Chapter 3

Price Deflation is Natural

The primary purpose of this chapter is to show how natural it is to have price deflation when you combine economic progress with a fixed monetary supply.

Although our economy has been dominated over the past few decades by inflating prices, we have still experienced glimpses of naturally deflating prices. Consider the price deflation that has taken place in the electronics industry over the past decade. Ten years ago I bought my first computer for $2,000. Today that same amount of money can get a vastly superior computer, a superior laptop, a cell phone with a camera, an iPod, an Amazon Kindle, a digital video recorder, a flat screen TV and even after buying all this there would still be hundreds of dollars left over. Calling this hyper-deflation would be an understatement. Deflation of prices is to be expected when there is progress and innovation.

Price Deflation Island Thought Experiment

Consider the scenario where 100 people are magically teleported to a completely isolated island. Assume these 100 people start off with nothing but a collective bag of exactly $100 in pennies which they determine to make their island's permanent, fixed currency. They divide up the pennies equally so the citizens of the island will each start off with 100 pennies.

Within the first week you probably have people buying and selling firewood, coconuts, and maybe even a few huts made with palm fronds. Maybe some fish are being bought and sold as well. Would you buy a coconut for a penny? Would the person who was able to climb trees and gather coconuts pay 5 pennies for a hearty fish to get energy for tomorrow's coconut harvest? Would the coconut entrepreneur pay 50 pennies for the best hut on the island so they could get rejuvenating rest after each work day?

In 60 years the population might have grown to 500 people. Think of all the goods and services being bought and sold after 60 years of people creating things on the island. There would be things like furnished homes, transportation, tools for farming, boats for fishing, and the list would go on and on. How much might things on the island sell for? Keep in mind that the average amount of money per person is now only 20 pennies. Maybe a two bedroom log cabin somebody outgrew might sell for half the average net worth of the island's population which is a mere 10 pennies. That is a lot of price deflation in 60 years.

Imagine if a few hundred years passed and the people of the island grew to a population of a million. Imagine they produced lots of automobiles, trains, tractors, planes and skyscrapers. The 100 founders each started with 100 pennies each and, after a few hundred years of growth, the total amount of money on the entire island would be 1/100 of a penny per person. However, that fraction of a penny would have tremendous purchasing power as an average home might sell for around the average net worth of a person which is only 1/100 of a penny.

Comments on Price Deflation

This simple thought experiment shows how natural and dramatic price deflation is within a prosperous economy that has a fixed money supply. For example, in our thought experiment the price of homes decreased from 50 pennies to 10 pennies to 1/100 of a penny. Also, at the same time the quality of homes increased from a palm frond hut to a log cabin to a modern home.

The example above almost makes price deflation seem like something to strive for especially considering the earlier chapter highlighting the abuses of inflation. However, it is worth pointing out that the desirable aspect of the example above is economic progress and not necessarily the fixed money supply that enabled price deflation.

You will get different answers about whether or not deflation is good or bad depending on the person you ask. There are plenty people beating the drums about the evils of deflation because it obviously isn't pretty when prices of homes drop resulting in home loans going underwater resulting in foreclosures which result in plenty of stories about people being evicted from their homes and taxpayers footing the bill for bank bailouts. However, there are also plenty of people who advocate that deflation is a necessary and healthy way to correct the malinvestments that were made as a result of excess inflation.

Regardless of whether or not deflation is evil or a necessary cleansing process, I think an ideal monetary system would be able to avoid excessive deflation as well as excessive inflation. One way for a monetary system to achieve this ideal situation would be to have the money supply increase proportional to the overall level of economic progress.

» Continue to Chapter 4: Pros and Cons of the Gold Standard
« Back to Chapter 2: Inflation is Not Natural