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Classical Deflation Theory

WP 03-13

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Thomas M. Humphrey
Federal Reserve Bank of Richmond

CLASSICAL DEFLATION THEORY1, 2
Thomas M. Humphrey 3, 4
Research Department
Federal Reserve Bank of Richmond
Working Paper No. 03-13
November 3, 2003

Abstract
Classical economists David Hume, Pehr Niclas Christiernin, Henry Thornton, David
Ricardo, Thomas Attwood, and Robert Torrens looked beyond the redistributive
(creditor-debtor) effects of deflationary monetary contraction to its adverse effects on
output and employment. They attributed these effects to price-wage stickiness; to rises in
real debt, tax, and cost burdens; to cash hoarding in anticipation of future price falls; and
to other determinants. Addressing deflation associated with post-war resumption of gold
convertibility at the old mint par, they advocated policies ranging from gradualism, to
devaluation, and even to outright abandonment of the gold standard in order to avoid or
mitigate deflation’s harm.

1

JEL Classification: E31, B31, B12.
Keywords: deflation, classical monetary theory, price-wage stickiness, output and employment, neutrality
and nonneutrality of money, resumption at par, ingot plan.
3
E-mail: Tom.humphrey@rich.frb.org Phone: (804) 697-8204
4
For valuable comments, I am indebted to my colleagues Margarida Duarte, Andreas Hornstein, John
Walter, and John Weinberg.
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1

CLASSICAL DEFLATION THEORY
Thomas M. Humphrey

Introduction
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 they marked 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 the latter’s 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

2

same proportion during the war5 – 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 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 shock. 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 were for restoring gold convertibility at the pre-war
par were willing to countenance contraction, albeit at a gradual pace so as to minimize
the costs of deflation.

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Classicals reasoned that the long-run equilibrium prices of goods, gold, and foreign exchange rose
proportionally through the following causal chain. Inconvertible paper money, via its impact on total
spending, determines domestic prices. Domestic prices, given foreign prices, determine the exchange rate
so as to equalize worldwide the common currency price of goods. The exchange rate between inconvertible
paper and gold standard currencies determines the paper price of bullion so as to equalize everywhere the
gold price of goods. In symbols, P=kM, P=EP*,and G=EG*, where P denotes goods prices, k a constant,
M the money stock, E the exchange rate, G the price of gold, and the asterisk * distinguishes foreigncountry variables from home-country ones. Normalizing foreign-country variables at 1, converting the
expressions into logarithmic form, and taking their derivatives yields m = p = e = g, where the lower-case
letters represent proportionate rates of change of their upper-case counterparts.

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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 fullyexpected 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 rising one. While these and other concepts of the
neoclassical literature are well known, the classical literature by contrast is largely
ignored. This article seeks to repair this deficiency by showing 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 whose constituent components 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.

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 for the first time key features of the classical theory, including the
assumptions that shocks are predominantly monetary, that deflation is partly
unanticipated or unperceived owing to agents’ lack of information, 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 stressed 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 pricesetters 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 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

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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- as opposed to purely distributional (creditor-debtor) effects
of deflation.
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….The workman
has not the same employment from the manufacturer and merchant; though he pays the
same price for everything in the market. The farmer cannot dispose of his corn and cattle:
though he must pay the same rent to his landlord. The poverty, and beggary, and sloth,
which must ensue, are easily foreseen” (40). Here is the source of the classical emphasis
on the real costs of deflation.
In analyzing these deflationary costs, Hume distinguished between those arising
from one-time versus those stemming from continuous monetary contractions. One-time
contractions produce temporary losses occurring in the short run but not the long. At first,
monetary shrinkage depresses real activity. Eventually, however, the real depression ends
and only lower prices remain. At this point Hume hints at a micro-foundations decision
mechanism that the Swedish classical economist P. N. Christiernin later was to sketch in
greater detail. Hume suggests that prices (and wages) start to fall only when price- and
wage-setters, noticing that their inventories of unsold goods and unused labor are
abnormally high, interpret these excessive inventories as signaling the need for
downward price-wage adjustment (Niehans 1990, 56). This correction continues until all
perception errors are eliminated and real activity returns to its natural equilibrium level.
Here is the source of the classical doctrine of the short-run nonneutrality and long-run
neutrality of deflationary changes in the money stock.
Hume claimed that long-run neutrality holds for one-time but not for a steady
succession of monetary contractions. The latter he believed to entail persistent real
effects. 6 His explanation is straightforward (Humphrey 1982, 244-45). Continuous
monetary contractions are partly unperceived and unadjusted for, perhaps because agents,
lacking information, harbor static expectations and so expect the current money stock and
price level to prevail in the future (Cesarano 1983, 198-99). Such contractions thus
forever stay a step ahead of sticky prices, perpetually frustrating their attempt to catch up.
The result is that the lead of shriveling money over dwindling prices persists indefinitely,
thus producing a permanent reduction in real activity. The upshot is that Hume, founder
of the classical neutrality doctrine as it applies to levels of and one-time changes in the
money stock, emerges as a believer in the long-run nonneutrality of continuous
deflationary contractions of that stock. As long-run nonneutrality holds for monetary
expansions as well as contractions, Hume’s advice was to exploit the former while
avoiding the latter. “The good policy of the magistrate,” he said, “consists only in
keeping it [the money stock], if possible, still encreasing; because, by that means, he
6

See the preceding quote where Hume refers to two nations possessing identical money stocks changing at
different rates, negative in one country and positive in the other. Here is his belief that it is money’s rate of
change and not its quantity that matters for real variables in the long run.

5

keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which
consists all real power and riches” (Hume [1752] 1970, 40).
All this applies to the closed economy where the sticky-price assumption holds
sway. Real effects vanish, however, when Hume, seeking now not to demonstrate
nonneutrality but to banish mercantilist fears of a permanent loss of money, drops the
assumption in his analysis of open trading economies. With prices now fully flexible, the
specter of persistent deflation bringing losses in output and employment gives way to the
notion of a specie-flow mechanism working swiftly to eliminate such phenomena. 7
Let deflation occur: In his essay “Of the Balance of Trade,” Hume supposes that
four-fifths of Britain’s money stock is annihilated overnight with prices sinking
immediately in proportion. At once British goods become cheaper on world markets and
outsell all foreign goods at home and abroad. The resulting export expansion and import
shrinkage produces a trade balance surplus financed by inflows of monetary gold. The
gold influx, by expanding the domestic money supply and hence total spending, bids up
domestic prices to their pre-deflation levels. It all happens so fast that deflation is of
extremely short duration. “In how little time,” Hume asks rhetorically, “must this bring
back the money which we had lost, and raise us to the level of all the neighbouring
nations?” (62). Indeed, in other passages Hume suggests that quick-acting commodity
arbitrage renders the process virtually instantaneous as it eradicates price differentials at
home and abroad (Cesarano 1998; Niehans 1990, 56).
Hume’s conclusion: Provided the world stock of monetary gold grows as fast as
the real demand for it, deflation, at worst a transitory problem for open national
economies, can never be a serious one. Deflation, in other words, is a speedily selfcorrecting phenomenon that brings its own remedy in the form of monetary expansion
through the balance of payments. The result is to underscore the key importance of price
inertia to Hume’s analysis. Its presence in the closed case and absence in the open case
renders deflation painful in the one and painless in the other.

Pehr Niclas Christiernin (1725-1799)
Hume was arguably the first classical economist to analyze deflation for countries
on a metallic monetary standard and fixed exchange rates. Pehr Niclas Christiernin, a
Swedish lecturer in economics at Uppsala University, was the first classical writer to do
so for countries on a pure paper standard and floating exchange rates.8 Sweden had
converted to an inconvertible paper currency regime in 1745 and had suffered inflation
under it during the Seven Years War (1755-1762). Christiernin wrote during the last
years of that period when paper money expansion had raised the prices of goods, gold,
and foreign exchange. With inflation reaching intolerable levels, Sweden’s Parliament

7

That Hume used his closed and open models for different purposes, the one to demonstrate short-run
nonneutrality, the other to expose mercantilist fallacies, perhaps accounts for his different treatments of
price flexibility and inflexibility in the two cases.
8
On Christiernin see Eagly (1971), Myhrman (1976), Niehans (1990, 56-9), and Persson and Siven (1993).

6

began to consider ways to arrest and reverse it. One group of politicians advocated
deflation to restore prices to their pre-inflation levels.
Christiernin opposed such policies. In his 1761 Lectures on the High Price of
Foreign Exchange in Sweden he argued that the best policy was to forgive the inflation
that already had occurred and to stabilize prices at their prevailing, post-inflation level.
The level of prices did not matter for real activity as much as its stability. Decisionmakers could get used to any level provided it was constant. They could not, however,
accept the risks associated with deviations from that level. It followed that under no
circumstances should prices be deflated. To do so when the “entire price and wage
structure” had become “fully adjusted to the current [depreciated] value” of the currency
would be to “destroy our…prosperity” and plunge the economy into a slump
(Christiernin [1761] 1971, 90). His fears were realized when in 1768 the policymakers,
failing to heed his advice, deflated the level of prices by roughly fifty percent and
precipitated a depression.
Echoes of Hume reverberate in Christiernin’s claim that deflation diminishes
“trade, industriousness, and the general welfare” (94). Like Hume whose work he knew
Christiernin saw that price-wage stickiness –wage stickiness in excess of price stickiness
being one of his innovations to Hume’s analysis -- transforms deflationary pressure into
falls in output and employment. With prices and nominal wages slow to adjust (the latter
more so than the former), monetary contraction leads to rising real wage costs, falling
real profits, reduced real spending, and sinking real activity before it fully lowers money
wages and prices. During the process, stagnation occurs in both the domestic and foreign
trade sectors.
In the domestic sector, several influences in addition to Hume’s sticky prices
work to accentuate deflation’s adverse real effects. According to Christiernin, these
influences include undesired inventory accumulation (also mentioned by Hume), rising
real debt and tax burdens, and deflationary expectations (the anticipated rate of return on
holdings of money balances) that increase the demand for idle hoards of cash. All inhibit
real spending, forcing it to fall short of its full-capacity level.
And in the export sector a falling, or appreciating, exchange rate – a result of the
money-induced contraction in income and demand including the demand for foreign
exchange -- combines with sticky prices to render the country’s goods dear in terms of
foreign currencies. This dearness reduces the foreign demand for, and consequently the
domestic production of, the export goods. The appreciating exchange rate also makes
foreign goods cheap in terms of domestic currency thus shifting domestic demand toward
imports and away from domestic import substitutes. By discouraging activity in the
export and import-competing sectors, “a reduction in the price of foreign
exchange…would have the worst possible consequence for commerce and industry
throughout our nation” (89).
All this demonstrates that Christiernin did more than just build upon Hume’s
work. He advanced deflation theory markedly beyond Hume and took a giant step toward

7

the modern analysis of the subject. Any compendium of elements that went into this step
must include at least three of Christiernin’s innovations. First, of course, is his
restatement and refinement of Hume’s sticky-price hypothesis, albeit with an asymmetric
twist. “It is easy,” Christiernin says, “for prices to adjust upward…but to get prices to fall
has always been more difficult” (90).
Second are the explicit micro-foundations for price-wage stickiness barely hinted
at by Hume. “No one,” wrote Christiernin, “reduces the price of his commodities or his
labor until the lack of sales necessitates him to do so. Because of this [condition] workers
must suffer want and the industriousness of wage earners must stop before the established
market price can be reduced” (90). In other words, producers and workers lower their
asking prices and wages only when unsold supplies of output and labor services
materialize. Rising inventories of goods and labor constitute the signals that trigger
reductions in prices and wages.
Third and most important are additional effects of deflationary monetary
contraction beyond those adduced by Hume. These include (1) falls in the consumption
and investment subcomponents of total spending, (2) undesired inventory accumulation
mentioned above, (3) rising real burden of fixed, nominal lump-sum taxes, (4) rising real
debt burdens and the associated rash of business bankruptcies, (5) growing deflationary
expectations (the anticipated appreciation gains from holding money instead of goods)
and the resulting increased demand for idle hoards of cash, (6) changes in the structure of
relative prices, and finally (7) appreciating real exchange rates. An impressive list indeed.
Of the items on the list, Christiernin wrote the following: On monetary-induced
falls in the separate consumption and investment components of spending, “ A reduction
of bank notes from circulation reduces everyone’s consumption and the output of all
sectors [including that of the capital goods sector]. The lack of capital [to equip labor and
enhance its productivity] means unemployment and less industriousness among the
working class, which results in less output” (93). On undesired inventories: a deflationary
“shortage of money…cause[s] many goods to lie unsold” (94), thus inhibiting production.
On real tax burdens: nominal lump-sum “taxes…levied and paid in money…form a
heavier burden…when…prices fall since more labor and goods are required to pay the
same tax” (95).
He continues. Regarding real debt burdens and bankruptcies, he says, “When
prices fall…the debtor must work longer and sell more commodities in order to retire his
[fixed nominal] debt” (92). “[D]ebt…become[s] correspondingly more difficult to service
and to repay…. Bankrupts…follow and the failure of one would pull down several more”
(91). A debt-deflation spiral ensues as “all debtors…wish to sell all they had in order to
pay off their debts before prices fell further” (94). Sellers hoping to beat the price fall
flood the market with goods only to find that consumers “would not buy except at a low
price – and even if they did buy (and the debts at the bank were repaid) the refunding of
the principal to the bank would cause a new reduction in the circulation of money” (94).
The result would be “nothing short of a complete credit breakdown” as “creditors
[would] not dare loan their money for fear of debtors’ inability to pay, and borrowers

8

would not negotiate any loans because the fall in prices would [by reducing creditors’
willingness to lend and so raising interest rates] mean they would have to pay more for
less” (94-5). A superior exposition of these phenomena, including the induced reduction
of the money stock, would have to wait until the 1933 publication of Irving Fisher’s debtdeflation theory of great depressions. Until then, Christiernin’s version set the standard.
Likewise, his discussion of deflationary expectations and the resulting increased
demand for idle balances was not surpassed until the 1920s. On these expectationsinduced demands for cash, Christiernin wrote that “Deflation…increase[s] the need for
money because of speculation and hoarding. When it was known that bank notes were
becoming more and more valuable as a result of reductions in the money supply and that
all prices in time would consequently fall, everyone would await that time and in the
interim would not purchase more than the bare essentials” (94), but would hoard cash
instead.
Finally, on the structure of relative prices, he says that “the price impact of a
reduction in the money supply is not uniform: Not all prices fall; not all prices fall at the
same time….Prices only fall for those goods that are less essential or that are in over
supply” (90). Christiernin never explained why these additional relative price changes,
which by definition average out to zero, adversely affect aggregate activity. They could
do so if producers, treating the variability of relative prices as a measure of business
uncertainty and risk, see the changes as evidence of such increasing risk and accordingly
cut production. Of classical deflation theorists, only Thomas Attwood, a Birmingham
banker, pamphleteer, and Member of Parliament, would provide a superior statement of
the effects of the unevenness of price falls during deflation.

Henry Thornton (1760-1815)
Although Christiernin’s work foreshadowed Thornton’s, there is no reason to
believe that Thornton, a London banker, Member of Parliament, and author of one of the
nineteenth century’s two best books on monetary theory, knew of it. 9 For one thing,
Christiernin wrote in Swedish, a language inaccessible to Thornton and his English
contemporaries. Then, too, Thornton differed from Christiernin on certain points. True,
both men feared the effects of monetary contraction deliberately engineered to reverse a
preceding rise in prices. But Christiernin always attributed the prior price rise solely to
overissue of paper, whereas Thornton recognized that real shocks also could be a cause.
And while Christiernin opposed reversing monetary overissues and the price rises caused
by them, Thornton, at bottom a hard money man, favored such reversal, albeit at a
cautious, moderate pace to avoid precipitating panics. Thornton reasoned that overissue
of the paper component of the money stock could, unless reversed by policy, persist
“permanently” even as gold was flowing out. That is, it could persist long enough to keep
prices high and render the country’s goods uncompetitive in world markets. It was price
rises due to real rather than to monetary shocks whose reversal by deliberate monetary

9

Much has been written on Thornton. Studies highlighting his deflation analysis include Hicks (1967) and
Salerno (1980, 357-400).

9

contraction he opposed. Real shocks, unlike overissues of paper money, tended to be
temporary and self-reversing. That being so, it made no sense to put the economy through
the wringer of monetary deflation to correct something that would quickly correct itself.
Thornton wrote during the first or inflationary phase of the famous Bank
Restriction period (1797-1821) when the exigencies of the Napoleonic wars forced the
Bank of England to suspend the convertibility of its notes into gold at a fixed price upon
demand. The suspension of specie payments and the resulting move to an inconvertible
paper regime was followed by rises in the prices of goods, gold, and foreign exchange.
An influential group of classicals known as the strict bullionists arose to attribute these
inflationary phenomena solely to the redundancy of money and to accuse the Bank of
taking advantage of the absence of a convertibility constraint to overissue the currency.
Against this purely monetary explanation Thornton contended that inflation must persist
for several years before critics could claim they had proof enough to blame it on the
Bank. For shorter periods, negative real shocks beyond the Bank’s control might be the
culprit.
The negative real shocks that concerned Thornton were nonmonetary disturbances
to the balance of payments. These disturbances included domestic harvest failures as well
as wars and their associated extraordinary foreign expenditures on subsidies to allies and
on the maintenance of troops abroad. All tended to put the balance of payments into
deficit.
Conventional wisdom at the time called for correcting such deficits with
deflationary monetary contraction. Such contraction would, by making the country’s
goods cheaper both at home and abroad, spur exports, check imports, and so restore
equilibrium in the external accounts. Thornton, however, opposed this remedy on the
grounds that, by precipitating a depression and disrupting production, it would reduce the
output of goods available both for export and for replacement of imports and so worsen
rather than correct the payments deficit. In explaining this perverse outcome, Thornton,
like Christiernin, identified channels additional to Hume’s sticky price circuit through
which deflationary contraction depresses real activity.
First was a money-demand channel. Unlike Christiernin, Thornton never stressed
the influence of deflationary expectations on cash holdings. But he did note that
manufacturers and merchants have a well-defined demand for money balances, balances
held for the purpose of conducting transactions, paying suppliers, and compensating
workers.
Given this money demand, a sudden, sharp contraction of the money stock creates
a cash deficiency that depresses real activity. Merchants, attempting to rebuild their
balances to the desired level “delay making the accustomed purchases of the
manufacturer….[whose] sales…are, therefore, suspended” (Thornton [1802] 1939, 118,
italics in original). This sales stoppage adversely affects manufacturing output and
employment. All the more so as the manufacturer is at that same time being “pressed for
a prompter payment than before” by his creditors while his continued outlay on labor and

10

materials means that “his money is going out while no money is coming in” (118).
Because of these considerations the “manufacturer, on account of the unusual scarcity of
money, may even, though the selling price of his article should be profitable, be
absolutely compelled by necessity to slacken, if not suspend, his operations” (118). In
short, merchant reluctance to buy transforms an excess demand for money into a deficient
demand for manufactured goods.
Thornton’s second channel through which deflation depresses real activity runs
through sticky money wages. By refusing to fall when prices fall, sluggish nominal
wages translate into rising real wages and falling real profits that destroy incentives for
employment and production. Christiernin, of course, had said the same thing.
But Christiernin had said nothing about the source, or cause, of wage stickiness in
the face of falling prices. Here Thornton had the edge. He located this source in workers’
beliefs that under the gold standard then prevailing (though temporarily suspended for the
duration of the Napoleonic wars) price falls are transitory and reversible. Workers,
expecting deflated prices to return soon to traditional levels, naturally are unwilling to
accept wage cuts in the interim. In his 1802 Paper Credit of Great Britain Thornton
expressed the whole matter in a passage that for clarity, precision, and perspicacity is
unrivaled in the classical literature and hardly surpassed today.
[A] diminution in the price of manufactures…may also, if carried very far,
produce a suspension of the labour of those who fabricate them. The
masters naturally turn off their hands when they find their article selling
exceedingly ill. It is true, that if we could suppose the diminution of bank
paper to produce permanently a diminution in the value of all articles
whatsoever, and a diminution, as it would then be fair that it should do, in
the rate of wages also, the encouragement to future manufactures would be
the same, though there would be a loss on the stock in hand. The tendency,
however, of a very great and sudden reduction of the accustomed number
of bank notes, is to create an unusual and temporary distress, and a fall of
price arising from that distress. But a fall arising from temporary distress
will be attended probably with no correspondent fall in the rate of wages;
for the fall of price, and the distress, will be understood to be temporary,
and the rate of wages, we know, is not so variable as the price of goods.
There is reason, therefore, to fear that the unnatural and extraordinary low
price arising from the sort of distress of which we now speak, would
occasion much discouragement of the fabrication of manufactures”
(Thornton [1802] 1939, 118-19, italics in original).
Thornton’s third channel features wastes and inefficiencies of capacity
underutilization and resource misallocation. It is through this channel that a deflationary
“diminution of notes prevents…industry…from being so productive as it would
otherwise be” (119). He sketches a scenario in which deflation leads to the squandering
of inputs as projects are halted and abandoned and the labor embodied in them is lost.
Capital equipment is shut down only to produce nothing during its period of idleness.

11

Unsold goods pile up in inventories where they lose value through physical deterioration
and obsolescence. Then too, cash-starved producers, in a frenzy to obtain liquidity, dump
specialized, distinctive goods on undifferentiated markets unsuited to their absorption.
For all these reasons, Thornton says, “There cease…to be that regularity and exactness in
proportioning and adapting the supply to the consumption, and that dispatch in bringing
every article from the hands of the fabricator into actual use, which are some of the great
means of rendering industry productive, and of adding to the general substance of a
country” (120-21).
It follows that “Every great and sudden check given to paper credit not only
operates as a check to industry, but leads also to much…misapplication of it” (121). This
wastage spells a further reduction in national product, or as he puts it, a “diminution of
the general property of the country…and, of course, a deduction also from that part of it
which forms the stock for exportation” (121). In short, deflation impairs efficiency
whose attenuation pushes output further below its full capacity potential.
Thornton concludes that deflation is the wrong way to spur exports and check
imports and thus to remedy real-shock-induced deficits in the balance of payments.
Deflation is ill-advised because “To inflict such a pressure on the mercantile world as
necessarily causes an intermission of manufacturing labour is obviously not the way to
increase that exportable produce, by the excess of which, above the imported articles gold
is to be brought into the country” (118). Better to ride out the real disturbances with
unchanged or even increased issues of paper money until the disturbances correct
themselves.
To summarize, Thornton’s position on deflation was this: Deflate to reverse price
rises emanating from monetary overissue. But never deflate to correct real shocks to the
balance of payments. Such deflation operates through the channels described above to
lower real output of exportable and import-competing goods and thus has a perverse
effect on the trade balance. Deflation in this case is unnecessary anyway because real
shocks are temporary and the balance of payments will correct itself.

David Ricardo (1772-1823)
Of classical monetary theorists, David Ricardo has the reputation of believing that
money and price-level changes have no effect on aggregate real variables in either the
short run or the long. But this reputation is not entirely warranted. His awareness of the
real costs of deflation underlies his policy rules for restoring equality between the market
and mint prices of gold after arbitrage-inhibiting inconvertibility has allowed the two to
move apart. Upon resumption of convertibility, he would deflate away small but not large
gaps between the two prices. Large gaps he would eliminate by raising the mint price to
the prevailing market price instead of by lowering the market to the old mint price. He
also recommended gradualism in deflation and the avoidance of policy mistakes that
worsen deflation. 10
10

On Ricardo’s view of the costs of deflation see Hollander (1979, 488-500) and Laidler (2000, 29-31).

12

Ricardo was writing in the second or deflationary phase (1815-1821) of the Bank
Restriction era when wartime inflation had given way to post-war deflation and the
authorities were considering how to implement resumption. During the war, the price of
gold had undergone substantial inflationary upward drift such that bullion commanded a
premium over its mint price. The decision to resume gold convertibility spelled the
elimination of this premium. No such premium could exist when agents could convert
paper, at the fixed mint price, into gold for resale on the market. Arbitrage would
eradicate the premium. But the authorities could determine, through their setting of the
mint parity, which price, market or mint, would adjust. Two-price equality could be
achieved either through a lowering of gold’s market price to the pre-war mint parity or,
by devaluing (debasing) the standard, through a raising of the mint parity to gold’s going
market price. The first option involved painful deflationary monetary contraction. The
second and far less painful option involved accepting the gold price rise that had occurred
during the war, re-basing the mint parity at that price, and keeping the money stock
unchanged.
Ricardo favored the deflationary option, but with two major provisos. First, the
gap between actual and mint prices of gold should not be too large. Deflation to eliminate
a 5 percent gap was one thing, deflation to eliminate a 30 percent gap quite another.
Should the gap be 30 percent or more, Ricardo was prepared to abandon restoration at the
old parity for a new parity established at the prevailing price. Instead of deflating back to
par, he would leave prices as they were. As he wrote, in a September 1821 letter to John
Wheatley, “I never should advise a government to restore a currency, which was
depreciated 30 percent, to par; I should recommend … that the currency be fixed at the
depreciated value by lowering the standard [i.e. raising the par], and that no further
deviations take place. It was [a] currency… within 5 percent [of par] and not with a
currency depreciated 30 percent, that I advised a recurrence to the old standard” (Ricardo
[1821] 1951, IX, 73-4).
Ricardo’s advice is of more than antiquarian interest. It speaks to today’s
distinction between zero-inflation versus price-level targeting where the former allows
for price drift and the latter does not. What should a central bank do when confronted
with an upward drift in the price level? Should it accept such drift and thereafter stabilize
about the new, higher price level? Or should it refuse to accommodate drift and instead
deflate prices back to their old target level? Ricardo’s position on these matters was
clear. In the case of large market-minus-mint-price gaps, he was for accommodating drift.
Instead of deflating gold prices back to par, or target, he would leave them as they were.
And in other passages, he made it clear that while he would accept the price drift that
already had occurred, he would rely upon restored convertibility to prevent further drift
from the re-based gold price level. So while he cannot be said to have been an inflation
targeter, he at least was for resetting the price-level target when the old one implied
excessive deflation.
Ricardo’s second proviso was that deflation, once the Bank of England had
decided to accomplish it, should be conducted gradually. Influenced by Thornton’s work,

13

Ricardo saw that precipitous deflation would wreck the economy. It “would be attended
with the most disastrous consequences to the trade and commerce of the country,
and…would occasion so much ruin and distress, that it would be highly inexpedient to
have recourse to it as the means of restoring our currency to its just and equitable value”
(Ricardo [1810-11] 1956, III, 94). Such sharp and sudden deflation should be shunned
absolutely. Gradualism, not abruptness, was the key to conducting deflationary policy to
close small price gaps. “If gradually done,” he said, “little inconvenience would be
felt”(94). In this connection he suggested transitory devaluation, that is, setting a
temporary new mint parity to which the market price would conform, and then lowering
both in easy stages to the old mint par.
Ricardo’s recommendation of gradualism said nothing about rational
expectations. As Lucas, Sargent and Wallace, and others have taught us, however, a fully
expected deflation adjusted for in all contracts should have no real effects. Now the
Bank’s pre-announced return to gold at the old parity was a perfect example of a
deflation that would seem to be fully expected. If so, the Bank could eschew gradualism
and deflate to par immediately without fear of precipitating a recession.
In Ricardo’s defense, however, as well as that of other classicals writing in the
sticky-price tradition, it must be noted that with inflexible prices even perfectly foreseen
monetary contractions can have negative output effects. If so, then price rigidity rather
than neglected rational expectations does the damage. In any case, it was not until 100
years after Ricardo wrote that the Swedish economist Knut Wicksell explicitly
enunciated the case for rational expectations under flexible prices and the corresponding
case for immediate movements to par. “If the price fall is clear beforehand and can be
fairly forseen,” said Wicksell, “businessmen ought to …be in position to adapt
themselves to the expected increase in the value of money…so that they can work
without…losses” (Wicksell 1918, 1920, cited by Boianovsky 1998, 225). With rational
expectations and flexible prices rendering money-stock contraction neutral in its real
effects, then policymakers can deflate to par “in one step.” Here is the crucial ingredient
missing in Ricardo’s analysis.
Ricardo’s greatest fear was that Bank’s own policy errors upon resumption would
worsen deflation. In particular he feared that the Bank, in acquiring extra bullion
reserves so that it could convert paper notes and deposits into gold coin when its
customers so requested, would exert a heavy demand for gold in world markets. This
demand would bid up gold’s value, or what is the same thing, it would lower the price of
goods in terms of gold. Deflation of this price would augment deflation of the money
price of gold to put double downward pressure on the money price of goods.
Ricardo’s argument was quite ingenious. Recognizing that the money price of
goods P is by definition equal to the multiplicative product of the money price of gold G
and the world real gold price of goods R, or P = GR, he saw that deflation accompanying
resumption could stem from two sources. Source number one was the fall in the gold
premium, or money price of gold G, necessary to restore the market price of the metal to
its mint parity. Source number two was a fall in the real gold price of goods R caused by

14

the additional English demand for the fixed world supply of the metal consequent upon
resumption.
To prevent the latter source of deflation, Ricardo, in his 1816 Proposals for an
Economical and Secure Currency, offered his famous ingot plan in which the English
money stock would consist solely of paper currency backed by and convertible into a
reserve of bullion ingots. Such a paper currency offered the advantage (over gold coin) of
greater flexibility in operation. It could, at the cost of variations in the reserve ratio,
readily be expanded or contracted to accommodate temporary shifts in money demand. 11
This, however, was but an incidental benefit of the scheme. Ricardo stressed the
essential one: By abolishing gold coin and the Bank’s need to hold specie reserves to
accommodate increased requests for such coin, his ingot plan would minimize England’s
demand for the fixed world stock of bullion. True, there might be an export demand for
gold ingots as well as a demand coming from the arts and industry. But such demands
would be negligible in comparison with the (abolished) demand for coin and coin
reserves.
By relieving the Bank of the need to hold large metallic reserves, the plan would
largely remove that institution from world gold markets where it consequently would
exert little downward pressure on the gold price of goods R. With gold’s real value
remaining largely unchanged, deflation of the general level of commodity prices P would
be limited to the fall in specie’s nominal price G necessary to restore parity.
Ricardo estimated that a deflation of no more than 5 percent would return gold to
par under his ingot plan. But neither Parliament nor the Bank would adhere to his
scheme. Indeed, Parliament set the plan aside before it could be executed and the Bank
filled its coffers with gold, which it had drained from the world market. The resulting
deflation was twice what Ricardo estimated it would have been had the Bank been
allowed to implement his plan. This entire excess deflation he blamed on policy
mismanagement of the resumption.
To summarize, Ricardo’s concern with falling prices is evident in the rules he laid
down for dealing with deflation: Deflate to eliminate small price deviations from target
only. In the case of large deviations, eschew deflation and accept price drift. If you must
deflate, do it gradually. Avoid policy mistakes that worsen deflation.

Thomas Attwood (1783-1856)
Writing in the deflationary phase of the Bank Restriction period, Birmingham
banker and pamphleteer Thomas Attwood, the most radical anti-deflationist of the
11

“Whenever merchants…have a want of confidence…more money…is in demand; and the advantage of a
paper circulation…is, that this additional quantity can be presently supplied without occasioning any
variation in the value of the whole currency…whereas with a system of metallic currency, this additional
quantity cannot be so readily supplied, and when it is finally supplied, the whole of the currency, as well as
bullion, has acquired an increased value” (Ricardo [1816] 1951, IV, 58).

15

classical era, would have none of Ricardo’s proposals.12 All of them, gradualism and
devaluation included, envisioned stabilizing the market price of gold, if not at its pre-war
parity then at least below its wartime peak when full employment had prevailed. This
price-stabilizing objective was anathema to Attwood who, hailing from an area
particularly hard hit by post-war depression, advocated full employment instead. “The
first and most important duty for the Legislature to attend to,” he said, “is to take care
that an ample demand for labour is restored and maintained throughout the country”
(Attwood [1843] 1964, 17). By ample demand, he meant “a demand for
labour…permanently greater than its supply” (17).
For Attwood then, full employment was the overriding policy goal and price
increases the essential means of securing it. Government had “the duty…to continue the
depreciation of the currency until full employment is obtained and general prosperity”
(Attwood 1831-32, 467, cited in Corry 1962, 86). The policy authorities, upon reaching
the employment target, should permit prices to rise to levels compatible with it
unconstrained by arbitrary ceilings. Inflation up to this height (but not beyond) was
acceptable, even desirable. For when you “restore the depreciated state of the
currency…you restore the reward of industry, you restore confidence, you restore
production, you restore consumption, you restore everything that constitutes the
commercial prosperity of the nation” (Attwood [1819] 1964, 66). But deflation, the evil
“which ought most to be guarded against, which produces want of employment, poverty,
misery, and discontent in nations” (Attwood [1843] 1964, 18) must be avoided at all
costs.
Fearing deflation even more than did his classical peers, Attwood saw it as
harmful because it worked its way slowly, unevenly, haphazardly, and disruptively
through the price structure. “If prices were to fall suddenly, and generally, and equally, in
all things,” he wrote, “and if it was well understood that the amount of debts and
obligations were to fall in the same proportion, at the same time, it is possible that such a
fall might take place without arresting consumption and production, and in that case it
would neither be injurious or beneficial in any great degree, but when a fall of this kind
takes place in an obscure and unknown way, first upon one article and then upon another,
without any correspondent fall taking place upon debts and obligations, it has the effect
of destroying all confidence in property, and all inducements to its production, or to the
employment of labourers in any way” (Attwood 1817, 78-79, cited in Viner 1937, 186,
italics in original).
Equally important, deflation lowered product prices below wages and other
contractually fixed costs. And when “the prices of commodities are suffered to
fall…within the level of the fixed charges and expenses…the industry of the country
dies” (Attwood [1826] 1962, 42, italics in original). It dies because profit margins, the
difference between prices and costs, vanish and with them the means and the motive to
produce. Output and employment then decline in a self-reinforcing downward spiral. For
the same falling prices that combine with rigid cost elements to depress profit also cause
12

On Attwood see Fetter (1964, pp. vii-xxviii), Laidler (2000, pp. 25-27), O’Brien 1975, pp. 164-65), and
Viner (1937, pp. 173, 186-87, 195, 199, 212-14, 289).

16

an unloading of stocks of goods. This dumping of goods puts further downward pressure
on prices and profits causing still another unloading of stocks, etc. The downward
movement continues until stocks are exhausted and the resulting shortage of goods spurs
a rise in prices that ends the process at the trough of the cycle. This sequence brings great
suffering to unemployed workers and hardship to businessmen. For these reasons it is
crucial that deflation be averted.
To Attwood the policy choices were clear. Use expansionary policy, inflating if
necessary, to achieve full employment. Require or induce the Bank of England “to
encrease the circulation of their notes…until all the labourers in the kingdom are again in
full employment at ample wages” (Attwood [1819] 1964, 44). Once the employment
target is reached, accept the market price of gold that coexists with it and establish that
price as the new mint parity. Never attempt to deflate away premia in the market over the
mint price of gold, not even when they produce external drains that threaten exhaustion
of the nation’s gold reserve. Instead, be prepared to abandon the gold standard with its
system of fixed exchange rates for an inconvertible paper currency regime with floating
rates. The latter regime gives the government the autonomy to pursue its full employment
objectives free of external constraints. 13

Robert Torrens (1780-1864)
No survey of classical deflation theory would be complete without mention of
Robert Torrens’s efforts to incorporate tariffs into the theory. Already in 1812 he had
recommended raising the domestic tariff as a means of preventing price declines when
restoring convertibility. Admitting that such a restriction on trade would be to sacrifice
the advantages of international specialization and division of labor, he argued that the
avoided costs of deflation outweighed the forfeited gains from free trade (Viner 1937,
207).
Then in his 1844 The Budget he showed how the imposition of a foreign tariff
could foist deflation on the home country in a gold standard regime. He established this
result with the aid of a two-country, two-good model – his famous Cuba-England, sugarcloth case.14 His model has the export sector of each country specializing in the
production of the good, fabricated at constant cost, in which it has the comparative
advantage. The model also features unit elastic demands for both goods in both countries.
With these assumptions, Torrens showed that Cuba’s imposition of a 100 percent
import tariff on cloth creates a trade balance deficit in England. The resulting specie drain
that finances the deficit causes England to lose one-third of her monetary gold stock to
Cuba before the trade balance re-equilibrates itself. No country, Torrens thought, could
13

“Self-existent, self-dependent, liable to no foreign nations, entirely under our own controul; contracting,
expanding, or remaining fixed, according as the wants and exigencies of the community may require, a
non-convertible Paper Currency presents every element of national security and happiness…” (Attwood
[1826] 1964, 34, italics in original).
14
On Torrens’s Cuba case see O’Brien (1975, 191-94 ), Robbins (1954, 199-203), and Viner (1935, 29899, 322, 463).

17

endure a monetary contraction and proportional price deflation of that magnitude. For the
collapse of prices would bring ruinous rises in the real burden of debts, wages, and taxes
whose nominal values were sticky and responded sluggishly to deflationary pressure.
Calamitous “crisis,…national bankruptcy, and revolution would be the probable results”
(Torrens 1844, 37, cited in Robbins 1958, 203).
To Torrens the policy implications were clear. Fight tariffs with tariffs. Cancel the
deflationary effects of foreign duties by erecting compensating retaliatory duties at home.
Such retaliatory duties, he said, “would bring back the metals…restore the circulation to
its former amount, raise the price of all domestic products, and mitigate the pressure of
the debt.” (37, cited in Robbins, 203). In a word, practice reciprocity. Raise tariffs pari
passu with the foreigner and lower your tariff only if he lowers his. Needless to say, such
reciprocity considerations did not sit well with Torrens’s classical contemporaries, all of
whom were unilateral free traders. But at least Torrens had highlighted a possible conflict
between the goals of unilateral free trade and anti-deflationism in a tariff-ridden, gold
standard world. For better or worse, Torrens’s arguments still are employed today by
those who put the blame for domestic deflationary pressures on foreign commercial
policies.

Conclusion
If the classical writers surveyed in this essay are at all correct, then current
concern over deflation is fully justified. For the essence of the classical doctrine is that
there is every reason to spare the economy the adverse real effects of deflationary
pressure. These effects, whether caused by lags of sticky prices behind money; or by lags
of sluggish wages, interest, taxes, and other costs behind prices; or by rising real debt
burdens and the resulting defaults and bankruptcies; or by cash hoarding in anticipation
of future price declines; or to a combination of these and other causes, are likely to be
painful in the extreme. Especially so for deflations that are sharp, sudden, or sustained.
It follows that a policy of inflation targeting may be superior to price-level
targeting as a means of eluding deflation. For suppose inflationary shocks and/or policy
mistakes and inertia have caused or permitted prices to drift upward. With inflation
targeting, the central bank forgives the price drift that has occurred and thereafter
stabilizes inflation about the new price level. It disinflates to its zero (or low positive)
target rate of inflation at this price level but need not lower the price level itself. By
contrast, under price-level targeting the central bank must engineer deflation and the
recession it brings in order to lower prices to target.
Of course, deflation under certain circumstances might not be a bad thing, that is,
might have no adverse real effects. If so, policymakers could ignore it or implement it
with impunity. Such would be the case for deflations that (1) are always fully expected,
(2) occur in a setting of complete wage-price flexibility, and (3) stem from productivityinduced growth in aggregate supply rather than monetary-induced contractions in
aggregate demand. With the possible exception of Hume, however, classicals paid
insufficient attention to these considerations and left their discovery to their neoclassical

18

successors. But even if they had acknowledged them, they would have merely
distinguished between bad and good (benign) deflations. As it was, they concentrated on
harmful deflations. And it is these deflations policymakers should seek to avoid. This
lesson remains as valid today as it did in classical times.

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