Ludwig von Mises on the Meaning and Significance of Deflation

After Richard Ebeling sent the letters from the Cambridge vs LSE debates, we had the following email exchange:

Wenzel: I note that Hayek comes out against deflation. I think it is pretty clear that Murray Rothbard would not be against such deflation. I'm curious if in your readings you have come across Mises anywhere explicitly stating his view on deflation? Do you think he would be in the Hayek or Rothbard camp?

Ebeling: We need to distinguish between "price deflation" and "monetary deflation."

Ludwig von Mises argued that falling prices due to growth in the economy (technological innovations, productivity improvements, increases in the supplies of the factors of production, etc.) that lowered costs of production and expanded the general supply of goods and services in the market was not in anyway harmful. Indeed, this could be considered one indicator of economic progress. It enables consumers to buy more with their given money incomes as a result of the increased purchasing power of the monetary unit.

And this particular analysis of a "supply-side" generated decline in the general "scale of prices" (price deflation) has been a hallmark of "Austrian" monetary theory and policy analysis since the 1920s. It is one that was shared in the 20th century by other Austrian Economists, including F. A. Hayek, Gottfried Haberler, Fritz Machlup, and Murray N. Rothbard, to name a few of the "older" Austrians. Among the more recent Austrians or Austrian-oriented economists, this view of price deflation has been defended by Lawrence H. White and George Selgin with great cogency, and many other "younger" Austrians.

Mises, however, was not in favor of an active government policy of contracting the money supply (a monetary deflation). His writings from the 1920s throughout the rest of his life make it very clear that he was not a "monetary deflationist." He pointed out that if a man is run over by a car and seriously hurt, you do not make his condition better by putting the car in reverse and running over him again. (See, Ludwig von Mises, 'The Non-Neutrality of Money' [1938] in Richard M. Ebeling, ed., "Money, Method, and the Market Process: Essays by Ludwig von Mises" (Mises Institute, 1990) p. 76.)

An monetary inflation generates a series of distortions and imbalances in the market. These distortions and imbalances are not set right by then intentionally contracting the money supply. In Mises' view, this merely, and inescapably, superimposes a new series of distortions and imbalances as a result of the monetary deflation.

Thus, when he wrote on or was questioned at lectures about the best means to, say, return to a gold standard, Mises never proposed contracting the money supply to return to the former pre-inflation purchasing power (a lower "price level") to restore the original parity or exchange rate between the currency unit and gold.

He argued that it was best for the monetary authority to stop any further increase in the supply of money and credit, allow the market a period of time to stabilize and determine, on an unregulated and free gold market, the post-inflation parity or exchange rate between the depreciated monetary unit and gold. Then, when the market had decided what that ratio of exchange should be based on overall supply and demand conditions, the monetary authority should declare that as the new official rate of redemption at which a unit of gold will be exchanged for a given quantity of the currency in circulation. This becomes the basis of a new legal gold standard.

To try to return to the pre-inflation gold-currency redemption rate for a reestablished, legal gold standard would necessitate dragging the domestic market and its structure of relative prices and wages down to a much lower scale (or general level) of prices to bring the internal market into balance with such a restored external value of the monetary unit.

On this point, Mises followed Carl Menger, the founder of the Austrian School. Menger was a participant in the deliberations that lead to the establishment of a gold standard in Austria-Hungary in 1892. In some of his writings, Mises quoted from and agreed with Menger's recommendation at that time that the new legal redemption rate between gold and the new Austrian "crown" should be established at the rate set by the market, and not artificially imposed at an exchange rate either higher or lower than this. To do so would only impose unnecessary adjustments and hardships on various sectors of the Austrian economy.

(See, for example, Ludwig von Mises, 'The Political-Economic Motives of the Austrian Currency Reform' [1907] in Richard M. Ebeling, "Selected Writing of Ludwig von Mises," Vol. 1: "Monetary, Fiscal, and Economic Policy Problems Before, During, and After the Great War" (Indianapolis: Liberty Fund, forthcoming, 2011).

However, Mises did believe that due to fractional reserve banking, during a period of an expansion of money and credit, the structure of relative prices and wages (and the allocation of labor and capital among alternative productive uses) will have been both distorted and pushed up to a general scale or level that will need correction. Once an monetary inflation had been brought to an end, the "discovery" of misdirected resources and malinvested capital that are unsustainable in the post-inflation market environment will necessitate a "rebalancing" of both the structure of relative prices and wages and the reallocation of labor, capital and other resources to reflect the post-boom reality of actual supply and demand conditions.

At the same time, part of the credit expansion induced by the increase in the monetary reserves within the banking system (and which has had a "multiplier" effect on bank credit due to fractional reserve banking) will likely contract as investment borrowers face some losses and bank depositors withdraw money from their accounts.

Thus, a degree of price deflation may be inevitable as an integral part of the readjustment of outstanding bank credit in the post-boom period. Mises occasionally, in his writings, makes the historical observation that this has been a pattern in the past once the business cycle is in its "downturn" phase.

What Mises did think can and had generated an unnecessary "cumulative" general decline in prices and wages, were rigidities in the structure of relative prices and wages. Thus, when selling prices are having to be adjusted (downwards) to a new "market clearing" level in the post-boom period, money wages were often "rigid" or inflexible in adapting to the new market environment due to government intervention or trade union resistance to accepting reductions in money wages to bring the cost of labor more into line with the lower prices at which goods that labor assists in producing could be sold for.

Falling employment due to money wage inflexibility reduces the unemployed's ability to buy goods, and the same cycle begins again. But the problem, Mises was adamant in emphasizing, is not a short-fall in anything called "aggregate demand" (as the Keynesians argued) but a failure for appropriate adjustments in the structure of money wages to the new relevant post-boom structure (and level) of goods prices to restore a sustainable and profitable pattern of wage costs relative to selling prices.

(See, for example, Ludwig von Mises, 'The Economic Crisis and Capitalism,' [1931] in Richard M. Ebeling, ed., "Selected Writings of Ludwig von Mises,) Vol. 2: "Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression" (Indianapolis: Liberty Fund, 2002) pp. 169-173.)

Thus, Ludwig von Mises, to a certain extent, would be somewhere in between either Hayek or Rothbard on the meaning and policy relevance of price deflation or monetary deflation.

Wenzel: Thanks for a great exposition. I want to push you a bit further on the point, though.

It appears that Hayek in the letter is referring specifically to price deflation, not caused by growth, but by hoarding. This I would argue is part of what is occurring in today's economy.

Since I am travelling, I don't have reference to my library, but, if I recall correctly, Rothbard explicitly stated that he has no problem with price deflation caused by hoarding--which appears to be in opposition to what Hayek signed as part of the LSE group.

I don't recall Mises ever discussing the hoarding that tends to go on during the down phase of a business cycle and am wondering if you recall doing os and if so, on this particular type of price deflation (from hoarding especially during the down phase of the business cycle), does he take the Hayek view or the Rothbard view.

Also, do you agree that Hayek's view may suggest money printing as a remedy--since he does see hoarding price deflation as a problem?

Ebeling: Mises is ambiguous on the issue of "hoarding" in the downturn. And never, to the best of my knowledge, addresses directly in the way you are asking about.

But from "reading between the lines" (if I may), I would suggest that he considers such an "abnormal" rise in the demand to hold cash balances ("hoarding") inevitable once the "crisis" emerges. General uncertainty, wanting to hold on to cash in the face of falling sales to have the means to meet financial obligations, etc., one of the side effects of the discovery of investment and pricing errors, and transition to a rebalancing as part of the adjustment process. That this may result in further downward pressure on prices in general is part of the process, as individuals attempt to grope their individual ways toward re-coordination of in the market.

He would NOT consider any attempt to "reflate" the supply of money and credit to "prop" prices up as a stabilizing step in the face of falling prices either resulting from the rebalancing to re-coordination or as a "solution" to the rigidity of various wages and prices that are retarding the adjustment process. Rather, it would run the risk of setting in motion a new wave of malinvestments and and unsustainable employments in various sectors of the economy. Furthermore, it would generate even more wasted capital in wrongly invested capital projects that will, then, mean even lower wages for workers due to a resulting lower marginal productivity of labor as a byproduct of squandering scarce capital.

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