Deflation is a monetary phenomenon characterized as a situation where money becomes more valuable (presumably because its scarcity increases) and the goods and services which are bought with it decline in price.   Technically speaking, deflation is not just declining prices, although declining prices might be evidence of deflation.  Deflation is, as Milton Friedman says of inflation, “everywhere and always a monetary phenomenon”.

For an example of deflation as Friedman defines it, consider an imaginary economic system that produces only two items–burgers and beans.  Each year they produce fifty burgers and fifty cans of beans, and each costs exactly one dollar, so there are one hundred dollars in circulation.  So far as real value is concerned a dollar is no different than a burger or a can of beans.  Suppose that one year, a breakthrough technology allows for the production of twice the amount of burgers as before.  If no adjustment is made to the amount of dollars in circulation, the price of burgers, and perhaps also beans, should decline, as there are now a hundred fifty goods (where before there  were a hundred) to be priced in dollars.  If the increased supply of burgers carries all the weight of the decline in price, burger prices will be halved, and a burger will only cost fifty cents, whereas a can of beans will still be a dollar.  But if beans and burgers are somewhat interchangeable (“substitutes”), then the price of a can of beans will also decline.  If the two goods are perfect substitutes for each other, then the new price for each will be $0.67, or two-thirds of a dollar (one hundred dollars divided by one hundred fifty burgers and beans).    This decrease in the price of burgers (and any burger substitutes) is a simple monetary deflation, wholly resulting from a decrease in the money supply relative to the amount of goods and services it is intended to represent.   In times of rapidly-progressing technology (such as during the Industrial Revolution) it is an endemic problem for economies with specie currencies like gold or silver, whose supply can not be controlled by central bankers.

This is all fairly simple thus far.  But what if the central bank wishes to keep prices from falling?  With fifty extra burgers on hand, it would need to increase the money supply (assuming now that it can create money at will).  By how much?  At a dollar apiece right now, it would seem easy enough to just increase the supply by fifty dollars.  But will that prevent the price of burgers from declining?  That’s where it gets tricky.  What if burgers have a stable demand, with no international market and a shelf-life of less than a year?  To induce people to buy more burgers than before–to induce them to increase their consumption of burgers over and above their normal demands–burger prices would have to decline to account for the increased supply, and again, if cans of beans are a at least a partial substitute good, their prices would decline as well.  This is not deflation.  It is a price decline attributable to efficiencies in production allowing more of a good to be produced at the same cost.   There is still one dollar per good as before, but prices have had to decline in order to induce people to want to buy the expanded supply.   The price decline reflects efficiencies gained in production.  It is perfectly normal and to be expected.

But if the central bankers in our imaginary economy  have a bias against price declines and see this price decline as a bad thing, they might add to the money supply again.  Let’s say they doubled the increase in the money supply, adding one hundred dollars to the existing one hundred dollars, for a total money supply of two hundred dollars.  Now, if burgers and cans of beans are perfect substitutes, their price, based on the increased money supply, should go to about $1.33 per unit.  But if they aren’t perfect substitutes, burger prices would be  lower than $1.33 and bean prices higher than $1.33.   But that doesn’t solve the oversupply relative to demand.  In fact, it may actually exacerbate it, by making a good being produced in excess more expensive than it was before.  It won’t appear as there is any damage to the market if burger prices stay at about $1.00 per burger, but if it does, the bean prices would have to go well above $1.33 per can to account for the excess money.  It then would appear burger prices are stable and bean prices are rising relative to year ago levels,  and they are, but only because of monetary hijinks.   Even though burger prices didn’t rise, they didn’ t go down like they should have.  This is inflation.  It, like deflation, is purely a monetary phenomenon.  Burger prices should decline in the face of productivity enhancements that allow the market to be oversupplied.  If they don’t then there is inflation.  Prices that don’t decline in the face of productivity improvements are like Sherlock Holmes’ dog that didn’ t bark. 

The third scenario effectively describes the trajectory of the US economy from about  1997 onward, as very few of the productivity enhancements attendant to the development and application of communications technology (internet, cell phones, etc.)  were allowed to resolve as lowered prices because of the policies of the US Federal Reserve. 

The Fed’s greatest fear is what it terms “deflation” but is really not.  The Fed fears any general decline in prices, whether due to productivity enhancements or to decreases in the money supply relative to the goods and services it is meant to represent, or to decreases in overall demand due to demographic forces.  Productivity enhancements and/or declining demand, so far as they are widespread throughout an economy, should cause a declining level of prices that looks very much like deflation, but isn’t.   Trying to prevent them (declining prices) will only result in exacerbating an oversupplied condition.  In the last example, the next year, since burger prices didn’t decline, the price signal for burger makers would be to create as many or more burgers as before, so the oversupplied condition will continue and worsen.   It will take even more monetary shenanigans to keep prices from declining with each subsequent year.  Eventually, there are far too many burgers (and for that matter, beans, because they are subject to the same distorted price signals) and prices collapse under the onslaught, never mind how much money is created.  The impetus to keep prices stable or rising has instead ultimately caused them to crash. 

The lesson, here again, is the ineffectiveness of monetary policy in changing anything real.  Monetary policy can temporarily distort price signals such that demand or supply-changing market forces are forestalled at the price point, but the effects are illusory and only temporary, and the illusions and misallocation of resources thereby created ultimately end up costing more than the problems the policy was trying to fix. 

The last scenario imperfectly describes the United States in the aughts, Japan to some extent in the nineties and the aughts, and finally now it appears, the Euro Zone.   It will take quite a while for the forces held at bay (for longer, probably, than anyone imagined) to work their way through these economic systems.