Why Deflation Is Bad And Inflation Is Good: Monetary Policy 101

by: Robert Wagner

One of the greatest myths in society today is that deflation is desirable to inflation. Nothing could be further from the truth, but this myth seems so commonsensical it is hard to dispel. How can anyone argue against cheaper products? The myth is so powerful it has inspired an entire monetary system called the "bitcoin" that is deliberately managed to create deflation. Facts are, deflation is the death sentence of a modern free market economy, a lesson we seem to have forgotten since the last major bout of deflation, the Great Depression.

First the basics:

The basic monetary model is called the "Quantity Theory of Money."

The formula, MV=PQ basically defines modern monetary policy. M = Money Supply, V = Velocity of Money, P = Price Level and Q= Real Output or the level of real transactions. V or the velocity of money is the number of times money changes hands over a given time period. P is the "aggregate" price level of goods and services across the entire economy (note: this is more than just consumer goods measured by the CPI).

The Application of MV=PQ:

How then does Ben Bernanke use this to implement our monetary system? The first thing is to send the objective. The objective of the Fed is STABLE prices, not inflation or deflation. In practical application however the Fed targets a low and stable rate of inflation. There is good reason for this, and I'll cover that later in this article.

When using MV=PQ, the variables are converted into percent changes. 0 represents today and 1 represents the end of the time period, so T0 is today, and T1 is the end of the period. In most cases a quarter or year.

So for this article we will assume that the desired change in prices over T0 (Today) to T1 (Time in the future) is 0%, so P1/P0 = P= 1.

The velocity of money, V, is considered fixed. From the chart above, that clearly isn't the case, but for the purpose of this article we will assume that V0 = V1, so V1/V0 = V = 1, or does not change.

If we assume P = 1 and V = 1, then the formula condenses down into M x 1 = 1 x Q, or % change in M = % change in Q, and that is how Ben Bernanke manages our monetary system. Ben attempts to increase the money supply at the same rate the economy grows. If V is considered fixed, and the target is stable prices or fixed prices, to accomplish that objective using MV=PQ, money must increase at the same rate as Q. It literally is that simple...on paper.

Sure it works on paper:

When you read the following analysis, envision riding a bike and having the rear gear skip to a lower level. The immediate response is to peddle faster, but because you are in a lower gear, the faster peddling only maintains the current speed, the speed doesn't get "inflated." In this analogy, the peddle speed is the Fed printing money, and changes in the speed of the bike is inflation or deflation. The Fed's objective is to maintain a peddle speed that keeps the bike at a manageable smooth pace.

If only life was as easy as the formula suggests. In reality life isn't that simple, and 2008 proved that. From the linked chart above it is clear that velocity isn't constant. Velocity dropped from over 10 in 2008 to about 6.5 today. In MV=PQ, if V drops, M has to increase to compensate. That is why the Fed "printed all this money out of thin air," they were doing it in part to compensate for the collapsing velocity of money. As people were stuffing money in their mattresses and burying it in mason jars in the back yard, the Fed was printing money to prevent a monetary collapse. They were effectively peddling faster to compensate for the velocity gear jumping to a lower level.

In 2008 we also fell into a deep recession, some call it the Great Recession. In the formula MV=PQ, if Q falls, and V falls, to maintain balance, the Fed has to increase M and "print all this money out of thin air," or the system collapses. Not only did the V gear jump, the Q gear jumped as well. The Fed had to peddle double time, just to keep moving forward. So in the above linked chart showing M1 Money Supply increasing from about $1.4 trillion in 2008 to about $2.5 trillion today, much of that simply went to compensating for a lower V and lower Q, and this is why we "printed all this money out of thin air," and don't have inflation...yet.

Printing Money Out of Thin Air:

Why would anyone support a system where you can "print money out of thin air" simply by turning on the printing press? That simply seems so wrong, "who would possibly defend such a system, have they never read history?" Well, yes, I've read history and I do defend that system. I do so because the alternative leads to catastrophic consequences like the great Depression when things go wrong. To understand why, one has to understand the basics of a monetary system. There are basically two systems:

1) An "elastic" currency which easily expands and contracts. When people refer to being able to "print money out of thin air," they are referring to an "elastic" currency. A "Fiat" currency that has "no intrinsic value" is another description used. In the above analysis, the Fed easily adjusts M in its effort to maintain stable P and full employment Q by "printing all this money out of thin air."

2) An "inelastic" currency which is fixed or difficult to adjust. The gold standard is an example of an "inelastic" currency. The money supply under a gold standard is effectively fixed in the short run, and expands at a random rate tied to the new discoveries of gold. The bitcoin takes it a bit further and sets a finite number of coins in existence, and after a certain date no more will be "minted."

With an "elastic" currency you have a flexible money supply and flexible exchange rates. With an "inelastic" currency you effectively have a fixed money supply and fixed exchange rates. Being a lover of free markets, I abhor fixing anything in a dynamic efficient market because it usually leads to trouble.

Unlike an "elastic" currency, the "inelastic" currency can ot rapidly adjust like the Fed does in the explanation above. Under an "inelastic" currency the die is cast, things are set in stone and if an economic crisis occurs, there "ain't a whole hell of a lot you can do about it." Unlike 2008 when President Bush, Henry Paulson and Ben Bernanke ran to Congress for emergency powers, allowing them to print money until the cows come home, there is no emergency power that can magically make gold fall from the heavens and solve our economic crisis. Under an "inelastic" system, the economy is held hostage by the currency. It is literally a manufactured "tail wag the dog" situation. Unlike the elastic currency where the economy dictates the monetary policy, under an "inelastic" currency the currency often dictates the economy. The most viscious business cycles this nation has ever experienced occurred under a gold or semi-gold standard system.

The gold standard didn't save us from dystopia. The gold standard was dystopia...The gold-standard era was a time of more frequent recessions, more protracted recessions, and more severe recessions. In other words, the bad old days.

Most puzzling about the gold standard movement is that Libertarians champion the idea. Libertarians also champion the "Austrian School of Economics" and the "Austrian Business Cycle Theory" of F.A. Hayak. The inspiration for F.A Hayak's business cycle theory was the late 1800s business cycle, a period when there was no Federal Reserve and the business cycle was caused in part by the gold standard. One only needs to watch the movie "It's a Wonderful Life" to understand the horrors an "inelastic" currency wreaks on society. Under the system today Mr. Bailey would simply visit the discount window at the Federal Reserve and get an emergency loan from the "lender of last resort." An "elastic" currency, if implemented properly eliminates the threat of a bank run destroying the banking system. That is why we never heard of any bank runs in 2008.

Inflation vs Deflation, "let's get ready to Rrruummbblllleee!!!"

Ok, we just reviewed how an elastic currency allows for the monetary policy to be maintained in a non-inflationary manner by balancing the money supply with the growth of the economy. In reality they shoot for slight inflation which I will cover later. Under a gold standard, the growth of the money supply is determined by the new discoveries of gold. There is a completely random nature to it. Tomorrow a huge find could be discovered and the money supply could double in a day, or Russia could go to war against South Africa and Australia and disrupt new gold discoveries, resulting in a stoppage or even shrinkage of the money supply. The point being, there is no nice formula like MV=PQ that works with a gold standard. M = random nature of new gold discoveries. There is no central authority that regulates the new gold discoveries to ensure the monetary system functions smoothly. What this means is that the monetary policy is separate from the economy. We could be in a Great Depression and new discoveries of gold could stop right when we need the stimulus. We could be experiencing hyperinflation and we could discover a huge new find, increasing the money supply right when we should be cutting it back. Money supply and the economy are completely separate and independent.

In reality what happens is that during times when money is in short supply, the economy experiences deflation, and when money is in excess supply the economy experiences inflation. This phenomenon is particularly hard on farmers and in fact was the main inspiration of William Jennings Bryan's Cross of Gold Speech given during the 1896 Democratic National Convention. Under an inelastic currency, farmers would bring their crops to market at harvest. This would be a huge increase of supply of product available on the market (Q). The supply of money ([M)) however would not expand to compensate for the increase in Q. If the velocity of money (V) remains fixed, the result is a decrease in prices (P), or deflation. Often this would create a panic as bankruptcies multiply, scaring people into hording what money they did have, further shrinking the available money supply and establishing a vicious downward deflationary spiral in the economy.

Farmers would have paid top dollar when money was in ample supply at planting, but by the time a small seed had grown into multiple ears of corn, the surge in supply for a given money supply resulted in prices collapsing. Where $1 used to buy 100 seeds at planting, there are now 400 ears of corn competing for that same $1. Farmers got hit on both sides of the transaction. Under the current system the money supply would have been increased to compensate for the surge in demand at harvest, and slowly decreased back to normal levels by planting, maintaining stability in prices.

It is important to note that it was the inelastic currency that caused the problems for the farmers, not droughts or technological changes. This is the manufactured "tail wags the dog" that a gold standard creates. No one argues that falling prices are good IF the lower prices are due to increased efficiencies and market driven lower costs. There is almost constant deflation in certain sectors of the economy, namely technology and electronics. That is great, but that isn't monetary induced deflation. Prices fall for many reasons, not just monetary. Increased technology, lower cost inputs, greater efficiency of a labor force, new discovery of natural resources and other factors can lower the price of goods and services. Those are all good things. New oil discoveries in the 1980s lowered the cost of oil. That was great, but that isn't monetary deflation.

Monetary deflation is when the shortage of money results in an AGGRIGATE fall in prices that is totally removed from the cost structure of an industry or firm. Monetary deflation results in lower prices being forced upon the market which are not the result of normal market forces. When Henry Ford introduced the assembly line to the world, he was able to dramatically lower the price of a car AND substantially INCREASE profits. He was able to double the wages of his employees not because he was a kind man, but because the assembly line made his workers 8 x more efficient. The key point being, market driven deflation through a lowering of the cost curve through technological advancement or other market forces results in lower prices AND higher profits. That is a good thing. Wal-Mart (NYSE:WMT) maximizes profits by LOWERING prices, which is made possible due to their size and ability to negotiate cost reducing contracts. Those are all good things, but that is not monetary deflation, that is simply the natural functioning of a competitive and efficient market. The lower prices aren't being forced upon WMT or Henry Ford because no one has any money to spend because it doesn't exist in adequate supply.

Still not sold?

Still not sold that monetary deflation is a bad thing? Consider this example of a fast food worker at a restaurant with a $1 menu. Assume the worker gets paid $5/hr. Therefore the worker must serve 5 $1 cheeseburgers an hour to cover their wage (yes, I'm ignoring the cost of the cheeseburger, this is just an example). The equilibrium productivity is 5 cheeseburgers per hour for the employee. Now imagine there is a bout of monetary deflation and the price of the cheeseburgers drop to $0.50. The employee must then either serve 10 cheeseburgers per hour, or they won't be able to justify their wage. If they can't double their productivity, their wage would need to be cut in half. That is why unemployment tends to increase during periods of deflation. Only the most efficient firms with the most productive employees can survive.

Nope, still not sold?

Okay, I've saved the best argument for last. Fixed income instruments and interest rates easily adjust to inflation. If inflation picks up by 5%, interest rates easily increase by 5%, there is no ceiling on interest rates, they can go as high as needed to compensate for inflation. That however isn't true for deflation. Interest rates can't adjust for deflation, interest rates can't go below 0% (actually they can, but that is beyond the scope of this article, and requires unique financial instruments). In the above example imagine the owner of the restaurant taking out a 5% loan when inflation was 2%. The nominal rate is 5% and the real rate is 5%-2% = 3%. If inflation goes up to 5%, the owner effectively has a 0% interest rate loan, and if inflation goes to 10%, the owner is effectively paying 5% less on the loan. Inflation transfers wealth from lender to borrower. Anyone that took out a 30 year mortgage loan in the 1950s was celebrating by the end of the inflationary 1970s, as they saw their mortgage payments in both nominal and real terms evaporate, and value of the home far exceed the original value of the mortgage. My in laws bought their home for $15,000, and my parents purchased almost 4 acres and a large home for $29,000. The current estimated values are near 10x the original purchase prices or more. That is a system that works. Over time wages, asset prices and prices slowly changed, and banks are compensated for inflation through the inflation premium built into the interest rate. It is a win, win, win situation.

Now, consider what happens with deflation. The restaurant owner takes out a 5% loan, and 10% deflation occurs. The real rate of interest in now 15%, or 5 x the original 3% real rate. Assuming a monthly loan payment of $1,000, it used to take selling 1,000 cheeseburgers to make the payment, now it requires selling 1,100 cheeseburgers to cover the payment. Deflation transfers wealth from the borrower to the lender. That is why in the Cross of Gold speech, Williams Jennings Bryan points out that the bankers love the gold standard, banks get paid back with more expensive dollars. Imagine taking out a mortgage that has a $1,000/mo payment, and you are making $1,000/wk. In that situation your mortgage payment is the equivalent of 1 weeks wages. Now imagine 10% deflation causing your wage to fall 10% to $900/wk. It now takes 1.11 weeks to earn your mortgage payment. In the real world, wages are sticky, and what would most likely happen is that you would either have to increase your productivity or get laid off.

In conclusion, the belief that fiat money, printing money out of thin air and the Fed's policy of moderate inflation are bad are some of the most destructive and dangerous financial myths in existence today. Deflation is the death sentence for a modern economy, and is something that must be avoided, not pursued. Once an economy slips into a deflationary spiral, there is little the Fed can do, and that is why they deliberately error on the side of caution and generate a bit of inflation. It is simply an insurance policy against the destructive consequences of deflation. To fight inflation all the Fed needs to do is contract the money supply, something they have a great deal of experience doing. To counter deflation they somehow have to get people to borrow and spend, when borrowing becomes more expensive IN REAL TERMS by the day. They don't have a great deal of experience doing that, and the Great Depression doesn't really represent a huge success for the Fed. Pursuing a deflationary policy would force the Fed into uncharted territories where the benefits are almost non-existent and the dangers are catastrophic.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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