Philipp Bagus, Professor Department of Applied Economics, Universidad Rey Juan Carlos – joins me to talk about why deflation is not what you typically hear in the mainstream financial press. In this conversation we talk about:

The real causes of deflation

Why deflation is not necessarily what causes recessions

Distinctions between growth deflation, and bank credit deflation

Contrasting life under a fiat money standard with a hard money standard

Real world examples

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Podcast Transcript:

Stephan Livera:

Philipp, welcome to the show.

Philipp Bagus:

Thank you, Stephan for having me.

Stephan Livera:

So Philipp, I am a fan of your work. I first came across your work in the Tragedy of the Euro. And I’ve seen some of your work as well around In Defense of Deflation and some of the articles that you’ve written as well. Can you tell us a little bit about yourself, just for my listeners who might not know you?

Philipp Bagus:

Yeah, I’m a German, but I work in Spain. I am a professor of economics at Universidad Rey Juan Carlos, which is located in Madrid. I did my PhD already here in Madrid under the supervision of Jesús Huerta de Soto. And yeah, I’ve been a professor at the university for more than 10 years. And as you said, my probably my most known work has been the Tragedy of the Euro. I’ve written a lot on the Euro. My main topics are monetary theory and business cycle theory and my PhD thesis was on deflation and then it was later published as a book with the title In Defense of Deflation. So I have also written a lot on deflation, but also on fractional reserve banking and business cycles.

Stephan Livera:

So I had the chance to read In Defense of Deflation. I really enjoyed it. I think it was a very comprehensive look at a lot of these aspects around deflation. So why did you choose that topic to write about?

Philipp Bagus:

There are several reasons. One is, when I first looked at deflation, this was in 2003 when I was a fellow at the Mises Institute, like a spring fellow, I was at the Mises Institute and Guido Hülsmann was also looking into deflation and he was still there at the time. And he said one of the topics that could be interesting would be deflation. And I also thought it was very interesting. Right before, in 2002, Ben Bernanke had the speech “Deflation: Making Sure It Doesn’t Happen Here.” where he basically said that the US has a printing press—the Federal Reserve, so it can always prevent deflation from happening because deflation would be so bad. So it was at this time already a topic. At that time, not much had been written on deflation at all.

Philipp Bagus:

I mean, still there’s not much written on deflation. So one reason was that I encountered the topic at the Mises Institute and then not so much had been written on it. And then of course that it’s a very, very important topic because this deflation is always the scapegoat for justifying monetary inflation. A few years ago in the Eurozone, it was again that, Oh, there’s a danger that we will drift into a deflationary territory, therefore we have to lower interest rates and have negative interest rates and do quantitative easing here. So central bankers like to invoke this specter, the danger of deflation to justify monetary inflation with all its harmful consequences. And therefore I thought it would be interesting to investigate the topic and later then I thought it’s important to show that there are many errors about deflation, that it’s actually not just the threat of deflation, or the danger of deflation does not justify this monetary inflation.

Stephan Livera:

Excellent. And I can see that your work really builds on some of the prior work of other Austrian economists. As you mentioned, Dr. Guido Hülsmann, his work Deflation and Liberty and The Ethics of Money Production. And also in this book I see some influence from Dr. Joseph Salerno’s Austrian taxonomy of deflation because there are four causes of deflation. I believe you list the same four, but you expand on that a little bit. So can you tell us at a high level, somebody who’s coming to this and if they haven’t read any Austrian economics and they might’ve just seen on the news, they might have this question, Oh, doesn’t deflation drive the economy into recession? How do you answer that question?

Philipp Bagus:

Yeah. Well, first of all, as as you said, one has to look at the precise cause of deflation there. And here it’s also important to point out of course that there are different definitions of deflation, like price deflation is just falling prices and what mainstream economists and the general public fear is price deflation or when you hear on the news that deflation is coming, what they mean is price deflation is coming. Austrians also have used another definition. Maybe a more precise definition, which is a decrease in the money supply. A decrease in the money supply can cause price deflation of course. But in my book I actually deal with price deflation because price deflation is what is commonly feared. When prices fall, we have to always take into account that we are buyers and sellers.

Philipp Bagus:

When we are buyers, we like prices to fall. When we are sellers—when we sell our labor service for example—we don’t very much like prices to fall. So if my buying prices—the things I buy, the food, the gasoline—if these prices fall faster, my buying prices fall faster than the selling prices of this, for example, my wage, then deflation is fantastic for me. If it’s the other way around, if my selling price—my wage—if I sell products that’s falling faster than my buying prices—the cost to produce the product—then it would be bad. So falling prices per se are not bad for someone. It always depends which prices are falling faster—the buying or the selling prices. So a priori there’s no reason to say that falling prices would be bad for an economy.

Stephan Livera:

Right. And I also liked the point that you make in the book, which is that much of government today is funded by inflationary fiat. And I think you explained some of the mechanism for this as well, because you explain in the book that because of this inflation, there’s a constant demand for government bonds. Can you tell us why is it that inflation helps the government expand its size?

Philipp Bagus:

Yeah. Government has basically two ways to finance its expenditures. One is taxes. Taxes are not very—people don’t like taxes—and they see a clear connection between increasing in government expenditures and taxes. Let’s say the government says, Oh, let’s increase public pensions by 5%. And yeah, to finance this we just increase income tax, also on average 5%. So then many people that are actually wage-earners will probably not like it very much, but if the government just increases public pensions and then gets more support by pensioners and then finances this by issuing bonds, and then these bonds are then monetized—that is, the money supply is increased to buy these bonds—and then prices increase a little bit, then people will probably not make the connection between, Oh, now I have paid $2 more at the gas station.

Philipp Bagus:

And this is because they just raised pensions. They will not make this connection. Therefore the resistance against financing government expenditures by the printing press is not so high as if it is financed by taxes, because people don’t understand the monetary mechanism. They don’t see that government expenditures go up and prices rise and they don’t blame the increase in the government expenditures on the rising prices. And it’s even more. I mean, if there’s economic growth, prices would actually fall. So now, if the government is increasing spending and issues government debts, this can compensate for the fallen prices that would have occurred due to increases in productivity. Like the Internet, new technology or the increase in the division of labor of China or India starting to produce for us.

Philipp Bagus:

So thanks to the increase in government spending and the new debt and the monetization of the debt, prices don’t fall, but stay the same or increase a little bit. And then people at the gas station will not say, Oh, today I pay the same for my gas like last year. But if the government would not have increased pensions and had increased government spending, now I could pay 10% less. So it’s hard to see the costs. The costs of government spending are much clearer when there’s increase in taxes. The cost of the government spending—if it’s financed through the printing press—is hidden. And how does it work? Well the government just prints the government bonds and the banking system buys the bonds and then sells it to the Federal Reserve and the Federal Reserve buys these bonds with new money and this new money then goes to the economy and fractional reserve banks can expand the money supply on top of it and then prices will be higher than they otherwise would have been. But people just don’t make the connection between the government expenditures, the deficit, the issue of government debts and the increase in prices or the prices that are higher than they otherwise would have been. Because they don’t know how the prices would have been, they cannot make this connection, actually.

Stephan Livera:

Right. And you mentioned the price inflation and people can’t necessarily make that connection. Do you also see a distinction between say CPI and asset inflation, so that the CPI might well be low—measured in a certain way because it’s a certain basket of goods—but then other assets may actually get inflated as well?

Philipp Bagus:

Yeah, of course. In the last few years the inflation has flown mostly to asset price markets—to housing markets in Europe for example, and of course the stock markets. So the price inflation, but the government of course, they define their own basket, the consumer price index and change the composition. Those are just numbers. The important thing is that the money supply increases and that prices will be higher than they otherwise would have been.

Stephan Livera:

When we speak about the inflation as well. As in creation of new money, just from what I have read, it looks like in the more naive countries, let’s say the Zimbabwe’s and the Venezuela’s of the world, that they just straight up print the money. But in other countries of the world it’s more like the government and the central bank create the fractional reserve banking environment in which the commercial banks do most of the actual money creation. Is that a good distinction to draw in your view or how are you thinking on that point?

Philipp Bagus:

Yeah, you have to take into account that the government like the United States has much credibility and it creates also let’s say a narrative of a central bank that is independent and run by wise technocrats, the best economists of the world, supposedly. They are wise. So there’s confidence in it while in Zimbabwe or Venezuela the government tells the governor of the central bank says Print me so much money—I need money, so just print money and give it to me. So the impression is that the central bank is totally dependent on the government and the deficit is completely financed by the printing press. And then the the confidence in the currency evaporates and there’s inflationary expectations. In the US or in Europe, in essence it’s not so different—they have created this narrative that it’s the entities—the Federal Reserve and the government or the ECB.

Philipp Bagus:

The governments are more independent and don’t follow direct orders. And as you said, the mechanism is also more indirect than just the central bank of Venezuela giving the government the money. As you said here, there’s a deficit in the US and then the US prints for the deficits papers, and writes on these papers “treasury bonds,” and then the commercial banks—with newly created money—they buy these treasury bonds because they know that the Federal Reserve accepts these treasury bonds in open market operations—buys them, and then the Federal Reserve buys them and monetizes them. That is the Federal Reserve. Then later, buys these government bonds. So it’s not like in Venezuela where the central bank buys directly from the government—the treasury bonds, the government bonds—but in the US or in Europe, first, the commercial banks buy these bonds and then give it to the Federal Reserve or the European central bank because they know that these are the preferred collateral or instruments for open market operations.

Philipp Bagus:

And they know, of course at the end, the central banks will always support the government. Last but not least, because there are so many government bonds in the banking system that if the central banks would not buy or accept these bonds in open market operations then the banking system would collapse and then the Federal Reserve on the ECB would have huge losses and the banking system would collapse. I mean they are so intricately connected and of course they all know it. So the process is more complex than in Venezuela or Zimbabwe, but in the end effect it’s the same.

Stephan Livera:

I also have seen from different talks and I think I’ve seen from Dr. Guido Hülsmann’s talk, he’s mentioned this idea that, under a hard money standard, so let’s say we were living under gold, that there would be much less role for debt and the debt that we would see would be more like commercial terms or trade credit, right? Things like, Oh, I’ll give you these goods and you only have to pay me in 30 days or 60 days as opposed to what we see today where it’s a very common practice to see lending for the sake of even starting a business. What’s your view on the role of debt under a hard money standard?

Philipp Bagus:

Today we live in an inflationary age and everyone knows it, that prices will increase. We tend to increase in the future, in the long run. Housing prices, all prices, wages. So in this environment, of course, it makes sense to indebt yourself because if I know that housing prices will increase, it will keep increasing the next 20, 30 years, then it does not make sense much sense to wait and to save money and then later buy the house. But I will rather go into debt and buy the house now, or the apartment now. And then there’s this price inflation. My wage will also keep rising during the next decades. So it will become even easier to pay back the debt. So this scenario, of course, if you live in an inflationary world, then it makes total sense and it’s rational to indebt yourself. On the other hand, it does not make sense to save in cash and wait, and only once we have the money saved in cash—to buy the house—because price inflation will devalue the savings.

Philipp Bagus:

And it’s the contrary. Of course, if we would live in a world of a sound monetary standard where there’s a tendency of prices to fall in the long run, then the real debt burden keeps increasing in time. So I will rather try to limit my debts to have them as low as possible. And if I just save in cash, then the real value of this cash will keep increasing. So it’s a totally different scenario and mindsets that people will develop in a sound monetary standard. People will indebt themselves much less and save more in cash. And of course we live in this inflationary scenario. I mean you can see it from 1971 when the last connections to the gold standard when the Bretton Woods standards were cut, then price deflation and indebtedness increased.

Philipp Bagus:

And of course this allowed the government to indebt themselves a lot more because now they can create the necessary money to pay the debts without any limits. They are not connected to gold anymore. So they have free leeway to inflate as much as they want, and as markets participants know this, they allow governments to indebt themselves much more and at much lower interest rates than before, and this has allowed governments to grow extraordinarily since 1971, especially the welfare state increased to a large extent because they were financed with debts and this debt financing would not have been possible with the gold standard. And this welfare state financing would not have been possible either by increases in taxes because people would have rebelled for the reasons I explained before. So there’s a clear connection between the end of a sounder monetary standard than we have now—that was the Bretton Woods system where there was at least still some links to gold—and the inflation rate after 1971 and the rate that the government has grown and the expansion of the welfare state. So it’s clearly connected.

Stephan Livera:

With that idea of living under a hard money standard—when we’re also saying that there wouldn’t be so much debt, is another way to reflect that just to think that the interest rate that you pay would just be much, much higher than what people pay today or is that an imprecise way of thinking of it?

Philipp Bagus:

What’s for sure is that now interest rates are manipulated by central banks artificially downwards. Negative interest rates is not something that would occur on a free market or a sound monetary standard. So now interest rates are artificially low and in a sound monetary standard they would be higher, that’s for sure.

Stephan Livera:

Yeah. And I’m curious as well with that because well, depending on which theory of interest you subscribe to, as I understand Mises has the PTPT, the pure time preference theory of interest. I’m not sure exactly where you sit on that particular question, but it might also be true to say that just generally speaking, if society has a very low time preference—they’re very patient—then they might be more willing to accept a lower rate of interest. But that would contrast with today where we have this artificially low interest rate. It’s almost like the central bank and the existence of the government money intervention is to make it look like we have low time preference when really we don’t necessarily because of all the inflation. What’s your view on that?

Philipp Bagus:

Yeah, most certainly you are correct. This is exactly what happens in the business cycle. If there’s a deception that time preference is lower than it actually is, so there will be more investments—entrepreneurs are deceived—they think there are more real savings available than there really is. But people actually have not lowered their time preference. They don’t save so much. They have a much higher time preference. And of course also this monetary system that is inflationary—incentivizes you to go into debt—increases time preference. People don’t have to wait anymore. They just indebt themselves and everything becomes much faster because you have to service your debt because you’re very highly indebted. While this would be much different in a sound monetary standard, where you’re not so much indebted and you’re more independent.

Stephan Livera:

Another question that a listener might be thinking at this point is if they are an entrepreneur and they have been accustomed to this current fiat inflationary world where it’s a common practice to go and get a business loan before you start a business, or there is a lot of credit flush around the world and there’s VC venture capital money flowing around the world, they might be thinking, Well hang on, is that a problem now? Because now people won’t be able to do their own businesses because they can’t get credit. Or is it more like we would be living in a different monetary order such that you would be more inclined to save up in cash and then start your business rather than everyone requiring a loan to start their business?

Philipp Bagus:

Yeah, exactly. Look, when everyone gets easy credit, needless credit, then prices will be higher. Prices will be bidded up. If anyone can bid for resources or for capital goods using this money traded by banks out of thin air, then the prices of these capital goods will increase. If we go to a sound monetary standard, then the prices of all these goods and capital goods will decrease and it will be much easier to purchase them because you don’t have this competition of this money that is created there and is trying to purchase these goods. So yes, you would probably finance much more with equity—your investments—in a sound monetary standard, and less with debt. And there would be less malinvestments because, at the end, the investments that can be done are limited by the real savings available and creating credit out of thin air does not increase the real amount of savings. So if we were to have a sound monetary standard, investments would be limited to the real savings available and this would be probably channeled much more through equity investments than through loans.

Stephan Livera:

And one other question on that, because right now when businesses do longer term contracts, they typically build in some kind of CPI term to say, Okay, we’ll build in 2% or 3% inflation in the cost of whatever I’m buying or selling. If we were to flip that, and let’s say we were living in a hard money standard or a sound money standard and we were living in a deflationary world, do you believe businesses would try to build in some kind of deflationary clause to say, Oh, okay, actually because we’re anticipating that the price will fall 2% every year or something like that—did they build in that kind of thing when people were living under a gold standard?

Philipp Bagus:

Oh, no, no, they did not. And I think that they probably would not. Why? I can tell you why: because if they foresee that prices will fall, the reason that they foresee this, a longterm trend in falling prices is because of productivity increases. So if there’s a increase in productivity by capital accumulation or innovations that allows more goods to be produced or better goods to be produced, that means that prices will fall in the long term. But that does not necessarily mean that nominal wages have to fall because if there’s this capital accumulation and innovation, that means that the productivity, actually, of workers will also increase. So then the increase in real wages would be justified by the increase in productivity. So there would be probably no need to actually have nominal wages to fall. While of course, it might be necessary in some cases. But if the fallen prices is actually because workers have been more productive, then at least part of it will be justified and it will be just like a natural dividend to society that consumer prices continuously fall.

Stephan Livera:

That’s really interesting to think about because obviously most of us have grown up in this inflationary world. We’re used to people having to negotiate with their employer to get increases every year just to keep pace. But in the sound money world, it might be more like your real purchasing power is actually increasing every year, even if your nominal wage stays the same.

Philipp Bagus:

Exactly, yeah.

Stephan Livera:

So let’s talk a little bit about some of the causes of deflation because I think as you do in your book, and also as Dr. Salerno spells out in his article, “An Austrian Taxonomy of Deflation,” there is sort of like four different types of causes. And it’s sort of like two of them are good and two of them might be seen as bad. I think the first one was growth deflation that we were sort of speaking to that just now. Can you just tell us a little bit about those different causes of deflation?

Philipp Bagus:

Yeah. First of all, there’s growth deflation. Again, I could talk here about price deflation, why prices fall: one reason why prices fall is that productivity increases, that more goods and services are produced, or better goods and services. And then there’s a tendency of consumer good prices to fall. This gross deflation can be caused by innovations, technology, Internet information technology. It can be caused by increase in the division of labor. The international division of labor has increased a lot in the last 30, 40 years. Because 40 years ago we did not have any products produced in China and, probably now, your computer, my laptop, they are all produced in China. So the the national division of labor has increased a lot. And of course, capital accumulation is another cause for productivity increases—that prices fall for price deflation. Again, this would be the natural result of a market economy. A market economy has a sound monetary system, sound monetary standard, and their prices in the long run tend to fall. Naturally of course it’s good because prices fall because there’s more wealth, there’s more goods produced, so it’s very positive.

Stephan Livera:

And then cash building deflation. Now this is more around what are the level of cash balances that we are all holding. What is the uncertainty that we all face? And if we are increasing our cash balance, what does that mean, a cash building deflation?

Philipp Bagus:

It means that people think that they do not have enough liquidity or enough cash, so they demand more money to hold. So how can I increase my cash balance? First of all, I can buy less than I did last month, from my salary I buy less, or I can sell more. And if people sell more and buy less, then prices tend to fall. And when prices tend to fall—let’s say everyone wants to have a higher cash balance and everyone is buying less and selling more—then the result will be that prices fall and that they actually achieve what they want, because if they hold the same nominal amount of money but prices fall, that means that their real cash balances—that is what they can buy with the nominal amount of cash that they hold—increases. So it’s also beneficial because it satisfies the needs and the wants of people that want to have a higher real cash balance, which they sometimes want when uncertainty increases.

Stephan Livera:

Yeah. And I like in the book as well, you spell out here, you actually disaggregate some of these different components and you spell out even inside this concept of cash building deflation, you can even disaggregate it further and talk about, Okay, there’s things like wealth storage demand for money and speculative demand for money. So could you tell us a little bit about those concepts? Wealth storage demand and speculative demand for money?

Philipp Bagus:

Wealth storage demand for money is that people want to store their wealth in money because it’s very liquid and you can transport it over time. The speculative demand for money is that you demand the money actually because you think that the price of money will increase—the purchasing power of money will increase—and thereby you actually speed up what we think that will happen because the demand of money then increases the tendency of prices to fall and the purchasing power of money to increase.

Stephan Livera:

Fantastic. And now let’s talk about some of the “bad deflation types,” if you will. So we’ve spoken about growth deflation and cash building deflation. And I think for listeners if you also read Dr. Guido Hülsmann’s essay Deflation and Liberty, he spells out why those might first seem really bad, but actually it’s more like the economy is self-correcting itself out. But Philipp could you tell us a little bit about bank credit deflation? What is that?

Philipp Bagus:

Bank credit deflation happens after an artificial boom when fractional reserve banks have expanded credit, have created more money and loaned it out at artificial low interest rates, then investment projects appear to be profitable that are not profitable at high interest rates. So there’s an artificial boom, people start this new project, even though it’s not justified by the real savings around because the projects I’ve just financed—by this money created out of thin air, by this bank credits—so we have an artificial boom, more projects are started than there are real savings around and sooner or later this will become obvious that not all projects can be successfully completed and there will be a bust. And what happens in the bust? Well, these investment projects, some must be liquidated, which means that some companies will go bankrupt.

Philipp Bagus:

This means that there will be losses for the banks that financed these projects. And when the banks have losses, they will become more prudent, they will try to increase their reserves and their equity ratio. How do they do that? By restricting credit, by not renewing old credit lines or when loans are paid back, they don’t give new loans. At the same time, of course bank clients—depositors—when there’s a bust, they look at the bank and see, Oh, the bank has losses, shall I not rather get my money from the bank or stop refinancing the bank. So for all these reasons, in a bust in a real recession, the banks are in a difficult situation and they restrict credit.

Philipp Bagus:

That is, they don’t give out more credit. So this is the bank credit contraction. In a Federal Reserve banking system, the banks can create new loans and when they create these new loans they create new money, the money supply increases. And then when these loans are paid back—and the banks don’t give immediately a new loan—then the money supply shrinks. And this happens typically in a recession, that the banks, when loans are paid back or not paid back because companies go bankrupt, then they don’t give out new loans immediately because they want to increase their reserve ratio and they want to increase the equity ratio. They become more cautious. And this happened of course after the great recession, that banks did not give out new loans. When new loans were paid back. They did not give out new loans, which means that the money supply then shrinks, but the bank credit deflation makes the money supply to shrink. And when the most supply then shrinks, then we have price deflation as a consequence. And then we can actually have a kind of a deflationary spiral because then prices fall, then indebted that companies will get problems to pay back their debts—that are nominally fixed—and they will go bankrupt, that will mean more losses for banks. More losses for banks means that they have to restrict credit even more. That means that the money supply falls even more, prices fall even more. There will be more problems for indebted players and more bankruptcies. So this is the famous deflationary spiral.

Philipp Bagus:

I see it positive—this kind of deflation—because it speeds up of course the recovery. It makes overly indebted companies fall faster or go bankrupt faster than they otherwise would. It has a purging effect. It has a cleansing effect. It makes people become more cautious to save more and more savings are also necessary for new sustainable projects and for recovery. It could also take down very indebted players with it that go bankrupt. It would be very positive. You know, that the highest indebted player in our economy is the government itself. So it gets into the problems as well. So all of these are positive effects and we have also to take into account what is the alternative? The alternative is to re-inflate the same thing and prop up these malinvestments and then the lingering and the malinvested resources would continue. There’s a problem when the bust comes that the resources are located where they should not be. They should be relocated as fast as possible. And the bank credit deflation speeds up actually this process of reallocating the resources. After the financial crisis, unfortunately, was done the wrong thing, the money supply was reinflated and the recession lasted much longer than it should have lasted.

Stephan Livera:

Right. And this is what typically people are scared about if you see the news and they say, Oh no, deflation is bad. This is normally what they’re thinking of. But as you’re saying, this is actually part of the corrective process. And I think it’s also an important point to note that it’s not that the productive assets out there are being destroyed. They still exist—the tractors and the computers and whatever—they still exist. It’s that they just need to be re-purposed to where the market, consumers want them to be repurposed to. Correct?

Philipp Bagus:

Exactly. One might have the preconceived idea that bankruptcies are something bad, but bankruptcies are not something bad in itself. They are actually very, very important in a free market because bankruptcy basically means that the scarce resources of society have been employed in a bad way. They have been employed to produce products that people do not want. Consumers want other products more urgently, and the losses are a sign that means, “Stop this. Stop doing this. Close this business. Reallocate the resources to produce something that is more urgently needed.” This is then what happens en masse in a recession because before there has been this malinvestment caused by this bank credit inflation—the artificially low interest rates—and then the bankruptcies speed up the reallocation of resources. The alternative is to maintain these malinvestments, these businesses there, and continue to waste these resources.

Philipp Bagus:

This is horrible from the point of view of consumers. From the point of view of consumers it is important that the bankruptcy actually occurs. The bankruptcy takes the resources out of the hands of, let’s say, the bad entrepreneur, and gives it to entrepreneurs who have the chance to do some something better with these resources. And as you said, through the bankruptcy these resources do not disappear—they are still there. They just changed the owner. Bankruptcy is just the change of the ownership of the resources. They change. They are in the hands of a failed, a bad entrepreneur, and then they go into the hand of another entrepreneur that has a chance to recombine these resources in another way, in a more productive, innovative way to produce things that consumers want more urgently.

Stephan Livera:

Excellent. And let’s talk about that last one. Fiat deflation. So what is Fiat deflation?

Philipp Bagus:

Fiat deflation is when the government causes price deflation. It’s bad because it’s caused by the government, it’s caused by coercion. The others are voluntary, they are caused by voluntary reactions. Gross deflation is caused by voluntary actions, cash building is voluntary actions. Bank credit deflation is actually, let’s say it’s a free market reaction against an intervention into the free market, against an aggression. But fiat deflation as the name indicates, is by government fiat. It’s done by the government. There are several types the government can cause prices to fall. The most simple one is just that it decreases prices to fall. It just says that all prices have to be lower 10%. Or let’s say they put in maximum prices that are lower than the free market prices for everything. And the other type is coercive monetary deflation—that the government actually confiscates and destroys money.

Philipp Bagus:

Why would it do that? Well, obviously it does not occur so often, but sometimes it does because there has been a strong inflation in the first place, and then they want to destroy this inflation—to get the money out of the way. And sometimes it has also been done when, in the past, there had been a connection to gold, for example, the redemption rate, and then the redemption rate had been suspended, like in the US Civil War. And then they had inflated the money supply and then they wanted to go back to the same redemption rate as before. And they could only do it if they destroyed at least part of this additional money that had been created to finance the Civil War, and they did it by issuing bonds and then destroying this money.

Stephan Livera:

I see. So in that way, it’s like a confiscatory tax almost, but just through another means. Okay. So one other topic that I’d be keen to touch on is this concept of, Oh no, the economy is in a “liquidity trap.” How do Austrians answer that point?

Philipp Bagus:

The liquidity trap argument says, if there’s a price deflation, that makes the interest rate to fall because the deflationary expectations are priced into the interest rate and there’s the zero bound that interest rates cannot be—at least this was the argument before—the interest rate cannot be lower below zero. That means that when we are in the liquidity trap, then the central bank loses its power to stimulate the economy by increasing the money supply and decreasing interest rates. But the Austrian answer to this is that we don’t want this, we don’t want the government actually to stimulate artificially the economy, or through monetary policy. Therefore this is not an argument against deflation because we don’t want the government to manipulate the money supply in the first place.

Stephan Livera:

Right. And I’m also keen to just discuss if you have any examples that you can share in terms of what does a growth deflation look like. And I think in the book you have the example of the US from 1865-1896. Are you able to tell us a little bit about what that looks like and how that might differ to what we are all used to today in 2020?

Philipp Bagus:

Yes, actually in most places in the 19th century there were long periods of price deflation. The American deflation from 1865-96 was one of the longest. Prices—I think they fell more than 30% continuously. And of course it was not a problem for the economy. It was not a problem for economic growth. Actually, it’s the other way around. Prices fell because of extraordinary economic growth, of extraordinary increases in productivity. So prices fell continuously over more than three decades, and the people got accustomed to it. There was no problem. In fact, there was tremendous economic growth. Of course, this is very different to what we are accustomed to right now. And there were of course also conflicts in this period because as I said before, price deflation is not a problem for the economy as a whole because when prices fall, buying prices fall and selling prices fall.

Philipp Bagus:

So it depends if my buying prices fall faster than the selling prices if I am a winner or loser. So if my buying prices fall faster than the selling prices, I’m a winner. But there will be also people who are in the opposite. If I’m a winner, then there’s also a loser because his selling prices fall faster than his buying prices. So this means that price deflation always implies the redistribution. It does not mean that the economy as a whole is getting poorer or it’s a problem for all. But for some it may be a problem, and these are—especially one group that loses in a price deflation are of course the debtors. The debtors lose and the creditors win. It’s not a problem for the economy as a whole because exactly what the debtors lose, the creditors will win, but of course the debtors will protest. They will say this is horrible. We have to do something against price deflation and they will invent theories about deflationary spirals and liquidity traps. And the point of course is that these debtors historically has been very well organized. Because big business, banks, they have been the big debtors. And of course the government is the biggest debtors of all. They have the common interest of getting out of a price deflationary scenario and get into price inflation, and the creditors—or the people who would win in a price deflation, which are the creditors and all people who hold money, they gain through the increase in purchasing power—they are not so well organized. They don’t have a lobby group that defends them.

Philipp Bagus:

So this explains why we have this in the media or in general, they have this fear of deflation and that we live in a world of price inflation because the people who win in a price deflation are much better organized and much closer to government power than those people who wouldn’t in a price deflation. Actually power itself, the government itself, wins in a price inflation and loses in a price deflation because it’s the biggest debtor. And that you can see also in the 30 years after the Civil War, that there were conflicts the people who were highly indebted, said this was horrible for them. Of course it was, they would have been better off if there would have been price inflation because they were debtors, but they were portraying it as if it would be a problem for the US economy as a whole. And it was not, it was a time of tremendous economic growth. And it may be that the relative wealth position of the debtors decrease, but overall wealth increased tremendously in these years.

Stephan Livera:

Fantastic. I really liked that insight about the political strength if you will, of the campaigners on the inflation side versus the deflation side. And I think maybe just to summarize, if you were to talk to the typical man on the street who hasn’t necessarily studied Austrian economics, he is probably confusing growth deflation with bank credit deflation. So when they hear on the news they think, Oh, deflation is bad, they’re probably thinking of bank credit deflation. Whereas those who are more in favor of a sound money, in favoring that hard money, sound money idea because they want the benefits that will come from growth deflation, wouldn’t you say?

Philipp Bagus:

Yeah, most certainly. The point is that central bankers, they don’t make this distinction at all. They, for example, like a few years ago in the Eurozone, when price deflation was coming close to zero—it was not even negative—and it was the inflation of what they measure, that is CPI in their terms. They were saying, well, we’re getting close to this [INAUDIBLE] so we have to inflate. But they did not even ask if this was caused by bank credit deflation or growth deflation. I mean, if it would be caused by growth deflation, most reasonable people would have to agree well this is fantastic, this is not a problem at all. So yes, one should decide between the two. Again, growth deflation is good for everyone. Bank credit deflation—it hurts—but it speeds up also the recovery process, right?

Stephan Livera:

Yeah. So it’s a corrective, yeah. I really liked the way you’ve explained that. I think it was really helpful for my listeners. Philipp, did you have anywhere in terms of, if my listeners want to follow more of your work, where can they find you online or read any other works by yourself?

Philipp Bagus:

Well, my website is philippbagus.de and my Twitter name is @PhilippBagus so if you want to follow me, you can also do that. And on the Mises website, I also have all the stuff that I published with Mises there.

Stephan Livera:

Fantastic. Well, thank you very much for joining me. I’ve really enjoyed chatting with you.

Philipp Bagus:

Thank you very much, Stephan. I also enjoyed it very much.