In my first post on this subject I suggested that, while deflation is not necessarily a good in itself, an economy that cycled between modest inflation and modest deflation might be superior to an economy like the one we been living in since the mid-1930s. Since that time, the Fed has insisted on managing the money supply so as to generate consistent, albeit modest, inflation. Indeed, I quoted Ben Bernanke to the effect that central bankers intentionally err on the inflationary upside so as to avoid the supposed horrors of deflation.

When you make the inconvenient observation that the Fed’s bias toward inflation has led to bubble after bubble and crisis after crisis, their stammering response is: “Well, deflation would be worse!” But would it? It’s hard to know that it would since the US hasn’t had any deflation for eighty years. So what makes the Fed so confident that deflation is so awful? The examples they would give – the only ones they have – are the Great Depression and modern-day Japan. In this post we’ll dissect the Depression claim.

No one, not even central bankers, argues that the Depression was actually caused by deflation, but many economists believe that the Depression was prolonged by it. I suggest that this is nonsense.

The Depression was launched following the bursting of (yet another) vast asset bubble, this time in the stock market. When the market collapsed in the fall of 1929, aggregate demand in the US (and across most of the industrialized world) declined rapidly. Instead of either stimulating or just staying the hell out of the way, central bankers and exchequers throughout the industrial world did exactly the opposite: they reduced the money supply, did nothing via fiscal policy to stimulate demand, and did their solemn best to kill off international trade.

The reduced supply of credit (credit defined as money in all its forms) caused demand to decline even further, which led companies to cut back on production, which led to layoffs and unemployment, which led to even less demand. On top of that, beggar-thy-neighbor policies like Smoot-Hawley(1) in the US and burgeoning Imperial Preference(2) in Britain ensured that global trade would decline even more than reduced demand would suggest.

So while it’s certainly true that deflation ran rampant between 1931 and 1933(3), it’s also quite clear that that particular deflation was the result of backassward policies and was neither itself a cause nor a prolongation of the economic malaise. If deflation were prolonging the Depression, for example, we would expect to find it persisting right up until World War II began (i.e., when the Depression ended). But we see nothing of the sort. As soon as Roosevelt was elected and reversed the miserly policies of the Hoover Administration,(4) deflation ended instantly.

By “instantly,” I mean instantly. After rising nearly 30% in 1931-33 (see note 3), the value of the dollar began to decline in 1934 and, except for minor blips in ’39, ’40 and ’50, we’ve had inflation ever since. (77 years out of 80, so far.) If deflation caused or prolonged the Depression, it would hardly have been so easily defeated while the Depression itself defied resolution until the US entered the war.

So if deflation was largely irrelevant to the commencement or duration of the Great Depression, why, we might ask our central bankers, is it worse than inflation? Oh, right – Japan. We’ll grapple with that particular bogeyman in my next post.


(1) The Smoot-Hawley Tariff Act of 1930 raised US tariffs on imported goods to the highest level since 1828. In a 2013 speech, Ben Bernanke remarked that, “Economists still agree that Smoot-Hawley and the ensuing tariff wars were highly counterproductive and contributed to the depth and length of the global Depression.” Smoot chaired the Senate Finance Committee and Hawley chaired the House Ways & Means Committee when the Act was passed. Having screwed up the global economy royally, both were defeated – too late! – in the election of 1932.

(2) Imperial Preference describes a series of reciprocal tariffs among England and the colonies of the British Empire. In 1931-32, Britain abandoned both the gold standard and also its commitment to free trade.

(3) 7% in 1931 and about 10% in 1932 and ‘33.

(4) Beginning with his second day in office, Roosevelt initiated a series of measures designed to stimulate demand and remove the US from the gold standard. These well-intentioned efforts did little to bring the Depression to an end, but they obliterated deflation. From 1934 through 1938, inflation rates were as follows: 2.3%, 3%, 1.5%, 2.2%, and 1%.


Next up: (On Deflation (Part 3))

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Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.