November 19, 2008

Inflation or deflation? What is going on?

For a while now, I have been worrying about the prospects of inflation. Well...not really the prospects, because I know it is a problem, even the government admits that we have inflation. Rather, I have worried that inflation is rapidly destroying the value of the money I have saved in the bank. Recently though, I have started hearing news about deflation, which I thought was utter nonsense. How could deflation be happening now? Gas prices were high; food prices were high; movie ticket prices were high; car repairs were expensive. If we had deflation, I thought, I would be getting richer every day. My money would be worth more as prices went down.
But then I started hearing people say deflation was a bad thing. They said that falling prices made people defer their spending and that made businesses suffer. They said that people in debt suffered with deflation because it would be harder to pay back debts. They said it was a "wolf" that was at the door ready to eat us all alive.
Then I started seeing gas prices go down; food prices started stabilizing so to speak; housing prices were still going down, and I wondered how it was possible? How could all this money that the Federal Reserve was printing actually allow any prices to fall? Then I started to worry again. What if deflation really is a problem? What if it does stifle business growth? I think I have come to a conclusion: deflation is just what we need right now.
Let me explain. In 2001, a recession caused the Federal Reserve to lower interest rates and 'pump more liquidity into the system'. This means they printed more money and expanded the money supply so that people could keep on spending money as if nothing had happened. Well, they printed so much money for so long that people began spending money like they never had before. Loans were easy to get. Cars were easy to buy. Housing prices went through the roof. People refinanced their houses and took the apparent appreciation in value of their homes and spent it on that trip to the Bahamas. In fact, we even were able to fight two wars at seemingly no cost and people were still having a great time. Life was good. Democracy was spreading. Capitalism was making us all so rich. What could have gone wrong?
Some of the first indications were people starting to default on their mortgages. You see, they had borrowed all this money and spent it on cars, houses, vacations, hot dogs, iPods, computers, flat-panel T.V.'s, and the irresistible yummies that they saw on those flat-panel T.V.'s. Suddenly, they had nothing to show for it. The cars were breaking down. The houses needed to be painted, recarpeted, and refurnished. The vacations were mostly just pictures on facebook. The hot dogs had long served their purpose. The iPods were out of warranty, and the flat-panel T.V.'s were too small to see the whole football field. They had spent all their money on things that brought absolutely no return. Worse, it had all depreciated in value and they were still making payments on the stuff. This could be called malinvestment.
It gets worse. You would think that businesses would have been smarter. They would have spent their profits on retooling, upgrading, and training. But they didn't. Rather, they payed for employee vacations and golf tournaments etc. They malinvested even worse than the consumer. Why? Because money was cheap, and they would pay it back with the profit they got when they sold their houses and businesses into a stock market that was always in the green.
Well, let's get to the point. In few words, prices got high. They got really high, and now no one could pay back all the money they owed. So people and businesses started going bankrupt. One by one they went down and all the talking heads said, "It can't get any worse" or "This is just a little dip". Now we face widespread bankruptcy.
So what do they say we have to do to solve it? Here's what we hear from all the big shots: 'Well, we need more liquidity. People don't have enough money to spend. We can't let large companies fail. Get people spending money again like they were and all will be better.' But how can the cure be exactly what caused the disease in the first place?
Here's what we need: deflation. We need a correction to what prices are supposed to be at. We need to return to sustainable prices of years ago (perhaps more). How long will it take? No longer than we let it. I remember in 2001, gas prices were even lower than they are now. Maybe we are getting there. Is anybody truly worried about the price of gas? Not really. Its a good thing insofar as we don't have to spend so much on gas and can start paying back all our debt. In fact, the more prices go down, the better off we will be in the long-run, because we will have disposable income to pay back our debts.
Some ask what will happen to the businesses though who suffer from deflation and lower profits. They may go bankrupt. Well, this is exactly what we need! I am serious! If they participated in the malinvestment during the boom, they have to accept the responsibility of the hard times that come with the bust. What remains will be stronger businesses who are better able to suit demand and smarter at investing.
What is the alternative? Well, we could do what we are doing right now. We could bail out all of America to itself. We could just get a new credit card with an unlimited line of credit and just put it all on that and start over.
We need to start over alright, but by getting out of debt, not by going into more. A wise man said, "As long as we live above our means, we are destined to live beneath our means." Are we ready for this? The politicians are scared to death. They think they are responsible, and they are, at least in part, but they are trying to cover their tracks by passing the buck to coming generations. Can we sacrifice now for our children? Can we accept personal responsibility for our foolishness and not shift that to another person who might not even be born yet? I admit, I am not sure I want to. Can't we just keep on going like we have--pushing the debt to our children, just as our parents pushed in onto us? After all, we are doing them a favor and making the world safe for democracy right? Isn't that an investment? Won't America and the world be so prosperous some day that we can pay back all our debts and live in peace and harmony?
I know I sound cynical and mocking here, but these are actually legitimate questions that reflect the views of a lot of people, even mainstream politicians and economists. How do we respond to them?

**I should note that strictly speaking, inflation is not a rise in prices just as deflation is not a fall in prices. Inflation is an increase in the money supply/goods and services in the economy ratio. That is, the total money increases relative to the goods and services available. The effect of this is an increase in prices but inflation itself is not defined as that. Deflation is the opposite.


Alan said...

This discussion about deflation leads me to this question:
What about entrepreneurs?

As you mentioned, deflation is a lower ratio of money supply to goods and services. This is generally accompanied by lowering prices, which offers a disincentive for entreprenuers to pursue their ideas.

The borrowed capital necessary to start a business would be much more difficult to repay if prices for goods and services continue to drop. This is due to the smaller and smaller profits received for goods and services, even if the % profit margin remains the same (again due to deflation). The original loan amount remains the same, so it will take longer to repay it with the smaller profits.

So it seems that a dearth of entreprenuerial activity is a necessary companion to deflation. Thoughts?

BEN said...

Remember that there is a supply and demand for money just like anything else. The "price" of money is called the interest rate. Borrowers (including entrepreneurs) are the demanders while savers are the suppliers. So, as savers forecast deflation (their money will be more valuable in the future), they will save more, causing an increase in supply of available money for investment. Supply goes up, price (interest rate) goes down. Thus, borrowers will have lower interest rates. When an entrepreneur takes out a loan, he is forecasting that whatever it is that he uses it for will give a greater return than the interest rate. Since the interest rate is lower, he will not be as worried about deflation. Also, if he is a smart investor, he will take deflation into account when he figures what his return will be.
This system places the burden of risk (deflation) upon who it rightly belongs: the entrepreneur. His success will also depend on his ability to forecast this factor as well. Not a big deal right?
Furthermore, for the rest of us, there will be an equilibrium between anticipated deflation and our time preference for consumption. That is, we prefer to have things now as opposed to later, but deflation actually encourages us to consume wisely (remember SMOOOOOOTH CONSUMPTION!) because our money will have more buying power in the future. The whole net effect of deflation will be a more stable, robust economy.
On the other hand, inflation does the exact opposite. Savers have less incentive to save because their money will lose its buying power over time. This discourages people from saving and encourages them to consume now, pay later. In the old days, people used to save up for things and then buy them. Now, people buy things on credit and pay them off over time, often still paying after the good is useless or greatly depreciated in value.
In any event, this would create high interest rates because the supply of savings is low. Entrepreneurs would have a harder time getting loans and they would have higher interest rates.
So what does the government do? Well, they set the interest rate artificially low and pump more money into the system. This creates more inflation and so on.
Anyway I think you see my point. The more I think about it, the more I am convinced that deflation would be a good thing.
Part of the problem we are having now is we have inflation (increased money supply due to low interest rates and other things that the govt. does) but we have stagnating economic growth. We see this as a decrease in prices due to a decrease in demand, but this I think is only temporary because the inflated money supply will eventually cause higher prices.

VeLynn said...

I had to mention that Deflation is as dangerous as inflation if not more. Deflation is not at term to be use for market correction. What you see with the gas price and housing prices is not deflation is market correction. It looks like deflation because the prices are going down, but, deflation is as dangerous as or even more dangerous than inflation.
Why is deflation more dangerous? It is because prices are going down, not because things are getting cheaper or because the market is correcting, it is because businesses are trying to increase their cash flow by getting rid of inventory so that they can maintain themselves afloat. This causes a sudden drop on prices but there is no one to buy – therefore, businesses close, consumers are not getting income, people save their pennies because they needed for essentials, they do not get credit because they do not have jobs, so the economy goes south faster. Consumers are not saving for a rainy day, they are saving to survive.
How can you save when you do not have cash flow, how can you get cash flow when you do not have a job, and how can a company hire you when they do not have sales.
The influx of money (bail out) will only provide money to companies so that they can continue their business (through lending), but, when people do not have money to buy, it does not matter what prices are in the market, the economy comes to a halt.
At least inflation moves money – deflation stops completely the movement of money.
Market correction is more in relationship to supply and demand. Deflation is survival.

BEN said...

I am not sure what you mean by dangerous. I think I gave the wrong impression about deflation, but at the end of the post I do explain that deflation is not necessarily a drop in prices. Thus, we have never really had deflation in this country because the central bank is constantly increasing the money supply. What we have is actually called stagflation. (Increasing money supply but a shrinking economy). This means that some prices may seem to go down in the short run, but they can't stay there because of the drastic increase in the money supply.
I am not sure what you meant here:

businesses are trying to increase their cash flow by getting rid of inventory so that they can maintain themselves afloat.

The assumption is that the businesses made a correct decision to have so much inventory in the first place. If a business made a forecasting mistake, they have to bear the consequences of that risk. However, the government is what facilitated this in the first place. That is, the businesses had more credit available to them than the market would have naturally allowed and they misallocated their funds. Either way though, they made a malinvestment. They invested in something that is not giving a return. This must be corrected by the market. This happens when they lower their prices to liquidate the debt. We see this as a temporary decrease in prices (which many refer to as deflation) but the government is not allowing this to occur. They are trying to keep prices high.
The problem we have been building is that investment has NOT been balanced by savings. The Federal Reserve has been setting a price ceiling on money (artificially low interest rates) which creates a shortage in actual capital available (credit crunch). Instead of backing out though and allowing the market to correct by having higher interest rates, they print more money to make up the difference in supply. Thus, their solution to the disease they caused by low interest rates is even lower interest rates. This is the absurdity.
The government makes it look to businesses like there is more capital to invest than there really is. Thus, when they invest, they see a temporary boom, followed by a bust because the boom was unsustainable. It was not a factor of real increase in capital available for investment. The government only printed more money, which isn't more actual production in the economy.
If government would step out, the supply of savers and the demand of borrowers would reach an equilibrium which would be the interest rate set by a free-market.

BEN said...

Any thoughts Royal?

VeLynn said...

You are getting away from your original point about deflation.
Deflation is dangerous to a society. Right or wrong the government knows that if no money in the market not purchases and if no purchases no jobs is no jobs chaos.
If you want to talk about inflation being created by the government, it is not true 100%. See what happened with the gas price – gas went through the roof because speculation.
The government did not do a thing to lower the prices.
Deflation makes people sell in desperation – even at a lost – that is what I meant with businesses selling to increase cash flow. This does not have anything to do with inventory levels. As a company you have fixed cost and variable cost. Fixed cost are things you have to pay for no mater you make things or sale thing (rent, your salary, employees, telephone lines, etc.)
When a business man produces goods they want to make sure that they can pay for their fixed cost – (and to meet their breakeven point) they may have to sell at a lost to maintain their fixed cost. If they don’t they close the doors.
This is what happens in deflation, they sell to meet the minimum payments – even at a lost, and when they run out of cash, they close – people do not buy because they do not have cash.
No purchase – No sells – No business – No jobs – No cash
Chicken and egg
That is why deflation is meaner than inflation

BEN said...

Alex, I just wanted to say I am glad you are taking time to read and post on my blog. Thanks! I appreciate it.
You are right, I am getting away from my original point about deflation.
But I think you misunderstand my point anyway. Government is not supposed to control prices in any way. That is not a free market. Whatever the govt. does to control any price is a distortion and leads to problems.
Now, I think you may be making the assumption that when companies go bankrupt, they simply disappear. This is not true. Their stock gets really cheap and they are bought by other companies. That is how the market works. All the productive capacity is still there, but the people running the business made unwise decisions, so they leave and others manage as decided by the new owner.
Yes, you are right that deflation can cause some bankruptcies, but these are necessary bankruptcies. They have a cleansing effect on the economy and get rid of the malinvestment. Those people will go on and start other businesses and life goes on.
Look, it seems you are saying it doesn't matter how we got here. But it does! If we don't recognize what caused the problem, we can't solve the disease.
You mention chicken and the egg. Well, guess what! In this case we know which one came first. A sound economy came first before 1913 and then the government got involved in a very serious way. They caused huge increases in the money supply during the 1920's and then we got the bust of the 1930's. But what did govt. do? The same thing they are doing now. They inflated even more and caused the depression to go on for many more years than it had to.
The busts are inevitable in a regulated economy such as ours. But they will be self-correcting and faster if we just let them. We have to take the medicine, even though it may hurt. I am arguing that the govt step out now before it makes it worse. They cannot fix the problem no matter what they do.

S. Logan said...

Inflation is more than merely the increased amount of money within an economy -- it's the amount of money against the amount of production in a country (not its GDP; not just its services, but the hard commodities it creates). Service based economies fail horribly, because there is merely an exchange of wealth -- not an increase. Absolute wealth cannot be measured by such things as home equity, because there is no hard asset or produced product (a house will always be worth something, if even just the land its on, but the equity in that house is not an increase in production); in a fiat currency system, money can be printed to match this artificial and arbitrary "wealth" increase found in home equity, but there is nothing solid backing the currency. Inflation in this system is bad, very bad.

As our currency started to slip over a year and a half ago, economists all praised this as a good thing for the economy because they said new business would come rushing into the United States to take us out of this "slump". With so many businesses going overseas, the inflation of our currency would provide for international wealth to come back into our own country. Well, it didn't, and it hasn't, and it won't. This has been reasoned for two reasons: (1) the failing trust in the dollar, and (2) the bad anti-corporation laws that have been enacted in the US that aren't found in other countries.

The Fed can only lower interest rates so far: 0%. After we're freely giving away money, the only place we have to go from there is to PAY people to take our money =). As of October 29, the Fed has cute interest rates to 1%.

The only choice we have is to deflate the currency -- through taking money out of the economy, and by raising the interest rate (initially; we should actually work, in the long run, towards a sound monetary system that's backed by some commodity so that our representatives don't think they can spend our money willy-nilly) -- to the level where it can find its equilibrium with production. If we lived in a free-market economy (that's currency was not artificially regulated), this problem wouldn't even exist; furthermore, even if it did exist, the market would shift with minimal disruption. Be that as it is, since the free-market dissolves around an artificially regulated fiat currency as controlled by a central bank -- the probability percentage of problems from a deflated currency goes up significantly. This is because no one man, or group of men, can know every facet of the economy to prepare for every needful thing -- it is nearly impossible to know exactly how much to deflate our currency.

Does this mean we shouldn't do it? Well, no. Yes, some business will suffer -- but what is the alternative? Businesses aren't staying in American, nor are there any international businesses setting up here -- at least not enough to counteract the number of businesses still leaving. Our production of hard-physical assets is absolutely imperative to our continued financial longevity; however, for that to happen the laws need to become more friendly. The only way we can save our currency and "wealth" in America is to either increase our hard production to meet with inflation, or to deflate the dollar to match our production; otherwise, it'll be virtually impossible to pull ourselves out of bankruptcy -- this is simply a matter of math. With Obama wanting to hike the income, corporate, and other taxes, and to further legislate other anti-corporate and anti-incentive laws to target even the somewhat wealthy business owners -- the chances of either of these happening are highly unlikely within the next 4 years.

Obama's fiscal policies can, at best, only momentarily stay the financial world from unwinding. His plan to illegalize the ownership of gold (coin, bullion, or certificate) is certainly meant to artificially control the populace from "overreacting" and pulling their investments out of the dollar into a hard commodity; however, this coercive reliance on a failing currency will not have the long desired effect he says he wishes to have. Stimulus packages won't work anymore, because this isn't a "slump" in the economy -- it is the complete absolution of everything we know as it exists. Simply forcing the people to have confidence in our currency can not save a fiat money from collapsing. The writing is on the wall, and I don't like what it is saying.

Yes, it's arguable that artificial deflation is possibly worse than artificial inflation -- but we've reached a point in the United States where we don't really have a choice. Deflation, with all that's associated to it, will most certainly put the United States into a position of more capability of returning to a sound monetary policy than it would otherwise.