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Ten Questions for Those Forecasters Who Predict Inevitable, Systemic Price Deflation

Gary North
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June 25, 2009

Over the years, there have been a tiny handful of hard-money industry forecasters who have predicted that there will be an inevitable era of falling prices. I don't mean stable money with slowly falling prices due to increased productivity, such as with falling computer prices. I mean a period of deflationary depression, where the central bank is powerless to stop falling consumer prices by pumping in fiat money.

These forecasters have been wrong. No post-World War II industrial nation has experienced falling prices as much as 2% per annum. Japan has had a few years where prices fell by 1%, followed by years where prices went up slightly. Japan's experience contradicts the deflationists: no secular price deflation. See the chart. Yet Japan is always the #1 example used by deflationists. This is because they have no other example. They never refer to this chart or any other verifiable statistics. They just talk endlessly about Japan's deflation, as if it were a reality. If you see any argument touting Japan as an example of inescapable deflation, you are being misled. Ignore the person making the argument. He does not know what he is talking about.

With respect to consumer prices, Japan's central bank has achieved what no other central bank has: price stability over many years. There are reasons to criticize the Bank of Japan. But its success in achieving stable prices is unique among central banks.

What would have been best is stable money and price deflation of 1% to 3% in response to greater productivity, but no depression. No central bank has achieved this since World War I began in 1914. To understand why not, read my mini-book, Mises on Money.

There are ten questions that the deflationists need to answer. If your favorite guru predicts inevitable price deflation, send him this article and ask that he respond on-line to these ten questions. If he refuses to answer all ten, with a link back to this article for his readers to see, find a new guru.

1. Was price inflation after 1933 caused by central banks and fractional reserve banks? The answer is yes. If they answer anything else, they are crackpots. They won't.

2. Is price inflation primarily a monetary phenomenon? Ludwig von Mises said it is. Milton Friedman said it is. See if the deflationist has another answer. Make sure he points to detailed studies that prove his answer: several books and a lot of scholarly articles on price history.

3. Is newly created money from a central bank or commercial banks created by purchasing an asset, usually a debt? It is. Since deflationists rest their case on this fact, they will answer in the affirmative.

4. Do commercial banks have an incentive to lend money to solvent borrowers? The answer is obviously yes. The debate comes when defining "solvency."

5. Do commercial banks pay interest on deposits? The answer is yes. Even in zero-interest accounts, such as checking accounts, the bank provides services that cost it money.

6. How can commercial banks afford to pay interest on deposits? They pay it by taking in more from borrowers than they pay to depositors. They make it on the spread between these two rates. The deflationist knows this.

7. When a central bank lends money to the government to buy its bonds, what does the government do with the money? The correct answer is "spends it."

8. When someone receives a check from the government, what does he do with it? The correct answers are: (1) "deposits it in his bank; (2) cashes it at a local bank or Wal-Mart or other check-cashing service.

9. What does the check-cashing company do with the check? The correct answer is "deposits it in its bank."

10. What does the bank do with the check? This is the central question. This divides inflationists from deflationists. Let's look at the possible answers.

A. It sends all of it to the regional Federal Reserve Bank as reserves and also excess reserves. The Federal Reserve pays the federal funds rate on excess reserves. These days, this is about 0.15% per annum. This is less than banks pay depositors. They lose money on the deal. The FED does, too: it does not lend this money. It's like vault cash.

B. It sends the minimal reserve (10% or less) to the regional Federal Reserve Bank and lends the rest. Whatever it lends is in the form of a check. The check is deposited in a bank. At that point, the receiving bank must decide what to do with it: A, B, or C.

C. It converts some or all of the money to vault cash. Vault cash is a legal substitute for reserves held at the FED. It pays no interest.

The deflationist argues that at some point, commercial banks will hold most of their money as vault cash or excess reserves. This stops the fractional reserve process. This stabilizes the money supply. But this argument does not answer this question: "How does a refusal to lend shrink the money supply?" Stabilization, yes. Contraction, no.

The inflationist says that banks can and do hold some (not all) deposits as excess reserves. This is a short-term policy. Banks cannot hold all deposits as excess reserves or vault cash. This is because banks must earn a return higher than what they pay to depositors. Otherwise, they go out of business.

Bankrupt banks' really bad assets are bought by the FDIC, which must sell T-bills to come up with the money, or else borrow from Congress, which must sell T-bills to come up with the money. The FDIC then pays depositors with checks. These checks are deposited in other banks.

The rest of the busted bank's assets are bought by other banks, which then are added to their balance sheets. This allows them to lend money.

So, the "how to pay depositors" problem does not go away from the banking system as a system. It is merely transferred from insolvent banks to solvent banks. The money supply does not shrink. There is no monetary deflation.


The inflationist argues that banks must eventually lend. When they lend, this begins the fractional reserve money-multiplication process.

The deflationist says, "There are no credit-worthy borrowers. Banks will not lend." The inflationist says this:

As long as a bank accepts deposits, it must eventually lend the money. The proof that bankers expect to have plenty of credit-worthy borrowers in the near future is the fact that all banks accept deposits.

This answer is the heart of the debate between deflationists and inflationists. This is the crux of the matter.

For the deflationist to make a logical case, he must explain why a bank accepts a deposit if it has no income to pay the interest on the deposit. He must explain what motivates bankers to accept deposits when they have no intention or possibility of lending the deposit.

Short-term, yes. A bank can hold excess reserves or vault cash, and pay depositors from the higher income on credit cards, consumer loans, and so forth. Long-term, no. The banks must lend to stay in business. The M1 money multiplier will go positive. Fractional reserve banking will then turn the central bank's balance sheet into fiat money.

The deflationist ignores the obvious: banks today honor credit card purchases. A credit card purchase is an extension of a loan to the user who uses his card. This is an unsecured loan. Banks honor these transactions.

The deflationist rests his case on banking as a system of currency in a mattress. Currency in a mattress explains anti-bank thrift. The person takes money out of a bank and hides it in a mattress. He forgoes interest. That is deflationary. This has not happened to the American banking system since the creation of the FDIC in 1934. That was why the government created it.

Banks cannot make money with vault cash. They do not make enough money with excess reserves. It's a holding operation.

They can make money lending the U.S. government money. They can buy bonds.

If they collectively face bankruptcy as a system, the Federal Reserve System and Congress can simply compel them to buy bonds. The deflationist must argue: "The Federal Reserve System would never do such a thing. Also, Congress would never do such a thing. Besides, no President would sign such a law, no matter how large the Federal deficit gets."

Ha, ha, ha. And, I might add, ho, ho ho.

I am not arguing that price deflation is impossible. If the Federal Reserve stops buying assets, or especially if it sells assets, there will be a depression and price deflation. The FED might do this if its economists believe that hyperinflation is more destructive than price deflation. That is a policy issue.

What I am saying is that the decision rests with the central bank. We are not facing a situation in which the central bank cannot prevent price deflation. The deflationist argues that this will be the case some day, and maybe today.

To which I respond with two questions:

1. Why does every bank accept deposits?

2. How can a bank stay in business if it accepts deposits and holds 100% of them in vault cash or excess reserves with the FED?

I am waiting for clear-cut answers to these two questions.


Note to deflationists: You must show how a bank accepts a liability (deposit) without creating an asset (loan). Begin with the T-accounts in Murray Rothbard's book, The Mystery of Banking. It's here. Free.

It's time for a deflationist to publish a comparable book that shows why all previous money and banking textbooks are wrong. He must show how and why a bank's T-accounts are created with liabilities (deposits) but no assets (loans).

Until we see this textbook, inflationists will say with confidence to deflationists: "Case not proven."

We are now 35 years into this debate. The deflationists have had time for one of them to write such a textbook on money and banking. They comfort themselves with this thought: "We don't need no stinking textbook!"

Their position necessarily contradicts 600 years of banking practice and 700 years of accounting practice. They really do need a book showing how all bankers and all economists have been wrong about how banking works.

If a bank's asset falls to zero, it must call in loans to cover for it, or raise bank capital. Isn't this deflationary? It would be if the central bank and the FDIC did not intervene to keep this from happening to the system as a whole. But they do intervene. The deflationist argues that at some point, this intervention will not save the system. They argue -- or at least assume -- that FDIC assets and Federal Reserve assets -- checks written -- will not really be assets, i.e., they will not create deposits that banks will lend.

I say, "Prove it."

Sorry, I can't resist: "Show me the non-money!"

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