Deflation Fears Hearken Back to a Simpler Time of Sound Money

The more commentary that appears in the mainstream financial media on the subject of "deflation", the more the relationship between our bubble-economy and this powerful word is starting to sound like the debate over whether alcoholism is an addiction or a disease.

As noted previously, when they set out to write about "deflation" today, far too many writers confuse our world of pure fiat money and government-sanctioned, serial asset bubbles with an earlier era of sound money. That is, when falling consumer prices were commonplace, presenting great difficulty for both the economy and the banking system when people began hoarding money in anticipation of lower prices.

This behavior made sense in the 1800s.

For example, if you lived during the late 19th century, you could look back a hundred years and see basically zero inflation. Given this view of the world, you could be pretty sure that this trend would continue far into the future.

Why not wait for prices of goods and services to bottom out before buying?

Fast forward more than a hundred years and you have meteoric advances and declines in stocks and housing compounded by wild swings in commodity prices - crude oil at $85 a barrel in January, then $147 in July, and then $46 in December - all of this presenting a dizzying price picture to consumers, but a picture that should not be confused with a world of zero inflation and sound money.

Increasingly, it seems as though writers with too short a view of history are trying to legitimize the world's bubble-economies (likely setting the stage for the next bubble's inflation in the process) by creating a new bogeyman in "deflation", akin to viewing alcohol abuse as a disease rather than an addiction that too few have the will to break.

Typical of this characterization of today's economic ills is this story in USA Today:

Deflation: Bargains abound, this could be a problem
Everything is on sale. And that's not a good thing.

Consumer prices in October fell at the fastest pace in more than 60 years, sucked down by the rapidly deteriorating economy. The prices of oil, food, cars, clothing and electronics have all plunged. Home prices continue to swoon and so do stock prices.

As the early reports from the holiday shopping season suggest, the nationwide fire sale might seem like a boon for consumers. But it's increasing the risk that the economy could become mired in a dangerous deflationary spiral — a widespread, sustained reduction in prices. That's something that hasn't happened here since the Great Depression.

Economists say it's too early to tell whether deflation has set in — and many say the government's aggressive responses to the credit crunch likely will prevent sustained deflation.
...
A deflationary spiral can have several causes, such as a widespread glut of goods that forces manufacturers to slash prices. In the current crisis, the bursting of the housing bubble has forced home prices down, pulling down the prices of raw materials, cars and even stocks.

As prices fall, consumers eventually stop spending, either because they are worried about their jobs, or because they figure they can get lower prices later. Companies start laying off workers because lower prices have pushed down — or eliminated — their profits. That, in turn, means even less demand.

A slowdown in consumer spending because workers are fearful of losing their jobs, perhaps realizing for the first time ever that they can't continue to borrow and spend like drunken sailors, is a completely understandable reaction to the current economic condition.

But, aside from the very short-term, to think that consumers will not spend because they see lower prices for consumer goods in the future is ridiculous. We've had almost a hundred years of non-stop inflation and, despite the confusion created by the bursting of asset bubbles all around them, consumers understand quite well that, over the long-term, prices for domestic goods and services go up, not down.

Even in the case where prices for imported goods have been falling for years - electronics and clothing, to name just two - falling prices have had not resulted in lower spending.

Yet, for some reason, writers continue to think that it might.

There aren't too many who understand this issue as it should be understood, but one of them is Robert Higgs who writes at the Mises Institute and offers the same critique of reporting on "deflation" today.

Nonsense about Deflation
We are now hearing ominous warnings about imminent deflation. Checking the welcome page at AOL this morning, I see that the lead item in the financial news section heralds "The Looming Threat of Deflation." This headline encapsulates two highly problematic ideas. The first is that deflation would necessarily be a bad thing. The second is that deflation is likely to occur in the near term.
...

You can see clearly that the rate of economic growth and the rate of price-level change have been independent, at least within the ranges of these variables in US economic history. (Hyperinflation or hyperdeflation would be another matter: either would be devastating by making economic calculation and long-term contracting virtually impossible.)

Any decent economics teacher makes sure that before the students have gone more than a week or two, they have mastered the difference between absolute (nominal) and relative (real) prices. All of economic analysis hinges on this understanding. Yet practicing politicians, investment gurus, news media hyperventilators, and others who play important roles in influencing public opinion are completely lacking in this basic understanding. The upshot is a destructive bias in favor of secular inflation, with the risk of periodic bouts of rapid inflation.

Which brings us to the second question: for better or worse, does deflation actually loom at present? If it does, its occurrence will surprise me greatly, because the Fed has been creating base money as if there were no tomorrow, and if the bailouts continue, as seems likely, more of the same is virtually certain. So far, the huge spurt in base money has simply been absorbed and held by the banks in the form of (legally) excess reserves, but the likelihood that the banks will sit on $268 billion of excess reserves forever is nil. Once they feel more secure, their loans and investments will go forth in search of a higher yield than the Fed pays them (since a recent change in policy) on their reserves, and at that point the banking system's money multiplier will kick in with terrific force.

In short, given the monetary conditions now prevailing, the greater threat by far is inflation, not deflation. And contrary to what the investment "experts," the politicians, and the mainstream economists believe, inflation is not a benign element in the economy's operation. It is, as it has always been, the most dangerous and destructive form of taxation.

At times like this it is much more convenient to have an easily identifiable bogeyman at the ready - the word "deflation" fits this role quite well - rather than dealing with the much more significant underlying problems of a fundamentally flawed monetary system and misguided economic policies that have been all too dependent upon debasing the currency and fostering asset bubbles over the last hundred years, a process that has accelerated sharply over the last twenty and may now be coming to a painful conclusion.

Comments

[patio:]

I always have the same question at the end of these articles- when the banks decide its safe to lend again, who will they be lending to? The remaining 75% who are still employed, but want no more debt, ever, in their lifetime if at all possible? And to buy what, more non-discretionary Stuff we don't need? I don't see it.

2008 Dec 04 08:29 AM

[Dr.Jackpot:]

It won't happen (deflation). I would welcome deflation because I've saved only to see my spending power eroded by inflation. Deflation would return a bit of the my savings but one overpowering factor is against it. The federal reserve and cronies live off of one factor--------inflatio... Without inflation (unearned money) the powers that be will collapse because they don't live off of earnings. Life is not fair and they have the guns. So it won't happen in the long run. In the short run it may appear so but there really are no bargains. When I see a $1.39 Hershey bar selling for 5 cents again I will believe it.

2008 Dec 04 08:47 AM

[User 143167:]

When a country has a domestic debt/GDP ratio over 250%, deflation will only lead to depression .

2008 Dec 04 11:24 AM

[Steve in TN:]

Excellent article by Mr. Iacono.
His analysis is reality, what we'll be facing down the road in a year (or two).
The way to safeguard your assets or investments when this latest "deflationary" period is over is to own real assets such as commodities. I for one will be buying the ETFs, DBA (agricultural commodites) and DBC (agri. plus selected metals and oil). I personally can't control what the govt(s) do buy I sure can try to protect my investments from their decisions. I would also short the long Treasury bond when this latest flight to safety is over.

2008 Dec 04 11:37 AM

[Commodity B...:]

I'm going to call bulls*** on the inflation argument for two reasons:

1. The inflation already occured during the massive derivatives/credit bubble that occured between 2001-7. Since this bubble is now collapsing on itself, the speed at which capital/equity is being destroyed is far greater than the governments ability to pump money into the system.

Since October of last year, world stock markets have plunged by some $22 trillion dollars in market value, not to mention the collapse in global real estate values, derivatives, credit default swaps, etc.. This is a FAR FAR FAR FAR greater number than the $2-3 trillion of "stimulation" that the Fed is providing right now.


2. Commodities were a bubble with a capital B. If you followed Jim Rogers and T.Boone pickens advice one year ago, you'd be down 50% on your investments. I'm not much of a genius, but the S&P has so far outperformed all of the commodity gurus.

I fully expect Gold to collapse under its own weight once these leveraged ETFs start having to sell due to the credit crunch. Given that gold ETFs are the third biggest holder of gold in the world, once they have to liquidate all hell will break loose.

2008 Dec 05 02:34 PM