Classical deflation theory.

Deflation, the opposite of inflation, is a situation of falling general prices. It should not be confused with disinflation, which refers to a declining inflation rate that nevertheless remains positive. It was the successful U.S. disinflation of the 1990s, a disinflation that lowered the inflation rate sufficiently to create concern that further downward pressure might push it into negative territory, that spurred recent fears of deflation. These fears have materialized in Japan, where deflation coincides with cyclical recession and stagnant growth. Most famously, deflationary fears became reality in the 1929-1933 Great Contraction in the United States when prices fell by a fourth while output was falling by two-fifths.

Such episodes indicate that dread of deflation stems from its association with unemployment, business failures, and financial stress. Deflation tends to occur in cyclical slumps when collapses in aggregate spending force producers to cut prices continuously in a desperate effort to attract buyers. While these cuts eventually help to revive economic activity, they hardly work instantaneously. In the meantime, output and employment languish. The best alternative, therefore, may be to avoid deflation altogether by deploying monetary and fiscal policies sufficient to maintain economic activity at full capacity levels with low and stable inflation.

Absent in much of the recent worry over falling prices is the recognition that deflation is hardly a new topic or a new event. Classical (circa 1750-1870) monetary theorists, in particular, had much to say about it. Classicals, of course, abhorred deflation because, when unanticipated, it occasioned arbitrary and unjust redistributions of income and wealth from debtors to creditors. But classicals looked beyond these distributional outcomes involving equal but opposite transfers from losers to gainers to deflation's adverse effects on output and employment. As we will see, classicals attributed such adverse effects to price-wage stickiness; to rising real debt, tax, and cost burdens owing to lags in the adjustment of nominal values of those variables to falling prices; to the hoarding (rather than spending) of cash in anticipation of future deflationary rises in the purchasing power of money; and to other determinants. In general, classicals assumed that deflation was unanticipated, the exception being their analysis of hoarding where they took expectations into account.

Generally, classicals wrote during or following periods of wartime inflation under inconvertible paper currencies. At such times the government had committed itself to return to gold convertibility at the pre-war parity. Such restoration, of course, meant that the price of gold, goods, and foreign exchange--all of which had risen roughly in the same proportion during the war (1)--had to fall to their pre-inflation levels. Achieving these price falls, however, required contractions of the money stock and so the level of aggregate nominal spending. Owing to the above-mentioned temporary rigidities in either final product prices or nominal costs of production, these falls in spending would depress output and employment first before they lowered costs and/or prices. With prices sticky, falling expenditure would show up in reductions in the quantity of goods sold. Unsold goods, the difference between production and sales, would pile up in inventories, thus inducing producers to cut back output and lay off workers. And if rigidities lodged in costs instead of prices, a reduction in spending would drive product prices below (inflexible) costs. The resulting losses (negative profits) would force producers to contract their operations. Eventually, however, rigidities would vanish, and prices and costs would fall in proportion to the monetary contraction. When this happened, real activity would return to its natural equilibrium or full-employment level, but not before workers and producers had suffered painful losses of income and employment.

Classicals analyzed these phenomena with a conceptual framework consisting of the quantity theory of money and the assumption of sticky product and/or factor prices. The quantity theory located the source of deflation in contractionary monetary shocks. And the sticky-price assumption explained the temporary adverse output and employment effects of the shocks. Together, these two pillars of the classical model reconciled the short-run nonneutrality with the long-run neutrality of money. In sum, on shocks and their propagation through the economy's impulse-response mechanism, the classicals largely were in agreement.

Agreement did not extend to policies, however. Far from it. The classicals' quantity theory framework told them that the way to avoid deflation was to refrain from monetary contraction. But support of or opposition to that prescription varied with the policy objectives of the individual classical economist. Those preferring full employment at any cost endorsed the prescription even though it implied accepting the high prices established during the preceding inflation. Should the prescription conflict with the gold standard, so much the worse for the latter. Full-employment proponents were prepared to abandon metallic standards for a well-managed fiat paper standard and flexible exchange rates. On the other hand, those who favored restoring gold convertibility at the pre-war par were willing to countenance money-stock contraction, albeit at a gradual pace so as to minimize the costs of deflation.

The foregoing classical contributions have never been given their due recognition. To the best of this observer's knowledge, no systematic survey of classical deflation theory exists. Instead, one sees references to the neoclassical (circa 1870-1936) literature featuring contributions such as Irving Fisher's debt-deflation theory, his distinction between real and nominal interest rates, Knut Wicksell's notion of a painless fully-expected deflation, and Willard Thorp's empirical finding (see Laidler 1999, 187, 217, 223) of a relationship between secular deflation and the frequency, severity, and duration of cyclical depressions. According to Thorp, hard times were more likely to occur along a falling price trend than along a flat or gently rising one. While these and other concepts of the neoclassical literature are well known, the classical literature, by contrast, is largely ignored. This article is an attempt to repair this deficiency. It shows that the speculations of six leading classical monetary theorists--namely David Hume, Pehr Niclas Christiernin, Henry Thornton, David Ricardo, Thomas Attwood, and Robert Torrens--constitute a rich and coherent body of deflation theory, the constituent components of which survive today even as they are often wrongly attributed to neoclassical writers. To be sure, these six economists were not the only classicals to write on deflation. Nevertheless, they stand out as the seminal and influential ones. Their writings represent classical deflation theory at its best.

1. DAVID HUME (1711-1776)

Classical deflation theory begins with David Hume. Contrary to other classicals, he drew his inspiration not from the topical problem of the resumption of convertibility, but rather from an episode that occurred more than a hundred years before he wrote, namely the economic stagnation associated with the efflux of silver from Spain's colonies in the New World between 1560 and 1650. Hume's work is important because it established key features of the classical theory. These included the assumptions that shocks are predominantly monetary, that deflation is partly unanticipated or unperceived owing to agents' lack of information on money supply variations, that prices lag behind prior changes in the money stock, and that monetary contractions therefore have nonneutral effects on real variables in the short-run if not the long. Most of all, his work demonstrates both the painfulness of deflation when prices are sticky and its painlessness when prices are flexible.

In his 1752 essay, "Of Money," Hume stresses the inertia of sluggish prices as the channel through which deflationary monetary contraction temporarily reduces output and employment. Sticky prices, which Hume attributes to the incomplete information price-setters possess on monetary changes and their resulting failure to act upon the changes, imply that deflationary pressure falls on real quantities first before it lowers prices. That is, from the equation of exchange MV = PQ where M denotes the money stock, V its turnover velocity of circulation, P the price level, and Q the quantity of real output, it follows that with V constant (as Hume always assumed it to be) and P sticky, a fall in M must, by reducing aggregate demand MV, result in a corresponding temporary oversupply of goods that induces producers to cut output Q and lay off workers before they begin to lower prices. Money stock shrinkages, Hume wrote, "are not immediately attended with proportionable alterations in the price of commodities. There is always an interval before matters be adjusted to their new situation; and this interval is ... pernicious to industry, when gold and silver are diminishing ..." (Hume [1752] 1970, 40). Here is the source of the classical recognition of aggregate real effects of deflation, as opposed to purely distributional (creditor-debtor) effects.

Describing these pernicious real effects, Hume writes that "a nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money, but is on the encreasing hand. …

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