The Case Against Monetary Deflation
The case against monetary inflation, the expansion of money supply, is generally straightforward. Inflation erodes purchasing power for those that save and, in fiat systems, unfairly redistributes wealth towards those closest to the source of new money creation.
Monetary deflation, the contraction of the money supply, is far less intuitive to evaluate. This is largely because it is often conflated with price deflation, which is generally beneficial. Price deflation occurs as productivity improves and the division of labor expands, causing goods and services to become cheaper over time. The key distinction is that price deflation driven by productivity lowers the cost of goods without altering the monetary unit itself.
This intuition is further reinforced by the fact that monetary inflation is harmful. If monetary inflation reduces purchasing power, it seems to follow that monetary deflation should enhance it. Taken together, this leads to an intuitive but incorrect conclusion: that deliberately reducing the money supply to induce falling prices must also be beneficial.
This reasoning is compounded by the fact that sustained monetary deflation is rarely observed in practice. Modern fiat systems consistently expand in supply. Gold, the dominant physical monetary commodity, sees its supply continue to grow slowly through mining. Bitcoin, though capped in total supply, will continue issuing new units for over a century. The closest modern attempt is the digital issuer Ethereum, which introduced a mechanism to burn transaction fees and reduce supply over time, though even this has not produced sustained monetary deflation.
The flaw in this reasoning becomes clear when considering the purpose of money. Money exists to facilitate exchange. It serves as an intermediary good, allowing individuals to trade with minimal friction. Ideally, it should remain neutral; it should not independently influence economic decisions. Inflation violates this principle by discouraging saving and encouraging consumption. However, a deliberately deflationary money introduces similar distortions, discouraging spending and altering behavior in its own way. Ultimately, only money with a stable supply can best serve as a neutral intermediary of exchange.
Deflation and the Stock-to-Flow Ratio:
To understand how monetary inflation and deflation impact money’s ability to act as a neutral intermediary, we can examine the stock-to-flow ratio, which measures a money’s existing supply (stock) relative to the rate at which new units are added (flow). A higher stock-to-flow ratio indicates that supply changes more slowly over time, allowing the money to remain more neutral and exert fewer independent economic incentives. A lower ratio indicates that supply is more volatile, causing the money itself to exert greater influence on economic behavior.
The stock is the current supply of the monetary good, while the flow is the number of new units created over a given period, typically annually. For example, if there are 100 units of a good and 10 new units are produced each year, the stock is 100 and the flow is 10. For a further explanation on the stock-to-flow ratio and its effect on purchasing power distortion, refer to pages 24-26 of the article Analysis of Money as a Market Good.
Inflation reduces the stock-to-flow ratio by increasing the flow of new supply. The greater the rate of inflation, the larger the flow, and the lower the ratio becomes. At first glance, it may seem that deflation is preferable to a stable supply, then, since the flow of new units would be lower, or even negative.
However, this is not the case. Deflation does not reduce flow; it reduces the stock. Because supply must be removed from existing units, the total stock declines. A reduction in stock lowers the stock-to-flow ratio by shrinking the numerator, just as an increase in flow lowers it by expanding the denominator.
In both cases, the ratio deteriorates. Inflation lowers the stock-to-flow ratio by increasing flow and tends to incentivize consumption, while deflation lowers it by reducing stock and tends to incentivize saving. Though the mechanisms differ, both introduce distortions that move money away from a neutral exchange good.
The issue is not that saving or spending is inherently good or bad, but that money itself should not systematically favor or incentivize one over the other, as this disrupts trade. A neutral monetary system allows these decisions to be driven by individual’s subjective evaluation of goods, not by the properties of the monetary unit.
Mechanisms of Deflation
While inflation increases the flow of new units into the system, deflation requires existing units to be actively withdrawn, and this occurs through two primary methods. It is important to note that the individual loss of supply, such as lost or forgotten holdings, does not constitute a systemic deflationary mechanism, as it does not arise from the structure or operation of the monetary system itself.
Method 1: Supply is diverted to non-monetary uses.
The use of supply in industrial or non-monetary processes is often cited as a strength of monetary commodities such as silver, and to an extent but less so, gold. However, when a monetary good is used in production, particularly in ways that make it difficult to return to circulation, it is effectively removed from the monetary stock, reducing the stock-to-flow ratio. More importantly, this reflects a deeper issue if a good is consistently valued for its non-monetary properties over its monetary ones, it is no longer functioning primarily as money. It is being partially demonetized. While it may still serve as a store of value, it is now behaving as an investment good rather than a purely monetary one.
Method 2: Supply is intentionally reduced through transaction-based burns.
This is a more recent, engineered approach, where a portion of the monetary supply is destroyed during transactions. The premise is that reducing supply increases the purchasing power of remaining units. However, this introduces a fundamental distortion. If deflation is driven by transaction activity, then using the money directly reduces its supply, rewarding those who do not transact. Money no longer acts as a neutral intermediary; instead, it penalizes exchange itself.
This discourages spending, just as inflation discourages saving. In practice, users seek to avoid these costs, as seen in the proliferation of alternative transaction layers that minimize fees and supply burns.
Conclusion:
Ultimately, both inflation and deflation weaken money’s ability to function as a neutral exchange good by introducing incentives that exist outside the trade itself. A stable supply, where the stock-to-flow ratio approaches infinity, best preserves money’s role as an intermediary good. It allows individuals to store value over time while benefiting from the natural price deflation that results from productivity gains and the expansion of the division of labor.
