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Inflation and Deflation: The Moral Distinction

Alan Greenspan, chairman of the Federal Reserve System, has expressed concern lately over the prospect of deflation. Deflation, by his definition, is a general decline in prices over the entire economy.

  • Timothy D. Terrell
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Alan Greenspan, chairman of the Federal Reserve System, has expressed concern lately over the prospect of deflation. Deflation, by his definition, is a general decline in prices over the entire economy. To be sure, Greenspan would be able to point to a few cases in which falling prices have occurred alongside a recession. The Great Depression is certainly one good example of this. As banks failed in large numbers, depositors’ money disappeared. With less money in the economy, each dollar had to go farther; each dollar had a higher purchasing power.

At the time the Great Depression began, the United States and other countries were on a gold standard. Some people have since blamed the Federal Reserve for failing to do enough to increase the number of dollars in circulation, and have said that an inappropriate attempt to preserve the gold standard before 1933 made the crisis more serious. Drawing on popular criticism of the banking system, Depression-era monetary reforms led to the destruction of the gold standard.

Franklin Delano Roosevelt certainly did his part. In early 1933, beginning immediately after taking office, Roosevelt closed the banks and started the process of collecting gold from the American people. In January, 1934, after monetary gold was in the hands of the Federal Reserve System, the Gold Reserve Act was passed. This transferred all the gold and gold certificates to the federal government, and ratified the (legally doubtful) presidential proclamations Roosevelt had made during the preceding year.

Having succeeded in getting his hands on the primary competitor to the unbacked Federal Reserve Note — gold — Roosevelt then issued Presidential Proclamation 2072, which devalued the dollar by 59 percent. Morally, this was no different than robbery. Roosevelt had taken in all the monetary gold from the American people, paying for it with Federal Reserve Notes at the rate of $20.67 per ounce. Now, having some assurance that the population was legally unable to exercise a preference for gold over the Federal Reserve currency, he declared that each ounce of gold was worth $35. If this change had been made while the gold was in the hands of the American people, it would still have had a negative effect—it would create uncertainty and a transfer of wealth from savers to borrowers. But who got to spend the extra $14.33 per ounce in this case? The federal government, of course. About $4 billion showed up on the government’s books through these accounting shenanigans. Enron and Worldcom have nothing on a government with a printing press.

Roosevelt completely missed the real cause of the Great Depression. He noticed that prices were falling, and figured that falling prices meant that firms were not getting much revenue, and that firms therefore would have to cut the wages paid to employees. Employees would then have fewer dollars to spend, and so the demand for products would be lower. The economy would spiral downward. It might be unrealistic to say that Roosevelt had thought this through, but a few in his administration undoubtedly did. Falling prices were seen as the source of economic problems, rather than a needed correction of deeper problems. (More on those “deeper problems” later.) So, taking a few pages from Mussolini’s fascist reforms in Italy, Roosevelt began to group American industries into cartels. These cartels, called Code Authorities, operated under government supervision and had immense authority. They could set quality, prices, and output quantities for the industry. Lower-priced competition was effectively outlawed.

This program’s failings are too many to elaborate on here, but John Flynn’s book The Roosevelt Myth would be a good start for someone wanting more on this topic. In brief, the cartelization scheme was economic nonsense. If this succeeded in pushing prices up in some industry, the employees in that industry might see the number of dollars they take home rise. Then they would notice that the dollars didn’t go quite as far as they had hoped, because of course the Code Authorities would have pushed the prices up in other industries as well. And these employees’ bosses would have problems, too, as soon as they attempted to buy equipment and supplies from other cartelizing firms.

Mercifully, this program (run as the National Recovery Administration) was ruled unconstitutional by the Supreme Court in 1935. But the monetary side of Roosevelt’s economic strategy was still in place. And, long-term, it would not be difficult to say that the abandonment of the gold standard in the 1930s was more destructive than Roosevelt’s alphabet soup of federal programs.

When the American people were deprived of their ability to exchange currency for actual, physical gold (not just the happy thought that at Fort Knox the government had a lot of it locked away), a major check against the government’s propensity to steal had been lost. Less than forty years after Roosevelt’s momentous first year in office, Nixon eliminated the last vestiges of the gold standard. Just a few years later, the Fed produced such large increases in the money supply that price inflation became a matter of serious concern. Today the effects are still with us. As the Austrian school of economics would argue, recent stock market bubbles and recessions are as much a product of the Federal Reserve’s money manipulations as they were in the late 1920s and 1930s.

Creating money out of thin air, as the Federal Reserve does, destroys the value of savings and transfers wealth into the hands of the state and the state’s friends. Morally, deflation is entirely different. Price deflation — and we understand that term to mean a fall in prices over time — does not usually result from the government’s attempts to manipulate the money supply (see Leviticus 19:35, 36). In fact, if the economy is growing and the money supply is not being expanded rapidly, it will be normal for prices to gradually fall. This rewards saving and does no damage to the economy. Of course, the deflation of the Great Depression was a result of banks taking the money entrusted to them by depositors and lending it to others who proved unable to repay. When the depositors came back for their money all at once, the banks shut their doors, leaving depositors with no hope of repayment or restitution. The fractional reserve banking system, in which multiple people have a claim on the same deposited dollar, made widespread bank insolvency possible. The Fed is to blame for the timing and the magnitude of the event. These are the “deeper problems” that led to the Depression. Price deflation was the result, not the cause.

Inflation, on the other hand, is dangerous both to the economy and to freedom. As Rousas J. Rushdoony pointed out in Roots of Inflation:

Inflation is an act of state, a very highly desirable act of state from the standpoint of politicians and the bureaucracy, because it increases vastly the powers of the state. The rise of the modern totalitarian state has its economic origin in the abandonment of gold coinage for paper money. As the creator of fiat money, of instant money by means of legalized counterfeiting of wealth, the state is always the wealthiest and most powerful force in society.

Alan Greenspan himself recognized the importance of a gold standard as a check on the government’s ability to produce inflation. Ultimately, he saw the gold standard as essential to the free-market order. Of course, he made this argument many years ago, in a 1966 article for Ayn Rand’s newsletter. As Gary North reminded readers on LewRockwell.com recently, the Fed Greenspan has so far not publicly disavowed the pre-Fed Greenspan’s statements on this point. Amazing what the offer of immense power will do to one’s principles.

Rushdoony was adamant in his opposition to the state power to inflate the money supply. Inflation went along with undue state power and coercion, and violated the Biblical command that just weights and measures be used in the marketplace (Leviticus 19:35, 36). Deflation is quite different, and does not deserve to be so disparaged by Greenspan. As a formerly outspoken advocate of the gold standard, he should know why.


  • Timothy D. Terrell

Timothy Terrell is associate professor of economics at Wofford College in Spartanburg, South Carolina. He is assistant editor of the Quarterly Journal of Austrian Economics and is an Associated Scholar with the Mises Institute.

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