There are two problems with understanding deflation: it is ill defined, and it has a bad name. This article puts deflation into its proper context. This is an important topic for advocates of gold as money, who will be aware that sound money, in theory, leads to lower prices over time and is often criticised as an objective, because it is not an inflationary stimulation.

The simplest definition for deflation is that it is when the quantity of money contracts. This can come about in one or more of three ways. The central bank may reduce the quantity of base money, commercial banks may reduce the amount of bank credit, or foreigners, in possession of your currency from an imbalance of trade, sell it to the central bank.

The link with prices is far from mechanical, because the most important determinant of the general price level is the relative appetite for holding money, and not changes of the quantity in issue, as the monetarists would have it. All else being equal, a deflation of the money quantity can be offset by a decline in the public’s desire for cash and deposits in hand, so that the general level of prices is unaffected. 

Alternatively, a fall in the general price level can occur without a corresponding monetary deflation. This happens if a general preference for holding money increases. A further consideration is a population might collectively decide, based on increased uncertainty about the future perhaps, to hoard cash instead of leaving their savings in a bank. The resulting mismatch between production on the one side, and consumption (both immediate and deferred) on the other, caused by changes in physical cash withheld from circulation, can have a noticeable effect on prices. 

At times of monetary stability, price deflation is likely to occur because of economic progress. In free markets when money is sound, a healthy relationship between consumption and savings develops. Competing businesses have access to savings to invest in more efficient production of better goods, leading to improved products and lower prices. Furthermore, production chains lengthen, bringing fully the benefits of specialisation to the assembly of the component parts in every product. But crucially, this conditions can only last if money is sound, by which we mean the factors that upset overall preferences relative to goods are broadly absent.

Critics of price deflation in a sound money environment fail to understand that the level of interest rates is self-regulating. Interest rates adjust the split between consumption and deferred consumption, and do not affect the overall quantity of money. Rates rise when businesses bid for funds to finance investment in production. Businesses investing in production calculate their costs based on expected prices, and if they experience a decline in prices, that will impact on the interest rate they are prepared to pay for new investment. Therefore, Gibson’s paradox, that interest rates correlate to the general price level, is explained, and why interest rates do not correlate with the rateof price inflation, as the monetarists believe. 

Sound and stable money is the optimum condition for an economy to deliver the most economic progress. These were the conditions broadly experienced in Britain during the nineteenth century through a mixture of a gold standard and free trade. Government stood to one side, and let people pursue their individual objectives. The principal error was in establishing fractional reserve banking, which permitted a credit cycle to develop, but looking through those highs and lows, economic progress delivered substantial improvements in living standards, lower prices, and the accumulation of individual wealth over time.

During the reign of Queen Victoria, which covered most of this period, prices fell while employment incomes remained generally stable. It was demonstrably a deflationary period at the price level, while being the most economically progressive in all economic history. When it is the consequence of sound money, price deflation is the ideal outcome which political leaders should embrace.

The amount of money required for this condition was set by the markets. Gold fulfilled the role of a deliverable reserve currency, being accepted internationally as true money. This meant arbitrage of prices worked effectively across borders, in turn moderating different preferences for money between jurisdictions, ensuring common price levels. This was in accordance with classical economic theory, and it worked very effectively. The first interruption to this market process came from the Bank of England, which in the wake of periodic credit-induced crises, took on the role of lender of last resort. Once the principle of intervention was established, further areas of “improvement” on free markets were bound to follow.

The world of yesteryear’s laissez-fare is not that of today. Classical economics has been replaced by post-Keynesian interventionism. The welfare state, more than free markets, drives individual expectations, particularly in the advanced economies. The combination of a free market, sound money and price deflation is now beyond our grasp without a major economic and financial reset. For that to happen, we must undergo both political and monetary upheavals, reversing the trend towards state control of everything. And that is only likely to happen through crisis, which is the context in which deflation is feared today.