We assume that in the course of a deflationary process the whole amount by which the supply of money (in the broader sense) is reduced is taken from the loan market. Then the loan market and the gross market rate of interest are affected at the very beginning of the process, at a moment at which the prices of commodities and services are not yet altered by the change going on in the money relation. We may, for instance, posit that a government aiming at deflation floats a loan and destroys the paper money borrowed. Such a procedure has been, in the last two hundred years, adopted again and again. The idea was to raise, after a prolonged period of inflationary policy, the national monetary unit to its previous metallic parity. Of course, in most cases the deflationary projects were son abandoned as their execution encountered increasing opposition and, moreover, heavily burdened the treasury. Or we may assume that the banks, frightened by their adverse experience in the crisis brought about by credit expansion, are intent upon increasing the reserves held against their liabilities and therefore restrict the amount of circulation credit. A third possibility would be that the crisis has resulted in the bankruptcy of banks which granted circulation credit and that the annihilation of the fiduciary media issued by these banks reduces the supply of credit on the loan market.
In these cases a temporary tendency toward a rise in the gross market rate of interest ensues. Projects which would have appeared profitable before appear so no longer. A tendency develops toward a fall in the prices of factors of production and later toward a fall in the prices of consumers' goods also. Business becomes slack. The deadlock ceases only when prices and wage rates are by and large adjusted to the new money relation. Then the loan market too adapts itself to the new state of affairs, and the gross market rate of interest is no longer disarranged by a shortage of money offered for advances. [p. 567] Thus a cash-induced rise in the gross market rate of interest produces a temporary stagnation of business. Deflation and credit contraction no less than inflation and credit expansion are elements disarranging the smooth course of economic activities. However, it is a blunder to look upon deflation and contraction as if they were simply counterparts of inflation and expansion.
Expansion produces first the illusory appearance of prosperity. It is extremely popular because it seems to make the majority, even everybody, more affluent. It has an enticing quality. A special moral effort is needed to stop it. On the other hand, contraction immediately produces conditions which everybody is ready to condemn as evil. Its unpopularity is even greater than the popularity of expansion. It creates violent opposition. Very soon the political forces fighting it become irresistible.
Fiat money inflation and cheap loans to the government convey additional funds to the treasury; deflation depletes the treasury's vaults. Credit expansion is a boon for the banks, contraction is a forfeiture. There is a temptation in inflation and expansion and a repellent in deflation and contraction.
But the dissimilarity between the two opposite modes of money credit manipulation not only consists in the fact that while one of them is popular the other is universally loathed. Deflation and contraction are less likely to spread havoc than inflation and expansion not merely because they are only rarely resorted to. They are less disastrous also on account of their inherent effects. Expansion squanders scarce factors of production by malinvestment and overconsumption. If it once comes to an end, a tedious process of recovery is needed in order to wipe out the impoverishment it has left behind. But contraction produces neither malinvestment nor overconsumption. The temporary restriction in business activities that it engenders may by and large be offset by the drop in consumption on the part of discharged wage earners and the owners of the material factors of production the sales of which drop. No protracted scars are left. When the contraction comes to an end, the process of readjustment does not need to make good for losses caused by capital consumption.
Deflation and credit restriction never played a noticeable role in economic history. The outstanding examples were provided by Great Britain's return, both after the wartime inflation of the Napoleonic wars and after that of the first World War, to the prewar gold parity of the sterling. In each case Parliament and Cabinet adopted the deflationist policy without having weighed the pros and cons of the two methods open for a return to the gold standard. In the second [p. 568] decade of the nineteenth century they could be exonerated, as at that time monetary theory had not yet clarified the problems involved. More than a hundred years later it was simply a display of inexcusable ignorance of economics as well as of monetary history. 
Ignorance manifests itself also in the confusion of deflation and contraction and of the process of readjustment into which every expansionist boom must lead. It depends on the institutional structure of the credit system which created the boom whether or not the crisis brings about a restriction in the amount of fiduciary media. Such a restriction may occur when the crisis results in the bankruptcy of banks granting circulation credit and the falling off is not counterpoised by a corresponding expansion on the part of the remaining banks. But it is not necessarily an attendant phenomenon of the depression; it is beyond doubt that it has not appeared in the last eighty years in Europe and that the extent to which it occurred in the United States under the Federal Reserve Act of 1913 has been grossly exaggerated. The dearth of credit which marks the crisis is caused not by contraction but by the abstention from further credit expansion. It hurts all enterprises--not only those which are doomed at any rate, but no less those whose business is sound and could flourish if appropriate credit were available. As the outstanding debts are not paid back, the banks lack the means to grant credits even to the most solid firms. The crisis becomes general and forces all branches of business and all firms to restrict the scope of their activities. But there is no means of avoiding these secondary consequences of the preceding boom.
As soon as the depression appears, there is a general lament over deflation and people clamor for a continuation of the expansionist policy. Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holding. This may be properly called deflation. But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after greater cash holding. The causation is the other way around. Prices of the factors of production--both material and human--have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they [p. 569] abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labor unions to prevent or to delay this adjustment merely prolongs the stagnation.
Even economists often failed to comprehend this concatenation. They argued thus: The structure of prices as it developed in the boom was a product of the expansionist pressure. If the further increase in fiduciary media comes to an end, the upward movement of prices and wages must stop. But, if there were no deflation, no drop in prices and wage rates could result.
This reasoning would be correct if the inflationary pressure had not affected the loan market before it had exhausted its direct effects upon commodity prices. Let us assume that a government of an isolated country issues additional paper money in order to pay doles to the citizens of moderate income. The rise in commodity prices thus brought about would disarrange production; it would tend to shift production from the consumers' goods regularly bought by the nonsubsidized groups of the nation to those which the subsidized groups are demanding. If the policy of subsidizing some groups in this way is later abandoned, the prices of the goods demanded by those formerly subsidized will drop and the prices of the goods demanded by those formerly nonsubsidized will rise more sharply. But there will be no tendency of the monetary unit's purchasing power to return to the state of the pre-inflation period. The structure of prices will be lastingly affected by the inflationary venture if the government does not withdraw from the market the additional quantity of paper money it has injected in the shape of subsidies.
Conditions are different under a credit expansion which first affects the loan market. In this case the inflationary effects are multiplied by the consequences of capital malinvestment and overconsumption. Overbidding one another in the struggle for a greater share in the limited supply of capital goods and labor, the entrepreneurs push prices to a height at which they can remain only as long as the credit expansion goes on at an accelerated pace. A sharp drop in the prices of all commodities and services is unavoidable as soon as the further inflow of additional fiduciary media stops.
While the boom is in progress, there prevails a general tendency to buy as much as one can buy because a further rise in prices is anticipated. In the depression, on the other hand, people abstain from buying because they expect that prices will continue to drop. The recovery and the return to "normalcy" can only begin when prices and wage rates are so low that a sufficient number of people assume [p. 570] that they will not drop still more. Therefore the only means to shorten the period of bad business is to avoid any attempts to delay or to check the fall in prices and wage rates.
Only when the recovery begins to take shape does the change in the money relation, as effected by the increase in the quantity of fiduciary media, begin to manifest itself in the structure of prices.
In dealing with the consequences of credit expansion we assumed that the total amount of additional fiduciary media enters the market system via the loan market as advances to business. All that has been predicated with regard to the effects of credit expansion refers to this condition.
There are, however, instances in which the legal and technical methods of credit expansion are used for a procedure catallactically utterly different from genuine credit expansion. Political and institutional convenience sometimes makes it expedient for a government to take advantage of the facilities of banking as a substitute for issuing government fiat money. The treasury borrows from the bank, and the bank provides the funds needed by issuing additional banknotes or crediting the government on a deposit account. Legally the bank becomes the treasury's creditor. In fact the whole transaction amounts to fiat money inflation. The additional fiduciary media enter the market by way of the treasury as payment for various items of government expenditure. It is this additional government demand that incites business to expand its activities. The issuance of these newly created fiat money sums does not directly interfere with the gross market rate of interest, whatever the rate of interest may be which the government pays to the bank. They affect the loan market and the gross market rate of interest, apart from the emergence of a positive price premium, only if a part of them reaches the loan market at a time at which their effects upon commodity prices and wage rates have not yet been consummated.
Such were, for example, the conditions in the United States in the second World War. Apart from the credit expansion policy, which the Administration had already adopted before the outbreak of the war, the government borrowed heavily from the commercial banks. This was technically credit expansion; essentially it was a substitute for the issuance of greenbacks. Even more complicated techniques were resorted to in other countries. Thus,for instance, the German Reich in the first World War sold bonds to the public. The Reichsbank financed these purchases by lending the greater part of the funds needed to the buyers against the same bonds as collateral. Apart from the fraction which the buyer contributed from his own funds, the role that the Bank and the public played in the whole transaction was merely formal. [p. 571] Virtually, the additional banknotes were inconvertible paper money.
It is important to pay heed to these facts in order not to confuse the consequences of credit expansion proper and those of government made fiat money inflation.