The Hubris of Central Bankers and the Ghosts of Deflation Past
By Richard Ebeling - July 06, 2010

In 2003, while the United States was at the end of another boom and bust cycle following the bursting of the "dot.com" bubble and the Y2K scare, there were many monetary central planners at the Federal Reserve and the European Central Bank who were expressing fears about the danger of "deflation" and the supposed perils it could create for the economies of the United States and the Europe.

Alan Greenspan and Ben Bernanke at the Federal Reserve and Otmar Issing at the European Central Bank were delivering speeches claiming to explain what they meant by "deflation" and what the U.S. and European central banks could and would do to prevent any deflationary forces that might come into play.

The same fears about deflation have been frequently expressed over the last two years during the current economic crisis. But the central bankers have not expressed what they mean by deflation and what they would do if it occurred with the clarity and detail with which they explained it in 2002 and 2003.

The following is an article that I wrote at that time on "The Hubris of the Central Banker and the Ghosts of Deflation Past."

I explain the different meanings of deflation and their significance. I also critically analyze what our central bankers', including the current chairman of the Federal Reserve, Ben Bernanke, generally mean by deflation and why their "solutions" would make any supposed deflationary "problem" even worse.

One fact should be pointed out in terms of the current economic crisis. There has been no monetary deflation — that is, an absolute decrease in the quantity of money and credit in the economy. Just the opposite. Since 2008, the Federal Reserve has increased the total amount of reserves in the banking system by around $1.5 trillion, mostly by buying up many of those "toxic" mortgages that were guaranteed by Fannie Mae and Freddie Mac.

This huge expansion in the potential quantity of money and credit that could flood through the financial markets and generate significant price inflation has been held off the market due to the fact that the Federal Reserve has been paying banks interest to hold those sums as unlent reserves. With key market interest rates being kept artificially low at near zero or one percent through activist Fed policy, banks have found it more profitable to earn that positive rate of interest at the Federal Reserve.

But unless the Fed finds some way to drain those "excess reserves" out of the banking system, significant inflationary — not deflationary — forces may be at work looking to the next few years ahead.


Nearly 75 years after the great stock-market crash of 1929, monetary policy is still haunted by the ghost of the Great Depression. The severity of the American stock-market decline during the last three years has again awakened fears among some policymakers that the economic downturn might bring about a deflationary period of collapsing output and employment like that experienced during the early 1930s.

Prominent members of the board of governors of the Federal Reserve System, as well as a senior member of the executive board of the European Central Bank, have delivered public addresses attempting to assure the financial community that it is in the power and ability of monetary central planners to prevent a repetition of the Great Contraction of 1930-33. On November 21, 2002, Federal Reserve governor Benjamin S. Bernanke delivered his address "Deflation: Making Sure 'It' Doesn't Happen Here" to the National Economists Club in Washington, D.C.

About a month later, on December 19, 2002, Federal Reserve Chairman Alan Greenspan discussed the dangers of and remedies for any deflationary threat at the Economic Club of New York in an address entitled "Issues for Monetary Policy." And on December 2, 2002, European Central Bank Executive Board member Otmar Issing evaluated "The Euro after Four Years: Is There a Risk of Deflation?" at the 16th European Finance Convention in London, England.

What is deflation? Its general connotation, of course, is something "bad." During a period of deflation, prices in general in the economy are decreasing and this is considered to generate negative consequences in terms of falling output, rising unemployment, investment uncertainty, and broad market instability and collapse.

But before the rationales for an "activist" monetary policy to combat deflation can be judged, it is first necessary to know what can be the causes behind a general decline in prices. And it is additionally useful to clarify the role of government in past episodes of price deflation.

It is possible to distinguish at least three causal factors behind a general fall in prices. They are: supply-side deflation, price-wage rigidity deflation, and monetary deflation.

Supply-Side Deflation

A general decline in prices may accompany significant increases in output resulting from productivity increases and cost efficiencies. One of the competitive forces in the market economy is the never-ending drive of entrepreneurs to bring better and less-expensive goods and services to market to the consuming public. New technologies and cost-saving innovations introduced within business enterprises enable more goods to be manufactured and sold at lower per-unit costs. Sellers, in one sector of the economy after another, increase their supplies offered on the market, and competitive pressure results in a lowering of the prices of those goods over time to reflect their lower costs of production. The cumulative effect is that the general level of prices will have declined when measured by various statistical price indices over a period of time.

In the period between the end of the American Civil War in 1865 and 1900, the general level of prices in the United States declined by about 50 percent. While the American economy did experience short periods of economic depression during those years (mostly due to the federal government's manipulation of the monetary standard), the nearly half-century era during America's Industrial Revolution saw a dramatic rising standard of living even though accompanied by an expanding population.

An open, free-market system tends to foster the incentives and profitable rewards for capital investment and innovation that bring forth increasing prosperity. Greater output at falling prices provides people with higher real income as each dollar they earn now buys a larger quantity of goods and services in the marketplace. Supply-side deflation, therefore, is an indication of a growing and dynamic market system that is improving the economic conditions and opportunities of the general population.

Price-Wage Rigidity Deflation

All economic change brings with it shifts in market demand-and-supply conditions. Continuous adjustment and balance within the market requires those affected by change to adapt to the new circumstances. In a world of constant change, the demands for some goods increase while other demands decline. Innovations and technological advancements as well as changing resource availability bring with it shifts in the demand and supply of various forms of labor and capital. The information about these changes and the incentives to appropriately respond to them are provided to people in the market through changes in the structure of relative prices and wages.

Any failure of prices and wages to correctly reflect the new patterns of market supply and demand only generates distortions, imbalances, and maladjustments between the two sides of the market. Under the influence of Keynesian economics, for most of the last 70 years, the resulting unemployment and falling output due to price and wage rigidities has been called "aggregate-demand failures."

The presumption has been that the level of total demand for goods and services in the economy in general falls short of the total supply of goods and services available for sale at prices equal to their costs of production. The problem, it is said, is not that prices and wages are "wrong" on the supply side but rather that aggregate spending is "too low" on the demand side. The policy presumption has been that government and its monetary authority must increase total demand, either through government deficit spending or the central bank's printing money and providing it for private investment and other purposes.

The free-market economist W.H. Hutt gave a refutation to this Keynesian reasoning in his two works A Rehabilitation of Say's Law (1974) and The Keynesian Episode (1979). Hutt argued that when the Keynesians referred to excess aggregate supply and an apparent weakness of aggregate demand to purchase that supply, they were looking through the wrong end of the telescope. There cannot be an "aggregate" excess supply unless there is a super-abundance of all resource inputs and consumer-demanded outputs, at which point there would no longer be an "economic problem" because there would no longer be scarcity. Why bother whether all are employed when the society has reached the point where it is so rich in all desired things that there is no longer any work left to be done?

What can exist is an oversupply of particular goods relative to the demand for them at the prices at which they are being offered for sale. What is preventing the buying of more of these goods is not that the aggregate demand is "too low" but rather that the particular prices for these goods are set too high, given the consumer demands for them.

In other words, the sellers of these goods or labor services are pricing themselves out of the market. As Hutt expressed it, "No one can purchase unless someone else sells…. Every act of selling and buying requires that the would-be seller price his product to permit the sale and that the would-be buyer offer a price which the seller accepts."

It is in the unwillingness of resource owners to price their products and services at levels commensurate with consumer demand that Hutt found the cause of prolonged depressions. "Discoordination in one sector of the economy will, if there are price rigidities in other sectors, bring about those successively aggravating reactions, one decline in the flow of services inducing another," he said. When a supplier is unwilling to lower his price or wage to induce greater sales when demand for his particular good or service turns out to be less than he had, perhaps, expected, then a part of his supply remains unsold and a portion of the labor services available for hire remains unemployed.

The loss of income due to a producer's or worker's maintaining his supply price too high relative to actual market demand results in a decrease in his ability to purchase the goods and services of others being offered on the market. If the suppliers of those goods and services, in turn, refuse to adjust their prices and wages downwards, given the now-lower demand for their output, then the circle of unsold products and unemployed labor starts to expand. A "cumulative contraction" of output and employment may develop in the face of such a network of relatively rigid prices and wages. As Hutt's old teacher at the London School of Economics, Edwin Cannan, expressed the problem in 1933 during the Great Depression, "General unemployment appears when asking too much is a general phenomena."

This problem arose in the early 1930s following an inflationary monetary policy by the Federal Reserve during most of the 1920s. What fooled many people at the time was the illusion of price-level stability through most of the 1920s. The high level of productivity increases and cost efficiencies during those years would have resulted in gently falling prices, as outputs of many goods and services were expanding. But the Federal Reserve's expansionary policy prevented prices from falling as measured by most of the standard price indices.

This monetary expansion, however, fed an unsustainable investment boom that finally burst in 1929. The malinvestment of capital and the misallocation of resources, including labor, during the boom years required significant adjustments through various sectors of the economy to restore balance and economic growth. But numerous government economic policies prevented or delayed the necessary price and wage adjustments, causing the rising tide of increasing unemployment, falling production, business bankruptcies, and bank failures.

(For a detailed analysis of the causes and cures of the Great Depression from an "Austrian Economic" perspective in contrast to that of Keynesian Economics, see, Richard M. Ebeling, Political Economy, Public Policy, and Monetary Economics: Ludwig von Mises and the Austrian Tradition (New York: Routledge, 2010), Ch. 7: "The Austrian Economists and the Keynesian Revolution: the Great Depression and the Economics of the Short Run," pp. 203-272.)

Hutt also emphasized that since the problem is incorrect pricing of particular goods and services, or "disequilibrium," the lowering of any such price or wage to its market-clearing level "will tend to initiate a positive 'real multiplier' effect — a cumulative rise in activity and real income. . .." In other words, whenever a price or wage that is too high is lowered closer to its equilibrium or market-clearing level, suppliers of those goods and services increase their sales and potentially earn higher income. Their higher incomes from pricing their goods and services more correctly, in turn, enable them to increase their demands for other goods and services and thus start a process of expanding the circle of employment and production opportunities in the market. Market-guided pricing puts the unemployed back to work and releases the flow of demand for a growing circle of goods in the economy.

Monetary Deflation

A general decline in prices can also be brought about by a monetary deflation. A contraction in the supply of money and credit reduces the amount of money in people's hands with which they can demand the various goods and services they wish to buy in the market. With less money to spend, there invariably results a downward pressure on prices and wages in general in the economy. If there are the kinds of price and wage rigidities discussed above, then the process of restoring balance between market supplies and demands at a required lower scale or level of prices can be prolonged and punctuated by "depressionary" unemployment and lower production.

Under central banking, monetary contractions are government-made. There have been instances when governments have intentionally contracted the money supply. The British government did so after the war with Napoleon in the early 19th century and then again after the First World War in the early 1920s. Other times it has happened as a result of the central-bank-managed fractional-reserve system, under which outstanding bank liabilities are a multiple of the actual reserves to meet all depositor obligations. In the early 1930s, bank loans went bad, depositors withdrew their funds out of fear of bank closings, and the amount of bank credit outstanding contracted as a multiple of the reserves withdrawn by depositors.

Throughout the second half of the 1990s, the Federal Reserve System maintained an expansionary monetary policy. By various measurements of the monetary aggregates, between 1995 and 2000 the supply of money and credit in the United States economy increased between 35 and 50 percent. During this same period, general consumer prices annually increased in the neighborhood of 1 to 2.5 percent. A leading explanation for the failure of prices to dramatically rise during these years was the significant increases in productivity, cost reductions, and increases in output of many goods across the economy. In other words, a replay in many ways of what was experienced in the second half of the 1920s before 1929.

But whereas there was a 30 percent decrease in the U.S. money supply between 1929 and 1933, since the stock-market decline began in 2000 the Federal Reserve has kept the monetary spigots wide open. Between 2000 and the end of 2002, the supply of money in the United States economy increased by about 18 percent, or about 9 percent a year. There is nothing in recent Fed monetary policy to suggest that there has been a decline in the supply of money and credit. If anything, the Federal Reserve has followed a high expansionary policy.

What then are Benjamin Bernanke, Alan Greenspan, and Otmar Issing concerned about? Each of them in his public address insisted that there were no signs or indications of present or immediate deflationary tendencies in either the U.S. or EU economies. They each seemed determined to assure those in the financial markets that if there were any tendencies for a deflationary process setting in, they — the monetary authorities of the United States and Europe — were ready and willing to work whatever monetary magic was needed to prevent a replay of the early 1930s.

Thus, they were soothing psychological fears, especially in a situation of already low interest rates. If nominal interest rates sank to zero percent, how could the central bank manipulate interest rates to try to stimulate private sector investment spending? Wouldn't the central banking authority then be left with no weapons to fight a deflationary spiral, if one were to set in? How then would the economy escape from a collapse similar to that experienced in the Great Depression?

The questions, of course, imply that (a) the central bank should adopt an activist policy to influence the direction and currents of the market; (b) the central bank has the wisdom and ability to stabilize the economy; and (c) central-bank intervention and manipulation will not make the situation worse than if the market is left to find its own path back to balance and coordination.

Bernanke, Greenspan, and Issing are confident on all three points. But their believing does not make it so. Indeed, their statements and analyses of the danger of deflation show just how deeply ingrained is the hubris of the monetary central planners around the world.


In spite of the fact that the monetary policies of the Federal Reserve System in the United States and the European Central Bank (ECB) have been highly expansionary during the current economic downturn, central bankers at both institutions have taken the time to deliver addresses assuring their listeners that there is no need for the public to fear a return to the deflationary experiences of the early 1930s. Alan Greenspan and Benjamin Bernanke of the board of governors of the Federal Reserve Bank and Otmar Issing of the executive board of the European Central Bank have laid out their understanding of what deflation means and its consequences as well as their proposals to combat deflation if it appears.

Bernanke defined deflation as a persistent decline in the general level of prices and assigned its cause to:

"a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending — namely, recession, rising unemployment, and financial stress."

Greenspan added, "Although the U.S. economy has largely escaped any deflation since World War II, there are some well-founded reasons to presume that deflation is more of a threat to economic growth than is inflation." And Issing insisted that "the ECB is concerned about risks of deflation as well as inflation."

Lowering Interest Rates

The first piece of monetary weaponry at the disposal of the central bankers, they explained, is the tried and true method of lowering short-term interest rates by buying short-term government securities and supplying additional lending reserves to the banking system. The increased reserves at lower interest rates are meant to stimulate private-sector investment spending to generate the additional "aggregate demand" for goods and services in the economy.

But what if a deflationary process has set in and nominal interest rates have fallen to zero? How will the central bankers stimulate borrowing when there is no longer any room to lower interest rates?

Have no fear, because then the Federal Reserve can always start buying longer-term government securities with maturities extending out anywhere from 10 to 30 years. If this were still to fail to do the trick, then the Federal Reserve can coordinate its money-creation process with direct expenditure by the U.S. government by printing all the money required to cover additional government deficit spending.

As Greenspan expressed it,

"If deflation were to develop, options for an aggressive monetary response are available. … The Federal Reserve has authority to purchase Treasury securities of any maturity and indeed already purchases such securities as part of its procedure to keep the overnight [interest] rate at its desired level. This authority could be used to lower interest rates on longer maturities."

And in the words of Bernanke,

"Indeed, under a fiat (that is, paper) money system, a government (in practice the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero…. The U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost. … We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

Since prevention is always better than having to suffer from a cure, the central bankers emphasize that the generally accepted standard of "price stability" for monetary policy does not mean zero inflation, i.e., a stable price level as measured by various price indices. No, price stability is defined as low inflation.

Issing says that the risk of any deflation "can be substantially reduced by making sure that inflation does not fall below some safety margin — say below a threshold of 1 percent — on a sustained basis."

Bernanke concurs that "the Fed should try to preserve a buffer zone for the inflation rate; that is, during normal times it should not try to push inflation down all the way to zero." Instead, the Federal Reserve should have an inflation target between 1 and 3 percent a year.

Monetary Bubbles

Greenspan sees the source of many economic downturns, and any deflationary dangers that may accompany them, in the bursting of asset-price bubbles on the financial markets. The problem, in his view, is that "bubbles tend to deflate not gradually and linearly but suddenly, unpredictably, and often violently."

Thus the "evidence of recent years, as well as the events of the late 1920s, casts doubt on the proposition that bubbles can be defused gradually."

But where do such "bubbles" come from? It is difficult to see how they are inherent in a free-market economy that is not being fed by increases in the supply of money and credit. If there were a wave of innovations that spark an increase in investment demand, the additional demand for borrowing would push up interest rates.

That would create an incentive for some income earners in the society to decrease their consumption spending and increase their savings to take advantage of the higher rate of interest.

Any direct purchase of equity shares of possibly more profitable enterprises available on the stock exchange also would have to be financed either through a decline in consumption or a decrease in bond purchases. Either way, there are no inflationary pressures, because the increase in one type of expenditure must be matched with a decrease in some other kinds, given no change in the total supply of money in the economy.

Of course, when there is investment in new products and technologies, there is always the possibility and danger of over-optimism about the cost-efficiencies being introduced or the degree of future consumer demand before the new product is actually marketed to the buying public. But even if there are losses suffered, due to a decline in the share prices of the companies applying the new technologies or marketing the new products, there would be share prices of other companies that would now be more attractive to purchase, given the actual pattern of consumer demand.

The only way that asset prices on the financial markets can be significantly rising while consumer goods and other prices do not decline, or even rise as well, is for the total quantity of money and credit available in the economy to have been increased. Then people would have enough money to maintain both their levels and patterns of spending and have the additional means to increase their demand for equity shares or bonds. If there is a financial and speculative "bubble," it is due to the central banks providing the monetary means to feed it. Thus, the very financial bubble that has so worried Greenspan and other central bankers is the result of the expansionary policies of their own central banks.

Monetary Policy and Recession

If either the Federal Reserve or the European Central Bank pursues as its policy goal a rate of monetary expansion sufficient to keep prices from falling over time in a growing economy, or even if they pursue a policy of low inflation, they are likely to set the stage for the very type of economic downturn that they are so determined to prevent.

As Austrian economist Friedrich Hayek argued long ago, in a growing economy experiencing productivity increases and cost-efficiencies, prices for goods will have to fall over time as more goods and less expensively produced goods come on the market. Given the consumer demands for those goods, the only way the larger supplies coming on the market can find willing buyers is through decreases in the prices at which they are offered to the public.

If, however, the central bank wishes to prevent this "supply-side deflation" from occurring, it can do so only by injecting additional money into the economy. In the United States the Federal Reserve increases funds by purchasing government securities (through what are known as "open-market" purchases). This, in turn, increases the supply of reserves available in the banking system for lending purposes. To attract additional borrowing, banks lower their interest rates, which often stimulates an increase in longer-term investment projects.

But the additional borrowing at the lower rate of interest now causes total investment spending to be greater than the total amount of actual savings set aside for lending purposes by income earners in the society. In fact, savings may actually decrease: at the now lower market rates of interest the attractiveness of savings decreases even while investment spending is expanding. Thus, in the name of price stability (possibly defined as "low inflation"), an imbalance is created between savings and investment in the economy.

This imbalance eventually requires corrections, with investment spending reduced and redirected to be consistent with the actual available supply of savings. When this investment "bubble" bursts, the market value of some capital investments will have to be written down or possibly even written off. Labor suppliers in some of the overextended sectors of the economy will have to be redirected into alternative employment consistent with the actual patterns of consumer demands for various goods. The same applies to the utilization and applications of many other resources and raw materials.

If capital-asset owners or resource suppliers, including workers, resist the necessary and inevitable decline in the prices and wages for their products and services in these misdirected employments, they succeed only in pricing themselves out of the market. Their incomes fall and their ability to demand other goods declines commensurately.

The demands for an array of other goods now experience a decrease, with resulting downward pressure on prices and wages in the affected sectors of the economy. If those producing the goods and supplying the labor in those sectors also resist required reductions in prices and wages, then the circle of unemployment and idle resources expands. And the pressure for prices and wages to adjust downwards only intensifies over time as the overhang of unsold goods and unemployed labor increases.

It should be clear that this type of "price-wage rigidity deflation" cannot be cured by the magic of paper-money inflation, contrary to what Bernanke and Greenspan may think. It may be true that such a monetary expansion can directly increase the demand for goods and services when financing government deficit spending. And it may be true that if the central bank has room to lower interest rates, it might stimulate some investment borrowing that might not otherwise be occurring if interest rates remained at a higher level. But this does not solve the fundamental problems of malinvestments and misallocation of labor and resources resulting from the preceding "boom" and "bubble."

Monetary Policy and Inflation

The product demand and employment opportunities created by direct government spending clearly can be maintained only for as long as the government continues its higher level of real spending. Any decrease in the amount of deficit expenditure for the particular goods and services demanded by the government will bring about a fall in the production of those goods and a decline in the employment opportunities of the workers drawn into those activities by the initial higher level of government spending.

Likewise, central-bank stimulus of additional private-sector investment spending to create production and employment opportunities in the face of deflationary pressures merely sets the stage for a future decline in investment activity. The investment projects that may have begun are dependent for their completion and maintenance on a continuing expansion of money and credit to sustain their existence.

Thus, an unstable inflationary process is set into motion in an attempt to get around the problem of unsold products, diminished investment activity, and unemployed workers caused by the unwillingness of some to adjust their price and wage demands in a downward direction to more correctly reflect the actual conditions prevailing on the market. As Austrian economist Ludwig von Mises noted years ago,

The course of the boom is not any different because, at its inception, there are unused productive capacity, unsold stocks of goods, and unemployed workers. … The beginning of every credit expansion encounters such remnants of older, misdirected capital investments and apparently "corrects" them. In actuality, it does nothing but disturb the workings of the adjustment process.

The continuing hubris of the central banker can be seen in his failure to fully appreciate that it has been his own monetary policies that have created the unstable booms and bubbles that he complains about and criticizes. And even when he admits that central bankers have erred in the past and have produced those very consequences to which they object, he continues to believe that "next time" they will get it right.

Otmar Issing has been more open about the limitations on the powers of central banking than others of his clan. For example, in an address delivered in Paris on December 9, 2002, he discussed these problems in "Monetary Policy in a World of Uncertainty." He admitted that central bankers (a) know little about the prevailing economic conditions in the market because of imperfect information and faulty factual data; (b) have no way of knowing what the appropriate equilibrium patterns throughout the market should be, because they have no demonstrably "correct" model of the economy and its precise interdependent relationships; and (c) cannot be sure how and in what form private-sector actors in the market will interpret and react to policies implemented by the central bank, and thus what interdependent outcomes will be forthcoming when the policies of the central bank intersect with the actions of the market participants.

At the same time, if the central banker is to have some capacity to influence the direction of market activities, Issing believes that "there are limits to the degree of transparency that central banks can realistically be expected to supply." In other words, the central banker cannot tell the public what it plans to do or why because then the market actors might respond in ways that would more or less completely foil the central banker's plan.

Yet Issing wants monetary "policy to be predictable in order to reduce uncertainty and volatility in financial markets." Thus, he wants the central banker to have his cake and eat it too. The reason he wants such secretive flexibility is that "a monetary authority should lead financial markets and not 'follow them.'"

Why? Because, he says, private traders in financial markets operate on the basis of "ludicrously short time horizons" while the central banker maintains the proper "long-term" perspective.

Here is the monetary central planner who admits his inherent inability to know enough to plan but who just cannot give up the ghost and let the multitudes of market participants find their own way in the marketplace. The lingering appeal of social engineering just remains too strong. The hubris just cannot be foresworn.

This article originally appeared in two parts in Freedom Daily and was published by the Future of Freedom Foundation, Fairfax, Virginia.