Dispelling the Deflation Myth

Are There Any Deflationistas Left?

As I have said and written over the past year: Deflation is not a threat, rather inflation is the greater threat. Significant and sustained Price Deflation is not a threat under a Fiat Currency and a profligate free spending Congress.

The Rise And Fall of Deflation

The modern inflationary era began in 1933, when the U.S. was taken off the Gold Standard, and the dollar became a fiat currency. It took the dollar many decades to be fully delinked from gold, culminating in the early 70's when the dollar was finally and irrevocably delinked from gold. Since 1933, the dollar has gone through progressive devaluations. The dollar became a fiat currency to give the US the ability to fight economic depressions. In a fiat money system, the central bank has the ability and the mandate to print as much currency as it sees fit and to issue as much credit as it sees fit to counteract the deflationary pressures experienced during recessions and depressions.

And indeed, as Rob Viglione's excellent chart shows above, the Fed has been remarkably successful at preventing price deflation. We have had only two bouts of mild deflation since 1933. The conversion from a Gold standard to a fiat currency, has effectively eliminated nearly all the deflation in the past 75 years, and has replaced it with deflation.

For a closer look at deflation since 1933, refer to a more detailed chart from the St Louis Fed. Both bouts of deflation lasted less than a couple of years, and levels of deflation were below 5%.

The Cure As Bad As The Ailment

The "cure" has had it's side effects: persistent inflation and a devaluation of the U.S. Dollar. The central aim of a Fiat Currency was to loosen money during recessions and then tighten money during booms. The U.S. Government addicted to easy money, neglected to tighten money during booms, as they found a way to print money and borrow with abandon during both good times and bad. Milton Friedman put it best:

The government solution to a problem is usually as bad as the problem.

Bad Money

Inflation has become a hidden tax on the American Saver, as it erodes the value of their fixed income and cash, to the benefit of the issuer of the currency as Alan Greenspan said:

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. … This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process… It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard. (1967)

The above statement doesn't mean that I am advocating the private ownership of gold. Instead, it means that every private citizen is better off under a stable currency policy.

Asset Deflation vs. Price Deflation

There are two types of delation: price deflation and asset deflation (Price Deflation being the opposite of price inflation). Asset deflation is a drop in the prices of assets including real estate and equities. When the stand alone word "deflation" is used, it nearly always refers to Price Deflation. During the bust of the late 80's, Japan experienced a simultaneous Asset Deflation, along with a mild Price Inflation. Japan did not experience a Price Deflation.

The same thing has happened here in the U.S. as we have witnessed an Asset Deflation. We have not seen a Price Deflation in the U.S., and due to the reflationary powers of the Federal Government, nor are we likely to.

Any more deflationistas left?

DISCLOSURE: Author is long U.S. Equities, Foreign Developed Equities, Emerging Markets Equities, US TIPS and WIP. You should perform your own due diligence and consult with a professional before investing.

Comments

[Thomas J. G...:]

Living4Dividends: These guys argue that money supply or what they call "hot money" funnels itself into certain asset areas. I respect these guys but I'm not sure I understand or agree totally with what they are saying:

www2.nationalreview.co...

Jun 12 03:27 PM

[user396040:]

I am concerned that the calculations of inflation used by the Government are inaccurate with respect to housing. They use a "rent equivalent" formula which treats the actual price of houses as essentially irrelevant. Because most Americans own their homes, I think it is very misleading to calculate housing costs this way when most Americans find the price of a house to be very relevant in their calculation of the cost of living. Because of this distortion, I think inflation was grossly underestimated during the 2002-2007 time period. Had it been calculated accurately, it would have been clear that we had substantial inflation and the Fed would have raised interest rates and the housing bubble would have been brought under control. Since 2007, the distortion works the other way - the decline in housing prices is treated as irrelevant in the calculation of inflation and this leads to an underestimate of deflation which in fact has been substantial.

Jun 12 03:38 PM

[Msoane:]

Good article. Incredible graphic.

Large productivity gains in the 1990's coupled with constant downward price pressure on consumer goods as a result of the growth of inexpensive Asian imports kept the lid on price deflation and hid the effects of large money supply increases. The money supply increases showed up in financial assets and homes, which don't suffer from a technology cost curve or overseas competition; therefore you certainly can have some sectors of the economy or asset classes experience asset inflation while others don't.

Jun 12 04:07 PM

[Living4Divi...:]

Agreed. You have a valid point. CPI is underreported. I hae researched on this and reported on this in my blog.

I don't know the real number The fudge factor is at least appx 1%/year.


On Jun 12 03:38 PM user396040 wrote:

> I am concerned that the calculations of inflation used by the Government
> are inaccurate with respect to housing. They use a "rent equivalent"
> formula which treats the actual price of houses as essentially irrelevant.
> Because most Americans own their homes, I think it is very misleading
> to calculate housing costs this way when most Americans find the
> price of a house to be very relevant in their calculation of the
> cost of living. Because of this distortion, I think inflation was
> grossly underestimated during the 2002-2007 time period. Had it been
> calculated accurately, it would have been clear that we had substantial
> inflation and the Fed would have raised interest rates and the housing
> bubble would have been brought under control. Since 2007, the distortion
> works the other way - the decline in housing prices is treated as
> irrelevant in the calculation of inflation and this leads to an underestimate
> of deflation which in fact has been substantial.

Jun 13 06:20 AM

[Living4Divi...:]

Thanks for the compliment MSloane.

I like the way you describe the divergence between price defl and asset defl

On Jun 12 04:07 PM Msoane wrote:

> Good article. Incredible graphic.
>
> Large productivity gains in the 1990's coupled with constant downward
> price pressure on consumer goods as a result of the growth of inexpensive
> Asian imports kept the lid on price deflation and hid the effects
> of large money supply increases. The money supply increases showed
> up in financial assets and homes, which don't suffer from a technology
> cost curve or overseas competition; therefore you certainly can have
> some sectors of the economy or asset classes experience asset inflation
> while others don't.

Jun 13 06:23 AM

[Jimbo:]

Several authors on SA, Including Living4Dividends, seem to hold TIPS and or recommend them to readers. I cashed out of my TIPS early last year. I fear that the government is cooking the books to hold the perception of inflation down. TIPS are calculated on the "official" inflation data, hence I see them as a losing game. Better to task a risk on commodities.

Jun 13 01:03 PM

[Spartacuss:]

Inflation is a monetary event whether that shows up in assets or what.

The graph of time versus say CPI shown is year over year and not cumulative. The cumulative effects obeys the hockey stick phenomena. The Keynes solution was criticized for this effect in his time as the math describes a transcendental, i.e., the function goes vertical at some point. His comment was "yeah, but we'll all be dead by then" which shows that greed overtakes reason and as long as "stimulus" reigns as the method of regaining financial foothold, we are all doomed.

Markets cycle, it is just the nature of the beast. Trying to moderate market activity by adjusting money supply is pure folly. Notice on the chart that in the later years, deflation was the bug-a-boo...just cannot have that, and the reason is that commerce slows down in a deflation, and investment slows down, people start saving money instead of borrowing which slows things down some more. I posit that we need periods of deflation so that people and companies as well put aside for that rainy day. Also, this would discourage governments from taxing the crap out of companies so that in order to make the bottom line, they too have to borrow, borrow and borrow some more until an implosion occurs which is ten times worse than normal market cycle phenom.

A stable economy rests on the occurrance of deflationary cycles.

Jun 13 02:41 PM

[Gregman2:]

You mention asset deflation as a real threat, and many suggest that it's due to excessive debt throughout our system. With still so much excess capacity and so much foreign manufacturing, it would be hard to see price deflation--or inflation--for anything other than real estate or large capital expenditures.

Jun 13 06:01 PM

[mbkelly75:]

Excellent article and comments also are well thought out. I believe the same thing - inflation is by far - the greater threat. The housing problem does not really effect me. My home and my children's homes (all eleven of them) have no mortgage and most were bought at a discount because someone had to sell. I got my latest home for a 25% discount 8 years ago and paid cash. Since we live in our homes, the paper prices up and down do not effect us. We hold both physical Gold and Silver as well as mining stocks and CEF for a bullion reserve that is both easily tradable and transparent. I recently read of a woman who survived Germany's last great inflation with a bath tub full of the COINS used before the devaluation took effect. With prices given in both New Dollars and Old Dollars (actually Marks probably - but you get the point) and a good supply of Old Dollars - she did okay. You might be just fine getting in a large supply of coins and hanging on to them. Things like bars of Soap, Combs, Toothbrushes, etc were useful also in areas around the world that have had a currency meltdown. This is history - learn from it. In many cases - Gold was unusable - the value was too high for daily needs. You could buy a house or a farm with it - not a loaf of bread. It is something to think about.

Jun 13 11:08 PM

[Nathaniel C:]

Von Mises warned that central banks always use the deflation argument to print money and debase the currency. Anyone who lives in the real world realizes that the US has not experienced deflation since the Depression. It is unfortunate that people associate delfation with the Depression and blindly listen to government officals and central bankers who claim that we have to "defeat" deflation and cause inflation to protect the economy.

Deflation can be a good thing. Look at the computer industry which experiences massive delfation and yet reports increased profits and high margins. In an advanced economy like the US we should be experiencing delfation as a result of increased productivity and technological improvement--not perpetual inflation like we are used to. The only way the US could experience deflation is if the Fed dramatically reduced the money supply (LOL).

Marc Faber noted that deflation is a good thing and that many countries have experienced prosperity during price deflation. Deflation increases your purchasing power and rewards savings (which forms the capital in capitalism as oppposed to debt financing).

It is bizarre that people like inflation and belive it to be a natural part of capitalism. Greesnpan in his memoirs noted that the US did not experience inflation between 1787-1913. The dollar maintained its purchasing power and prices were truly stable (there were of course periods of inflation during war times but that was followed by deflation). The US economy did very well during this period but of course we were under a gold standard.

Jun 14 01:54 AM

[rdasher:]

A typo you might want to correct : "The conversion from a Gold standard to a fiat currency, has effectively eliminated nearly all the deflation in the past 75 years, and has replaced it with deflation."

Should read: "The conversion from a Gold standard to a fiat currency, has effectively eliminated nearly all the deflation in the past 75 years, and has replaced it with inflation."

Great article and charts.

Jun 14 08:09 AM

[Fred Voetsch:]

I am completely amazed at how anyone can look at our current economy and its effect on individuals who are now underwater on their homes or have lost 40% of their retiement and state that deflation is not a threat.

Jun 15 03:01 PM

[Fred Voetsch:]

On Jun 13 11:08 PM mbkelly75 wrote:

> Excellent article and comments also are well thought out. I believe
> the same thing - inflation is by far - the greater threat. The housing
> problem does not really effect me. My home and my children's homes
> (all eleven of them) have no mortgage and most were bought at a discount
> because someone had to sell. I got my latest home for a 25% discount
> 8 years ago and paid cash. Since we live in our homes, the paper
> prices up and down do not effect us.


Your statements only show that you are not a good judge of the current situation because YOUR situation is unlike that of the typical American. Please see my previous comment which does apply to most of the people in America.

Jun 15 03:03 PM

[Living4Divi...:]

Jimbo - I have already answered this before. You are correct - the CPI is under stated (that is fudged to make official CPI look lower than actual inflation). I believe the fudge factor to be appx 1%/year. What the real level of under reporting, no one knows. Every investment is like buying a dog. with every dog you have to decide if you want to put up with some fleas.


On Jun 13 01:03 PM Jimbo wrote:

> Several authors on SA, Including Living4Dividends, seem to hold TIPS
> and or recommend them to readers. I cashed out of my TIPS early last
> year. I fear that the government is cooking the books to hold the
> perception of inflation down. TIPS are calculated on the "official"
> inflation data, hence I see them as a losing game. Better to task
> a risk on commodities.

Jun 16 11:09 AM

[Living4Divi...:]

On Jun 13 02:41 PM Spartacuss wrote:

> Inflation is a monetary event whether that shows up in assets or
> what.
>

over time, yes. agreed

> The graph of time versus say CPI shown is year over year and not
> cumulative. The cumulative effects obeys the hockey stick phenomena.

agreed. that's compound interest for you: it works whether we want it to or not.

>
> Markets cycle, it is just the nature of the beast. Trying to moderate
> market activity by adjusting money supply is pure folly. Notice on
> the chart that in the later years, deflation was the bug-a-boo...just
> cannot have that, and the reason is that commerce slows down in a
> deflation, and investment slows down, people start saving money instead
> of borrowing which slows things down some more. I posit that we need
> periods of deflation so that people and companies as well put aside
> for that rainy day. Also, this would discourage governments from
> taxing the crap out of companies so that in order to make the bottom
> line, they too have to borrow, borrow and borrow some more until
> an implosion occurs which is ten times worse than normal market cycle
> phenom.
>
> A stable economy rests on the occurrance of deflationary cycles.

The Great Depression was a time of this so called "healthy deflation." Families were uprooted. Family farms were lost. A great amount of needless misery and despair was visited upon the American people. My Grandparents were alive during this era and it taught them to be thrifty.

Whether or not deflation is a good thing, is a moot point. The fiat based currencies of the world are a fact of life. An inflationary world is here to stay. Price Deflation can and will be avoided (especially by Helicopter Ben)

Jun 16 11:19 AM

[Living4Divi...:]

On Jun 14 08:09 AM rdasher wrote:

> A typo you might want to correct : "The conversion from a Gold

RDasher - Nice catch. I will correct.

>
> Great article and charts.
>

Thanks for your compliment about my article

Jun 16 11:23 AM

[mbkelly75:]

That I was intelligent enough to avoid debt does not mean that I do not understand the current problem. It can mean that I saw the problem coming and avoided it years ago. If you actually read what I wrote - you will see that I did NOT say that deflation is not a problem - what I said was inflation is a GREATER problem. The housing market's (and the stock market's also) ups-and-downs can be a really big problem for a lot of people - there is no denying that. HOWEVER, those losses are PAPER losses - they are not actually a loss in real terms unless the home is sold. As long as you are living in it and continue to live in it - you have a chance to eventually regain what you have lost on paper. That is how my sister and her family is currently handling the same problem is S. Calif. She followed her hubbies advice on this instead of mine and they are still living through it. Her stock market account is making money though - she followed me there.


On Jun 15 03:03 PM Fred Voetsch wrote:

> On Jun 13 11:08 PM mbkelly75 wrote:

Jun 17 01:57 PM

[Living4Divi...:]

MBKelly - Thanks for the compliment on both my article and comments. I wrote about the use of Gold solely as a portable wealth transport in one of my earlier articles.


On Jun 13 11:08 PM mbkelly75 wrote:

> Excellent article and comments also are well thought out. I believe
> the same thing - inflation is by far - the greater threat. The housing
> problem does not really effect me. My home and my children's homes
> (all eleven of them) have no mortgage and most were bought at a discount
> because someone had to sell. I got my latest home for a 25% discount
> 8 years ago and paid cash. Since we live in our homes, the paper
> prices up and down do not effect us. We hold both physical Gold and
> Silver as well as mining stocks and CEF for a bullion reserve that
> is both easily tradable and transparent. I recently read of a woman
> who survived Germany's last great inflation with a bath tub full
> of the COINS used before the devaluation took effect. With prices
> given in both New Dollars and Old Dollars (actually Marks probably
> - but you get the point) and a good supply of Old Dollars - she did
> okay. You might be just fine getting in a large supply of coins and
> hanging on to them. Things like bars of Soap, Combs, Toothbrushes,
> etc were useful also in areas around the world that have had a currency
> meltdown. This is history - learn from it. In many cases - Gold was
> unusable - the value was too high for daily needs. You could buy
> a house or a farm with it - not a loaf of bread. It is something
> to think about.

Jun 17 05:07 PM

[user396040:]

One of the problems with deflation is that wages are sticky on the down side. As a result, in a period of deflation, an employer is faced with the dilemma of having to cut wages constantly and face employee resentment or leave nominal wages the same and thereby give employees constant increases in real wages. The result is often that employers lay workers off, cut back on overtime, etc. rather than actually cut anyone's salary. Over a long, long period of time, everyone would get used to this and a salary cut would not be a tramatic experience. But coming after some 70 years of inflation, a period of deflation would almost certainly be accompanied by higher unemployment brought about by the sticky nominal cost of labor which would necessarily mean an increasing real cost of labor.

On Jun 14 01:54 AM Nathaniel C wrote:

> Von Mises warned that central banks always use the deflation argument
> to print money and debase the currency. Anyone who lives in the real
> world realizes that the US has not experienced deflation since the
> Depression. It is unfortunate that people associate delfation with
> the Depression and blindly listen to government officals and central
> bankers who claim that we have to "defeat" deflation and cause inflation
> to protect the economy.
>
> Deflation can be a good thing. Look at the computer industry which
> experiences massive delfation and yet reports increased profits and
> high margins. In an advanced economy like the US we should be experiencing
> delfation as a result of increased productivity and technological
> improvement--not perpetual inflation like we are used to. The only
> way the US could experience deflation is if the Fed dramatically
> reduced the money supply (seekingalpha.com/symbo...;br/>
>
> Marc Faber noted that deflation is a good thing and that many countries
> have experienced prosperity during price deflation. Deflation increases
> your purchasing power and rewards savings (which forms the capital
> in capitalism as oppposed to debt financing).
>
> It is bizarre that people like inflation and belive it to be a natural
> part of capitalism. Greesnpan in his memoirs noted that the US did
> not experience inflation between 1787-1913. The dollar maintained
> its purchasing power and prices were truly stable (there were of
> course periods of inflation during war times but that was followed
> by deflation). The US economy did very well during this period but
> of course we were under a gold standard.

Jun 18 12:21 PM

[Living4Divi...:]

user396040 - I agree with you that "One of the problems with deflation is that wages are sticky on the down side" If real wages needed to be forced lower, in order to stay competitive, rather than deflate the wages, it is easier for a government to inflate the currency. The net effect is the same.

On Jun 18 12:21 PM user396040 wrote:

> One of the problems with deflation is that wages are sticky on the
> down side. As a result, in a period of deflation, an employer is
> faced with the dilemma of having to cut wages constantly and face
> employee resentment or leave nominal wages the same and thereby give
> employees constant increases in real wages. The result is often
> that employers lay workers off, cut back on overtime, etc. rather
> than actually cut anyone's salary. Over a long, long period of time,
> everyone would get used to this and a salary cut would not be a tramatic
> experience. But coming after some 70 years of inflation, a period
> of deflation would almost certainly be accompanied by higher unemployment
> brought about by the sticky nominal cost of labor which would necessarily
> mean an increasing real cost of labor.
>
> On Jun 14 01:54 AM Nathaniel C wrote:

Jun 19 09:13 AM