is the management director of the IMF, the International Monetary Fund. So she must know what deflation is. And she has a definition of deflation which finally allowed me to find a photo, a picture of deflation on the internet. I studied deflation for a long time and finally I got a picture actually out of it. So what is deflation for Christine Lagarde? Deflation is an ogre. Okay, it's similar to the economists know that it's somehow threatening. So the next question is what can we do about this? What can be done against this ogre? What do you think can be done against it? Exactly. That is what can be done about it. Bernanke already in his speech in 2003, tied to deflation, make sure it does not happen here, said the US government has a technology called a printing press that allows it to produce as many US dollars as it wishes, at essentially no cost. Great insight that you can destroy the value of your currency no matter if you only try hard enough, you can destroy the value of your currency. So the solution to the ogre is we just print the money and give them the money to the banks and the Wall Street guys and they will save us from the deflation ogre. And just as simply as that. Thank goodness for these Wall Street guys because they will take the new money and fight bravely and unservicefully against the deflation ogre. What would we do without them? We would probably die in a deflation holocaust or something like this. So you see deflation is used as a scapegoat to justify inflation. It's portrayed as such a disaster that it has to be fought at all costs. You have to inflate and inflate and inflate. Even if prices are rising because when prices are increasing only slowly a little bit like one or two percent you're still very close to the abyss because deflation is basically like quicksand. If you get into it you will be sucked into it. So if price inflation is only one or two percent it's already too dangerous because one foot is in it then you might be lost in a deflationary downward spiral. And you know of course when there's inflation when there's an increase in the money supply there's a redistribution the first receivers of the new money they buy at the old still low prices. Prices are beaten up and they are the later receivers and the last receivers of the new money that see that prices are increasing they're buying prices are increasing but the income has not increased yet. So there's a redistribution in favor of the first receivers to the detriment of the last receivers. So the strategy is simple. Whenever over-independent agents, individuals, banks, governments want new money they say well the deflation over comes so please print new money engaging quantitative easing, lower interest rates buy government bonds, bailout fees and so on. Okay, yeah this is what we just said. So come on, what is deflation then? In the mainstream the definition is a general decrease in prices. Austrians tend to distinguish between price deflation, general fall in prices and monetary deflation, a reduction in this money supply. I will here focus on the ogre which is price deflation. What are possible courses? Now we look on the courses of price deflation economic growth, innovations, new technology, capital accumulation extension of the division of labor more goods and services are produced the producers try to buy money with them so the price of money is bent up prices tend to fall, the purchasing power of money tends to increase but you would not really think that this is negative that this is an ogre or a threat but rather this would be a blessing when prices fall due to economic growth. Second type, here comes the ogre you already see the second type of deflation is or course of deflation is an increased demand for money or also called cash building deflation and there are several reasons why there may be an increased demand for money one is an increased industrial demand when we have commodity money and we have gold as money for example and there is more industrial demand for some reason people start to value subjectively gold more than silver, gold jewelry more than silver jewelry people stop buying silver rings stop buying silver rings and start buying gold rings then there is an additional industrial demand for gold and therefore the price of gold, the purchasing power of money will rise for industrial reasons another reason is that the quality of money increases the quality of money is subjectively perceived capacity of money to fill its functions to be a good medium of exchange unit of account and store of value so a good money fulfills good these functions especially the store of value function so when people for some reason start to think that money begins to be a better money they will start to value it higher in comparison to other goods and services so this is actually similar to the industrial demand in the case of the industrial demand people start to value gold higher because they like it suddenly because maybe a celebrity started to wear gold jewelry instead of silver so they value gold higher and here we have this case that people start to value the money higher in relation to other goods because they think it has become a better money an example would be, folks, after the civil war specific payment was suspended there was no redemption in gold you could not go with your green bag and receive gold and then in 1875 there was a resumption of specific payment so this resumption of specific payment would be an increase in the quality of money because it makes a difference if you can get gold for your green bag or not and obviously the act of the resumption itself did not change the quantity of money at all it only changed the quality, increased the quality another example would be that we have a fiat currency and the government that is at war with other governments so if it loses the war maybe the currency is not worth anything anymore and then the government starts to win an important battle probably now it will win the war so the fiat currency will survive an increase in the quality of the currency another reason for an increased demand to hold money is an increased uncertainty people hold money because they don't know when they have to make the expenditures nor how much money they will need so when uncertainty increases people prefer to hold a higher cash balance for example in an economic crisis which is also very useful because it gives agents and companies flexibility of course in an economic crisis it is unclear where the demand will shift to which sector the new demand will go so it's good if you are liquid, if you have high flexibility, high cash balance here the question is how would this work when everyone at the same time tries to increase their cash balance this cash building deflation when all people want to increase their money holdings at the same time without an increase in the supply of money when all people want to hoard these evil horrors when they all become evil horrors at the same time well there we have to remind you think that what people want are real cash balances not nominal cash balances they want a cash balance, they want money to buy goods and services so what is not important is not the nominal cash balance if I have $1,000 or $2,000 but how many goods and services I can buy with them if an uncertainty increases I want to have a higher real cash balance so I will be able to buy more goods and services so let's imagine that we all convert into evil horrors we want more money but the money supply is constant there is no monetary inflation so what would we do? what would we do? we will stop buying and we will try to sell our goods and services as fast as possible to get more money but obviously no one wants to buy our services and goods because all want to have a higher cash balance so what will happen? we will have to lower our prices until we find someone willing to buy so prices will fall what is the consequences of falling prices? what happens with the real cash balance? goes up or down? up, exactly that is what we wanted how much will prices fall until they are at a level where people start to buy again and restrict their selling when they desire cash balances real cash balances are attained so when individuals finally attain their ends so due to an increase of uncertainty people want to hold a higher real cash balance and they attain their goals so also in this case the market works people attain their end with the cash building deflation prices fall, they get a higher real cash balance so how can we say that this would be a threat for the economy or an ogre? because what it does is it fulfills the ends, the objectives of the people we will come back later to this question then we have also speculative cash building when people expect the purchasing power of money to increase they will buy money and by this already bid up the purchasing power now we come to a course of deflation that would not occur in a free market therefore we see the ogre there a little bit closer this is bank credit deflation which occurs after a credit expansion of a fraction reserve banking system which could not occur in a free market with a full reserves you know that fraction reserve banks can expand credit and introduce this new money this new credit through the loan market and due to the additional loans entrepreneurs start more ambitious investment projects more than can be successfully completed with the scarce resources of society and sooner or later this will become apparent and the bust will occur businesses will go bust people will not be able to pay back their loans and then banks will have losses and due to this losses the confidence in the banking system will be reduced especially if there is not a central bank they will try to redeem their deposits they will throw their money in cash they start to pay more in cash banks become more cautious when old loans are paid back banks don't give out new loans immediately there will be bad loans loans that will not be paid back so all this causes the amount of loans to be reduced there is a credit contraction which is a reduction the supply of money which is a natural consequence of the boom it's inevitable that the money supply shrinks in a recession of course you can have the central bank work against it but there is this tendency that there will be credit contraction in the banking system this speeds up the liquidation of malinvestments because the fall in prices makes it harder for indebted businesses to stay afloat to survive only the best companies will survive they will be strengthened because their competitors will be gone so the malinvestments will be liquidated faster the resources that are sucked up in these malinvestments will be liberated faster and be available for more sustainable projects faster so the bank credit deflation actually is just a market reaction to the aggression of bank credit expansion and the artificial boom and it speeds up the recovery so it's actually also something that is beneficial if you think that it's beneficial to speed up the recovery but again it would not occur on a free market because on a free market you have full reserves and no artificial credit expansion well, now comes our friend the government the government can also cause prices to fall the most crude example is price decrease deflation the government just decreased prices to fall it introduces maximum prices below the market price the price for one gallon of milk is four dollars it says, well, the maximum price you can ask for is one dollar this would be a price decrease deflation does not occur very often, sometimes in Germany in 1930s it occurred that Chancellor Brunning declared for example that all wages had to fall 10% the price decrease deflation in this case Labour unions had very much power too much power, the wages were artificially high so he just decreed that wages had to fall 10% second type of fear deflation introduced by the government is the coercive monetary deflation so a coercive reduction of the money supply how does this work? well, basically it means that the government collects money and then destroys it or it uses the money to give it to the banks and tell the banks to increase their reserves and instead of 10% that you have reserves we give you this tax money and you increase your reserves to 20% actually it's a possible way to resume species payment this is what was done in the US after the civil war when species payment was suspended and it may be actually used to introduce a 100% reserve system if you use the tax money and give it to the banking system to increase its reserves there are two types of it there's the fiscal coercive monetary deflation where the government just takes the taxes the tax money destroys the money or gives it to the banking system to increase its reserves or to give it to the central bank and a gold standard to give gold to the central bank so the central bank has higher reserves a bond deflation is that the government issues bonds and takes the receipts, the money to destroy it or to increase the reserves of the banking system or the central bank and then we have confiscatory deflation that the government just confiscates the money in order to destroy it or to exchange it for new money or to freeze it temporarily there an example would be Germany after the Second World War a currency reform in 1948 all old gold rice marks were confiscated and exchanged for ten old rice marks you would get one new German mark so it was a confiscatory deflation a recent example are the bank holidays in Greece the government basically said froze the money people cannot get their money right now so they are not allowed to withdraw their money it has been confiscated at least temporarily so there is a downward pressure on prices and lastly we have here legal tender deflation let's assume that there are two currencies in use gold and silver and then the government declares gold legal tender which means that even though you have a contract made in silver you are allowed to pay it in gold which implies that the government established an exchange rate between gold and silver you can use, even though you have a silver debt you can use gold to pay with it and in this exchange relation and then it's typically used to or one of them is overvalued if gold is overvalued then gold will disappear from circulation no, if gold is overvalued silver will disappear from circulation because it's undervalued, people will hoard the silver and people will only use the overvalued gold which means that the reduction of the money supply because before people used gold and silver is a medium of exchange and now one of them silver is driven out of circulation so we have here also a reduction of the money supply caused by the government feared deflation so there we might say it's actually an ogre but because the reason for it is the use of violence and this is of course more beneficial the other types of deflation because they fulfill the ends of individuals voluntary interacting once now on the consequences of deflation now we look on the consequences independent of the cause of the fall in prices what is the price? it's just an exchange relationship and in any exchange there's one buyer and one seller the buyer, as a buyer we normally prefer lower prices and the seller we normally prefer higher prices what does it mean when prices fall? good for buyers, bad for sellers so the most important consequence here is a redistribution buyers, profits in comparison to the situation when prices would have been higher and sellers lose in comparison to the situation where prices would not have fallen would have been higher the thing is that in a market economy we all are buyers and sellers we sell our goods and services services mainly our labor services and as sellers we want higher prices and we are also buyers we buy goods and services as buyers we want lower prices there we want price deflation moreover obviously the buying price of one is the selling price of the other party of the exchange so if we don't know the cause of price deflation but we only know that prices are falling we cannot say at all that this is bad for the economy as a whole there's just a redistribution if my buying prices fall faster than my selling prices I benefit and if your buying prices fall slower than your selling prices you lose so the main effect is a redistribution some individuals will win others will lose but in the aggregate for the overall economy we cannot say that we are worse off so there's obviously no financial threat there's no over so what are the arguments brought forward to say why deflation is such why deflation is the biggest problem for the world let's look at the myths about deflation the first myth is that falling prices hurt companies because companies have lower sales revenues and therefore there's a cumulative contraction as they have lower sales they will contract less workers and there will be even less demand, lower sales and so on well not so fast it's like accounting 101 what is essential for companies is the spread between buying and selling prices to make profits a company needs a positive spread between the selling prices and the buying prices its costs and one can have a positive spread between the selling prices and the buying prices at a higher and at a lower price level it's not only the selling prices for but also the buying prices imagine a company that has revenues of 1 million dollars and costs of 800,000 dollars let's now assume that there's a price deflation and revenues collapse to 500,000 dollars costs collapse also to 400,000 dollars the real profit situation of the company has not changed and of course you can assume a situation where the costs fall faster than the revenues the buying prices the costs fall faster than the selling prices so the real profit situation may actually increase during a price deflation a falling prices does not say anything about the general business climate the question is always what happens with the profits the differential between the buying and the selling proceeds and of course this differential may increase or decrease when prices are generally rising or falling the general tendency in prices does not say anything about the tendency in this price differential for profits okay so this was the first argument the second argument is somewhat more sophisticated because it says that not falling prices are a problem but the expectation the expectation of falling prices would be a disaster for the economy it's like as a consumer I expect prices to fall so I think well tomorrow prices will be lower so today I don't consume and it happens that I write prices fall and say well I was correct I now think it will continue tomorrow prices will be even lower so I don't consume either I get a little bit thinner then next day prices are lower and I say oh great it worked I will not consume either tomorrow I get thinner until I die what is the problem with this argument well no one would act like that no one would do that or imagine that you expect that gasoline prices will be 10% lower 10% lower next year would you not fill up your gas tank for one year because of that we all know for example that prices in the technology sector will fall or that the quality will improve we know that the next generation of smartphones will be cheaper or better than today's or both cheaper and better so there we have deflationary expectations does this mean that the technology sector is depressed or that businesses are not investing there because they fear that prices will fall no not at all the sector flourishes and sales even increase and not only consumers consumers that buy technology also investors companies they invest in new technology even though they know that the technology will be cheaper in the future or there will be better technology available but nevertheless they buy it now because it gives them a competitive edge to have the newest technology and they want the newest technology rather sooner than later and consumers want the new iPhone 6 rather sooner than later that's the universal law of time for France moreover even if people abstain from consumption for some time the decreasing sales prices for businesses lead to a pressure to reduce costs so companies will then start to replace workers with machines and more machines must be produced so there will be increase in the demand for labour in the capital goods sector workers who lost their jobs in the consumer goods sector will find new employment in the capital goods sector so the capital stock grows when people save without leading to mass unemployment so the increase in real savings due to expectations due to the expectation of falling prices is not a threat but would lead to sustainable economic growth okay next argument it says hey okay it says yeah you are right the price differential is the important thing it's true that costs also fall but they fall only in the long run and in the short run they are sticky they fall slower than the selling prices the selling price of companies falls quickly but some costs are fixed they fall only with a lack there we have two two types well first of all is we have to say that entrepreneurs the main task is to anticipate future prices they have an idea of a product that would satisfy consumer wants and then in the next step they have to think to anticipate what will consumers be able willing to pay for this product and in function of the expectation of the price of the product they will bid for factors of production they have the entrepreneur has a new smartphone and he thinks he will be able to sell it in one year for $100 in function of this price he will bid for workers for other factors of production so you see here that actually the prices of the factors of production are determined before the price of the product so buying prices yes they can fall faster than selling prices logically actually it's not that costs determine prices it's not that first are the costs and then later the prices determine at the expected prices in the future that determine the costs so you would expect actually costs falling before prices of course the entrepreneur may be incorrect and in one year he will not be able to sell the product for $100 but only less and then he might have bid too much for the factors of production he will suffer losses but an entrepreneur can always be too optimistic on the future selling price of the product even if prices rise 10% he maybe have been too optimistic with his $100 so entrepreneurs can if prices generally rise or fall this is not an argument and then the argument is that wages are sticky but here we have also to keep in mind that entrepreneurs try to anticipate the selling price of the product in the future and the workers they also when they negotiate for their wage they are trying to anticipate the future purchasing power of money and of their wage and if a worker actually expects the purchasing power of money to be lower then it actually will be and ask for too high wage or wage that is too high he may bid himself out of the market so let's think of a worker that believes that the price level will increase 20% and he demands a 20% wage increase but then prices only increase 10% then he might have bid himself out of the market that is due to rising prices the same is true when prices fall let's say that the worker thinks that prices will fall 20% and then he agrees okay I agree that my wage will be cut 20% but he errs prices fall not 20% but 50% then he will also driven out of the market so you see the general tendency of prices does not matter the worker can always ask for too high wage that will cause him to be out of the market and of course it's also true that the government interventions in the labour market make wages more and more sticky that wages cannot adapt quickly cannot be renegotiated easily and government interventions can and do cause unemployment by lifting labour costs below the level of the market but again government intervention will cause unemployment no matter what the general tendency of prices is when prices fall or when prices rise and lastly when prices cannot fall because of rigid labour markets because of government intervention and this causes unemployment so the problem is not a fall in prices the problem is not price inflation the problem is exactly that the opposite that prices do not fall the problem is not the price inflation but price inflation would be the solution of the problem the fall in prices would be the solution of the problem so the problem the solution would be more falling prices in this case wages would be allowed to fall but the government intervention prevents this price inflation. Okay this on wages now on debts. This argument goes the following. It says some costs are fixed in the short and medium run and these are debts. Depth payments are normally fixed so the argument goes that the real debt burden of companies increase in a price deflation and when companies expect prices to fall they will not take on more debts they will not invest because it will become ever more difficult to pay to service the debt. Let's say before a price deflation your income your income is $3,000 you have a monthly debt payment of $1,000 then due to a price deflation your income falls to $2,000 but your debt payment remains the same and becomes more difficult to service the debt. This is a problem. Then the argument goes as the debt burden has increased the economy will collapse as there is a contraction of aggregate demand. Okay let's think about this argument. It's true that here the debtor the debtor is losing but at the same time the creditor is winning of course. The creditors receive higher payments or payments with a higher purchasing power of money so the aggregate demand does not contract at all. The losses of the debtors are exactly balanced by the benefit profits of the creditors. There's a problem for debtors but there's a profit for creditors so there's a redistribution but not a problem for the overall economy or would you think that's a problem for you if you receive money with a higher purchasing power? No. If you receive as a creditor money with a higher purchasing power you can or you can consume more than before or you can make more investments than before. Okay but then it goes on and then the enemies of deflation which among us the enemies of deflation are the friends of inflation. They make another argument. They say okay but price deflation can be so extreme that the debtor goes bankrupt so he cannot even pay back his loan. So then the creditors also worse off because he does not receive money with a higher purchasing power. Some of his money does not receive at all because the debtor goes bust and this would be bad because companies go bankrupt even though they have a viable business model if they would be fully equity financing they could have survived. So what is the response to that? Again the society would not be worse off. The production potential of the society would not be hampered. Imagine a factory owner that is highly indebted and there's a price deflation and therefore he cannot service his debts anymore. The consequence of his bankruptcy is a change in ownership. The old owner loses control of his assets of the factory and he loses the control to the creditors that better predicted the evolution of prices. So the bankruptcy just implies a redistribution and a change of ownership but the factory, the machines, the workers they will not disappear by the bankruptcy. They are still there. This can still produce and the creditors if the business model is viable and not just the bubble factory, bubble business model but it is viable then they will continue production. They will continue production. The production potential of the economy is not hampered. The creditors may actually even hire the former owner as a manager if they are interested in his knowledge of running the business because sometimes the argument goes but then the entrepreneur goes bankrupt and he has all his private subjective insight knowledge on how the factory has to be run. But you can. The creditors could hire him and then the question is of course is he really such a good entrepreneur if he anticipated the evolution of prices so badly that he over indebted himself. The creditors if they have no expertise in running the factories, they could also sell the factory to competitors in the field that have expertise in this field or they could have just renegotiated the loan if they believed so much in the capacities of their entrepreneur who was formerly the owner. And you also have to recall that bankruptcies are not bad. We cannot say that some amount of bankruptcies is too much or too little for a market economy. You cannot say that. Bankruptcies have an important function that is they shift the control of resources and factors of production to those most capable of employing them for consumer needs. And this happens also when prices fall and debts cannot be serviced. Okay so these were the main myths and errors about deflation. Where comes the aversion against price deflation come from? Mainly from those debtors that would lose if prices would fall. All debtors are always against price deflation because it could lead to their bankruptcy. So the finance industry opposes it highly indebted big businesses and most importantly the biggest debtor in our economy do you know who that is? Our best friend the government. All these players have a very strong interest to portray deflation as a catastrophe. And unsurprisingly they are also the first ones to receive the prescribed medicine against deflation, the new money. They are the first ones. They are in the privileged position to receive the new money first that is injected to prevent price deflation. And we should never forget that this new money not only causes redistribution but also causes new malinvestments, new bubbles, new distortions. So you already here we have them again. So you can understand that I titled my book in defense of deflation because price deflation per se only falling prices are not bad for the economy. We have always we have to look at the causes of price deflation. If a price deflation occurs in a free market because there's economic growth or there's cash building even if it's a free market reaction to a government intervention into the banking system in the case of a bank credit deflation we cannot say that it's it's bad. Of a different nature of course is of course price deflation caused by the government fear deflation. So falling prices per se do not pose a problem to the economy as a whole. They just lead to a redistribution and they endanger the position of over-endepted companies and the political elites. And they have these elites of course have an interest and portray deflation as an ogre. And this explains deflation's bad press. In fact deflation can have the liberatory effects of bringing down the bankrupt banking system monetary system and bring down bring down over-endepted political elite. So long live deflation. Thank you very much.