Sunday, June 27, 2010


As with inflation, there is a great confusion as to what deflation is. The people who steadfastly insist that inflation is raising prices are consistent in insisting the deflation is falling prices. This is why, time and time again, since the 1930s, they insist that prices need to be kept at least level when the economy hits a bad spot. They hold this position in the face of overwhelming evidence to the contrary, but that is another issue that involves considering their philosophy. Maintaining price levels has resulted in some of the most insane actions that we have seen in the free world. The classic is FDR’s requirement that crops be destroyed and land kept out of production when there were bread lines and people going hungry.

That dropping prices are not a bad thing has lots of evidence. The best I think refers to the time period from the end of the Civil War to the end of the 19C in the U.S. I have seen some suggestion that prices tended to stay level during this period, so there needs to be some more research (anyone know of some good references?) but there is also strong evidence that prices tended downward. Certainly, several important products saw sharp price declines as new technology was applied, including better business management techniques (e.g., Standard Oil managed by J.D. Rockefeller).

In today’s world we see prices dropping for many important items in spite of the continuous inflationary pressure of new made-up money being pushed into the economy. But overall, even the much maligned CPI shows some upward trend of consumer prices. The “core” inflation rate (which excludes what is considered volatile, energy and food; isn’t that really dumb) is slightly up year on year at less than a percent. Those who figure that the CPI has been manipulated for political reasons and to keep the masses from getting restless prefer the shadow statistics analysis that says we are seeing closer to 6 or 7% inflation this year, especially in food. Bottom line though is that we are definitely not seeing falling prices.

Those who are deathly afraid of falling prices would be demanding that the Fed, the White House, and the Congress do something, anything, if prices do start to fall. They fear a depression. If prices do begin to fall, we will see such a massive pumping of money, demands for price controls or supports, and really weird stuff that will take our breath away.

It was the fear of falling prices that prompted many of the actions at the beginning of the recession in 2008. The consequence of that was the prevention of the liquidations and readjustments necessary in the economy to allow it to return to productivity. It is why we are still in a mess. More actions to keep prices level would not be helpful.

Another group, to which I belong, regards deflation as a reduction of the money supply. The money supply indicator for the U.S. that I use (MZM) has dropped about 3%, but has now stabilized. The main driver of the money supply in the past 50 years has been the expansion of bank credit, primarily to businesses, but also to consumers. Bank credit has decreased almost 25% in the last 18 months. Even so, the money supply has not shrunk. Further, we are continuing to have balance of payment shortfalls, which means we are sending dollars we don’t miss out of the country.

So what? What would it mean to us, now and into the future? Remember that one issue of inflation is the entry point of new money. In the same way, in deflation, it matters where the money is being taken from. Right now, money is being injected into the economy via federal payments, i.e., stimulus, medicare, “jobs” programs, social security, and other payments. Where has money being taken from? Loans to businesses are decreasing, as I mentioned before. What isn’t? Loans to government. The Federal Budget is in massive deficit in 2010, and will be so in 2011 and thereafter unless something extreme happens. Money is not being taken out of the economy so much as savings is being diverted from any activity except government debt.

The question I keep coming back to in the discussion of deflation is how actual deflation could possibly happen. Those who argue for deflation of the money supply do not actually explain how it could come about. They merely point to certain trends and extrapolate from there. That’s fine. But the trends have not actually reached deflation. And those trends have now been going on for a while, and still no deflation.

So how could the money supply decrease? One idea given is that if we go into (further into?) recession again now, business lending will decrease further and total checking deposits will fall. Checking is ready money, which is the backbone of the money supply. So far, however, bank loans have decreased 25% and money supply has remained flat, even with the export of dollars as our balance of payments have remained in deficit. The fall in banks loans is not leading to deflation.

As I see it, the federal budget deficit and BO’s expansive spending (he wants more stimulus) is pushing on the money supply faster than any deflationary trend. If, somehow, BO were to stop spending, the budget deficit stabilized, someone figures out that we don’t need more fake jobs and production-killing regulations, and no panic response comes from Congress or the Fed, we could wonder into deflation. Yeah, that is likely to happen.

An actual deflation would do some good in that it would wipe out more made-up money. The real issue, of course, is what happens to savings and actual productive investment. It doesn’t matter that much what the money supply is doing (if the government is not actively inflating it), if there is actual savings and the savings is being put to use productively, profitably. In fact, real money supply deflation is fine if savings is invested productively. In deflation, a saved dollar is becoming more valuable, i.e., can buy more as time goes on, and, therefore, saving a dollar automatically increases one’s wealth. Putting it into the hands of someone who can turn it into a profitable endeavor makes the dollar even more valuable. All of this doesn’t happen when the government is sopping up every dollar it can find to fund its deficit.

The bottom line isn’t whether we are in deflation or not. It is what the government does. Since there is no one in position to make decisions that holds principles in ethics, politics, or economics that are connected to reality, we can be certain that what they will do will not be beneficial. But that is true whether we have inflation or deflation. They are right now taking every bit of savings, and with the recent new law increasing the regulation of the financial sector, the power and flexibility of our system for funding production is further damaged.

Deflation, then, is a fake issue. It is another way in which analysts, politicians, bureaucrats, commentators, bloggers, and journalist can feel as though they are grappling with the important economic issues and evade reality.


  1. Great post. What about an elderly person who has a 401k north of $40,000 and is worried that a hyper-inflation will render that money worthless. My advice would be to invest it in secure accounts, like cash accounts with really low interest and maybe put a few thousand into gold and silver stocks. Isn't it true that a deflation would made that money worth more? Isn' it also true that before a deflation happens we'd have to experience an inflation first?

  2. Thank you for your response, Michael. Going in reverse order, I don't know of any reason why an inflation would be needed to lead into any kind of deflation. In our circumstances, we have had inflation for a long time. Since 1982 our money supply has grown by a factor of 10. We have seen constant increases in prices, especially in certain areas like health care, and two asset booms in the last 12 years. So we have had inflation. Yes, deflation would make units of our currency have a higher purchasing power (as said in the text). A low interest rate would be very positive during a deflation (watch out for income taxes!).

    My post is not intended to suggest that deflation is going to happen, only that it is a fake issue. Ben Bernanke has sworn that he will not let deflation occur. According to what he has said publicly in what is called the "Helicoptor Speech", he is willing to do amazingly stupid things to keep deflation from happening. Inflation and even hyper-inflation is still more likely. Falling prices, as the housing market is doing, would be much better for us.