In a short essay (pp. 595- 602) summarizing a 2004 study done by Andrew Atkeson and Patrick J. Kehoe called Deflation and Depression: Is There an Empirical Link?, Professor Salerno explains that the connection between deflation and economic depression is not as strong as once thought. It’s an interesting read, but there’s a point of contention I want to make. First, Salerno claims the following,

the monetary disequilibrium approach to depression, which has been embraced by many, but not all, of the “free banking” wing of Austrian macroeconomics, seems to now have a serious problem. According to this approach, which was initiated in the writings of the proto-monetarist, FDIC official Clark Warburton in the 1940s, the primary cause of depression is the emergence of an excess demand for money in the economy whose effects are not instantaneously or rapidly neutralized by a corresponding increase in the supply of money. The result is a tendency toward a general fall in prices (deflation) and, at least in the short run, in real output (depression). The lack of a historical relation between deflation and depression found by Atkeson and Kehoe, however, seems to indicate that the monetary disequilibrium theory of depression, which is also a logical-deductive theory, is inapplicable to most, if not all, of empirical reality. Along the same lines, the study also demolishes one of the main props of the argument in favor of unregulated fractional reserve banking. If there is no link between deflation and depression then there is no need for banking institutions that putatively respond to every change in the demand for money with an offsetting change in the supply of money

This is a gross misrepresentation of the monetary disequilibrium position. They do not claim that deflation has an inherent link with depression. On the contrary, the concept of a deflationary monetary disequilibria focuses on the demand-side of the economy. Monetary disequilibrium theorists, such as George Selgin and Steve Horwitz, say falling prices coming from increases in productivity are benign and even beneficial for economic growth.

In fact, it is curious how Salerno makes this sweeping claim that they decry falling prices since Selgin himself has written a book called Less Than Zero: The Case for a Falling Price Level in a Growing Economy! It’s obvious to anyone who understands the free banking position that they support the expected deflation that accompanies increases in output stemming from improvements in productivity and capital accumulation. In fact, Selgin even mentions this very study Salerno cites when saying “The deflation that the gold standard permitted wasn’t such a bad thing:

Why is deflation sometimes depressing, and sometimes not? The simple answer is that there is more than one sort of deflation. There’s the sort that’s caused by a collapse of spending, like the “Great Contraction” of the 1930s, and then there’s the sort that’s driven by greater output of real goods and services–that is, by outward shifts in aggregate supply rather than inward shifts in aggregate demand. Most of the deflation that occurred during the classical gold standard era (1873-1914) was of the latter, “good” sort. Although I’ve been banging the drum for good deflation since the 1990s, and Mike Bordo and others have made the specific point that the gold standard mostly involved deflation of the good rather than bad sort, too many economists, and way too many of those who have got more than their fare share of the public’s attention, continue to ignore the very possibility of supply-driven deflation.

What is needed here is to see what the nature of these deflationary episodes really were, so it can be seen empirically what the connection is between depression and independently both (1) supply-side deflation and (2) demand-side deflation. But there’s nothing in the study that should keep the monetary disequilibrium theorists up at night, despite Salerno’s claims. While many of the recessions had little to do with deflation, there’s reason to believe that the ones that did may in fact have been periods where an excess demand for money caused a short-term fall in output and employment.

It’s interesting to note that at the beginning of the essay, Salerno (almost but not quite) seems to accept the reality of what we may call “good” deflation and “bad” deflation. If he had, that would have been peculiar considering his historical insistence that there’s nothing wrong with deflation in general. That being said, Salerno makes an unfounded accusation at the monetary disequilibrium position here (and by proxy, the free bankers). Unfortunately, this isn’t the first time he’s misconstrued a topic or someone’s position on a matter. I hope to bring more of this to light soon.