A Healthy Capitalist Economy Is Deflationary
Why do economists teach the opposite of the clear facts?
Heads up, everyone. This might just be the most controversial article I’ll ever write. All you have to do is mention the word “deflation” around most economists, and watch them start to hyperventilate. They’ll start freaking out, babbling about about the Great Depression, about market crashes and recessions and people hoarding money and the whole economy grinding to a halt.
This is largely nonsense, and in many ways is the precise opposite of the truth. In a capitalist free-market system, a healthy economy will always be deflationary.
Please note that I just said exactly what I just said, and did not say anything that I did not say. In particular, I did not claim that “deflation is always healthy for the economy,” or anything like that. But that’s the strawman argument that will get pulled out 9 times out of 10 in response to a claim like this.
We’ll come back to that. But let’s set it aside for the moment and talk about a normal, healthy capitalist economy.
What is capitalism?
The term “capitalism” has gotten a bit of a bad rap over the last few decades. On the Left, you have the Communists, who teach that capitalism is full of greed and oppression and needs to be destroyed, and on the Right, we have Libertarian infiltrators who have come up with an impostor system that’s legitimately full of greed and oppression and needs to be destroyed, validating the Left’s claims, and called that “capitalism” when it’s really nothing of the sort.
Just for simplicity’s sake, let’s call the Libertarian system “corporatism.” It’s based on the idea of extreme laissez-faire, that government intervention in markets is basically always both counterproductive and morally wrong, and that wealth gained through commerce is always fairly earned and deserved.
In other words, it’s the Law of the Jungle, just with the force of violence replaced by the force of contracts and economics — which are of course backed by law, and the State’s monopoly on violence, though Libertarians rarely mention that little detail.
Actual capitalism is similar enough for corporatism to pass as a decent counterfeit, but at the same time very different from it in many important ways. It was defined by Adam Smith in The Wealth of Nations, which was a follow-up to his earlier work, The Theory of Moral Sentiments, which as the name suggests concerned itself largely with a discussion of morality. And as such, The Wealth of Nations did not lay out a corporatist system of capitalism; quite the opposite in fact! It was primarily dedicated to an exploration of how a system of free-market trade and commerce could be made to work in a moral fashion, without running into all of the exploitative problems that give today’s “capitalism” such a bad name.
Smith was, in fact, deeply suspicious of the motives of powerful businessmen, and recommended multiple ways that their power be limited. He spoke against monopolies, in favor of taxing the rich more heavily than the poor (with the justification that they benefit disproportionately from the amenities of civilized society, and therefore ought to pay the lion’s share of the costs of providing such amenities,) and in favor of keeping the economy as local as possible rather than internationalizing at every opportunity. In fact his famous “invisible hand,” that Libertarians take every opportunity to claim will bring prosperity if giant corporations are left free to do whatever they want and send all of our jobs overseas, comes from a passage specifically describing how prosperity comes from “preferring the support of domestic to that of foreign industry.” Smith was largely against the notion of corporations in the first place, as they have a tendency to concentrate too much power in too few hands, and stated that “An incorporation … makes the act of the majority binding upon the whole. … The pretence that corporations are necessary for the better government of the trade, is without any foundation.”
In the last few years, we’ve received a pretty stark wakeup call over our departure from these principles. As giant, powerful companies, often monopolies or near-monopolies in their own sectors, have gone woke, they’ve used their power to suppress the ability of conservatives to communicate, to engage in trade, and often even to find employment. Internationalization bit us in the butt pretty hard when Covid lockdowns disrupted international shipping seven ways from Sunday. And the classic libertarian “solution” that if you don’t like what hostile businesses are doing, “just build your own,” was starkly revealed in 2020-2021 for the bad joke it’s always been, when various conservative businesses did exactly that and then got their operations pulled out from under them by powerful monopolists at all levels of internet infrastructure. (Are we expected to build our own internet next?!?)
The “capitalism” we have today is garbage, but unfortunately it’s what we have and we’re stuck with it. That doesn’t mean, however, that we can’t try our best to clean it up and bring it back in line with real capitalism.
Capitalism and inflation
The Wealth of Nations had some harsh words to say about inflation. In chapter 5, Smith goes over the history of money, how it began as weights of precious metals, then evolved into minted coins containing a certified quantity (weight) of metal to simplify the process of commerce by removing the need for careful, exacting weighing of gold and silver on scales. But this enabled a nefarious process:
in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal, which had been originally contained in their coins. The Roman as, in the latter ages of the republic, was reduced to the twenty-fourth part of its original value, and, instead of weighing a pound, came to weigh only half an ounce. The English pound and penny contain at present about a third only; the Scots pound and penny about a thirty-sixth; and the French pound and penny about a sixty-sixth part of their original value. By means of those operations, the princes and sovereign states which performed them were enabled, in appearance, to pay their debts and fulfil their engagements with a smaller quantity of silver than would otherwise have been requisite. It was indeed in appearance only; for their creditors were really defrauded of a part of what was due to them. All other debtors in the state were allowed the same privilege, and might pay with the same nominal sum of the new and debased coin whatever they had borrowed in the old. Such operations, therefore, have always proved favourable to the debtor, and ruinous to the creditor, and have sometimes produced a greater and more universal revolution in the fortunes of private persons, than could have been occasioned by a very great public calamity.
In other words, nations in debt turn to inflation to more easily pay down their debts, which screws over everyone except the debtors. Modern governments may not make coins out of gold and silver anymore, but this “avarice and injustice … abusing the confidence of their subjects” continues unabated in our own time. The more things change…
Healthy capitalism is market competition
In chapter 7, Smith speaks of supply and demand, the effect it has on prices, and the effect that competition has upon supply and demand, and thus on prices. He speaks of monopolies in harsh, condemnatory terms that would get him branded as “a socialist” by modern-day corporatist economic thinkers:
The price of monopoly is upon every occasion the highest which can be got. The natural price, or the price of free competition, on the contrary, is the lowest which can be taken, not upon every occasion indeed, but for any considerable time together. The one is upon every occasion the highest which can be squeezed out of the buyers, or which it is supposed they will consent to give; the other is the lowest which the sellers can commonly afford to take, and at the same time continue their business.
Under capitalism as described here, “the natural price” of a product and “the price of free competition” are one and the same, and it is the lowest price that the sellers can afford without going out of business. Smith’s logic implies that when you see a company operating with high profit margins, this is a warning sign that something is going wrong with capitalism.
The most common examples of such companies today are those that produce products and services based on one form or another of intellectual property. They are granted monopoly status through patent or copyright laws, thus giving them the ability to charge monopoly prices and get away with it, rather than free competition driving them down to the natural price. Adam Smith was not the only person to have a problem with such arrangements. When discussing the nascent Constitution with James Madison, Thomas Jefferson wrote that he did not like “the omission of a bill of rights providing clearly & without the aid of sophisms for freedom of religion, freedom of the press, protection against standing armies, restriction against monopolies, the eternal & unremitting force of the habeas corpus laws, and trials by jury.” That list looks pretty familiar to us today; virtually all of those ended up in the Bill of Rights, with one notable exception.
In Madison’s reply letter, he largely agrees with Jefferson about the need for a Bill of Rights, but downplays the importance of a protection against monopolies:
With regard to Monopolies they are justly classed among the greatest nusances in Government. But is it clear that as encouragements to literary works and ingenious discoveries, they are not too valuable to be wholly renounced? Would it not suffice to reserve in all cases a right to the public to abolish the privilege at a price to be specified in the grant of it? Is there not also infinitely less danger of this abuse in our Governments than in most others? Monopolies are sacrifices of the many to the few. Where the power is in the few it is natural for them to sacrifice the many to their own partialities and corruptions. Where the power, as with us, is in the many not in the few, the danger can not be very great that the few will be thus favored. It is much more to be dreaded that the few will be unnecessarily sacrificed to the many.
In simple terms, Madison wanted a system with protection for patents and copyrights, and saw “infinitely less danger of … abuse in our Governments then in most others” because the nature of a democratic government means that The People can revoke these grants of monopoly rights if they become too abusive.
And… yeah. If you’re at all familiar with the history of copyright and patent laws in America, you know that that never happened, and trying to get it to happen today would be exceptionally difficult for a variety of reasons. Turns out Jefferson was right on this point, and we’ve all been paying for it ever since. Especially since the passage of the DMCA in 1998, copyright interests have taken a turn for the openly abusive and extractive, simply because they now could, exactly as Adam Smith predicted.
In a healthy capitalist system, by contrast, free competition abounds.
Market competition drives prices down
When prices become too high, and the competitive landscape is not encumbered by monopolies and barriers to entry, there are incentives for talented entrepreneurs to compete. Someone will build the proverbial “better mousetrap” and bring it to market at a lower price, and the competition has to figure out how to respond.
Under capitalism, they respond through competition. They’ll try to figure out how to match or even exceed the newcomer’s process, either bringing down the cost of their own offering or improving its design, to differentiate themselves and compete on quality. Under corporatism, what we often see instead is consolidation: a large competitor uses their capital not for legitimate capitalist purposes, but instead to either buy out the competition or run them out of business, through litigation, dumping, or other predatory practices. Successfully doing so means that they don’t need to compete and drive their prices down to the natural price, and so they get to enjoy higher profit margins, at the expense of their customers.
We do have plenty of examples of this going right, though, particularly over the course of the past few decades. I’ll always remember my sense of amazement as a child when my mother told me how, when she was a little girl, oranges were so rare and expensive that they were a treat she and her siblings were delighted to receive once a year in their Christmas stockings. By the time she grew up and started having kids of her own, increased competition had driven the supply up and the price down to the point where you could by as many as you want at any local grocery store, year-round.
When I was a child, home computers cost thousands of dollars. I remember what a big deal it was in the late 90s when fully-featured sub-$1000 PCs started to be introduced on the market! Today, you can find plenty of fully-functional PCs for under $200, and a few for under $100. And those old prices aren’t even adjusted for inflation! There’s been a massive slide in prices for consumer electronics (it’s not just computers; TVs and other electronics have seen similar price decreases over the years) in the last 40 years, because of robust competition, delivering us products that are thousands of times better in every way, at prices coming down significantly faster than inflation has been driving general prices up!
We have a name for prices going down…
This is how capitalism is supposed to work. A freedom from barriers to entry creates robust competition. Competition creates abundance and high quality. Abundance drives prices down.
Prices going up is inflation. The opposite, prices going down, is deflation. A healthy capitalist system is inherently deflationary, and that’s a good thing.
So why do we hear that deflation is bad?
Official economists always talk about deflation as if they’re terrified by it. Why would they be, if it’s a good thing and a sign of a healthy economy? Well, two reasons. First, because we’re tens of trillions of dollars in debt and inflation as a debt-management strategy is official policy, and deflation throws a wrench in that. (And honestly, it’s not just the government; a whole lot of individuals are in debt across the nation, and to the degree that they’re in debt, they benefit from inflating it away too.)
Second, because of a severe confusion of several points related to recessions and what’s known as the business cycle. The simplistic version of the business cycle goes like this: “natural fluctuations” cause alternating periods of expansion and contraction in an economy. When things start to go wrong, demand dries up, businesses lose revenue, some of them go under, people get laid off, and it’s all a big basket of misery we call a recession, until things start flowing better again, and then you get recovery and a return to prosperity and happiness.
If you’ve been reading this Substack for a while, you probably noticed that this explanation is a bunch of magical reasoning, full of effects with no causes. So here’s a much better understanding of the business cycle:
Prosperity leads to a desire for further prosperity. Businesses see good times all around, and want to expand more and faster.
A desire for further prosperity leads to debt. Businesses take out loans, or issue bonds, in order to expand. Everyone’s happy to lend during good times, because it feels like the party will never end, so plenty of businesses have easy access to cheap money.
Not all businesses can deliver on their promises. Sometimes their reach exceeds their grasp; sometimes they were just straight-up frauds or ill-conceived entities that should never have been in business in the first place. Eventually something goes wrong, these businesses fail, and their debts don’t get paid for various reasons.
No one wants to lend if they won’t get their money back. Once the defaults and bankruptcies start rolling in, credit begins to tighten up as a reaction. This often happens indiscriminately across the board, making it harder to access even for responsible companies that can handle their debts.
Everything snowballs from here. As credit tightens, more businesses get in trouble, often surprisingly so. Businesses that everyone thought were healthy go bankrupt because they can’t meet expenses without further loans. As Warren Buffet famously put it, “only when the tide goes out do you discover who's been swimming naked.”
The trash gets taken out. Unhealthy businesses go out of business, and those that managed to weather the storm come out the other side all the stronger. You end up with a much cleaner business landscape, with a lot of toxic debt cleared away.
Consolidation and low competition leads to opportunities for entrepreneurship. Have a look sometime at just how many of the most powerful and recognizable household-name businesses today first came into existence during or immediately following severe recessions. As people get the sense that the crisis has passed, lenders and VCs become more free with their money, and new businesses get off the ground.
Increased competition leads to prosperity. And now we’re back to the top of the cycle. People call it “the business cycle,” but that’s really kind of a euphemism because no one wants to call it what it really is: a debt cycle.
On the way down in this cycle, as the supply of money tightens and people are losing employment, there’s less money available to spend on all sorts of things. In other words, demand drops. This causes prices to fall: deflation. And so you get a textbook causation/correlation fallacy, where people say “we don’t want deflation, because that means a recession.” No, not at all; the recession causes the deflation, not the other way around.
That’s where we get to the strawman argument from the top of the article: people will say that deflation is not a sign of a healthy economy because it shows up during recessions. And yes, when this happens, it’s painful, definitely. It’s not immediately healthy for the economy; quite the opposite in fact.
But in the bigger picture, it’s healthy in the same way that a fever or vomiting can be good for your health when you’re sick: it’s helping to get rid of the toxic things that are making you sick. Without clearing out the bad debts that are dragging everything down, the economy might never recover, and deflation helps with that.
But no one would spend!
The other common argument against deflation is “it will make economic activity grind to a halt as people try to wait it out.” If you expect something will be cheaper tomorrow, why buy it today? And at first glance, this seems like a reasonable argument, but then you think about it for five seconds and realize it’s mostly nonsense.
What are you buying? What are you, personally, buying in your day-to-day life? Mostly the basics. You buy your groceries. You put gas in the car. You pay your bills. How much of that can you simply choose not to do just because prices are falling? If you think groceries are going to be cheaper next week, yeah, that’s cool and all, but what exactly are you going to eat until then?
If you mention this, the standard response is something along the lines of, “well sure, for consumer goods maybe, but on the large-scale economy, you’re going to see a major decline in investment!” To which I can only laugh at the sheer absurdity of this utter failure of analysis. As Charles Babbage famously put it, “I am not able rightly to apprehend the kind of confusion of ideas that could provoke such a [conclusion].”
Think about it. Pretend you’re a big-shot investor with millions of dollars, looking for the right time to invest in something. What would get you more excited? The inflationary scenario, in which you invest expensive dollars today in the expectation of receiving debased future dollars? Or the deflationary scenario, in which you invest cheap dollars today in the expectation of receiving more-valuable future dollars? To ask the question is to answer it!
Debt, debt, debt, debt, debt.
Ultimately it all comes down to debt. Over and over again, at every turn, we see that debt is the problem, the uber-problem from which so many other problems spring. If you’re in debt, do everything you reasonably can to pay it down quickly. If you’re in some position of influence, push for policies that will allow our nation to do the same.
Only by getting out from under our mountainous, ruinous debts can we hope to build a healthy, capitalist economy.