What is Deflation

What is Deflation

First, what is deflation? The word itself means something is getting diminishing. But as with inflation, people often conflate the change in the money supply with the change in prices. And they also often don’t consider how the economy itself is growing or shrinking. But it’s the change in the supply of money (including credit) against the change in the size of the economy (total of goods and services produced) that causes changes in general prices.

You have to keep these in mind: change in volume of goods and services compared against the change in the overall supply of money yields change in general prices.

Monetary deflation is a contraction in the overall supply of money.

Price deflation is a fall in general prices…which happens either when the growth of the economy outpaces the growth of the money supply;or the drop in the money supply outpaces the contraction of the economy. It can also happen when people simply stop spending in anticipation of lower prices later.

When economic activity itself declines or contracts, we call that a recession. When it gets really bad (as determined by some fairly arbitrary macroeconomic numbers) we call that a depression.

What is the Paradox of Thrift and Why Does Government Hate Savings

The Paradox of Thrift essentially says that the savings that are good on an individual level is bad for the overall economy. What a paradox!

Governments would like you to believe that recessions and depressions are destructive natural forces–rather like earthquakes or tornadoes–that are caused when people stop spending. Whether people stop their spending because of worry and fear about the future or because savings are rewarded as prices drop, the government aims to get people spending again. The entire field of modern macroeconomics rests on the conceit that it is government’s sacred duty to fight recessions by inducing spending.

In a free market environment, minor recessions would occur from time to time to clear out any excesses before they get too excessive. But in a fiat currency environment subject to government intervention, the excesses can become incredibly excessive. The only thing worse is the government’s attempt to prevent any corrections and keep consumption going.
In a free market system with sound money, banks that lend more than they have on deposit run the risk of failing when the depositors catch on to this kind of chicanery. In a fiat money system such as ours, lending far above reserves is allowable by law and at times actively encouraged.

The government can induce spending simply by printing more of this paper and thereby decreasing its value, while they’re central bank buddies keep borrowing cheap by artificially lowering interest rates. The latter only works for so long before people simply can’t take on more debt to fuel consumption (and then the central bank is “pushing on a string”). The former provides disincentive to hold onto cash as it becomes worthless by just sitting under mattresses and in bank vaults. (Remember, when cash gains value, people have a strong incentive to save.) Modern macroeconomics says there can only be harmony when government actively fights savings, encourages consumption (by borrowing!) and slowly destroys the value of its the currency it issues and which it has the ability to print at will.

What is the Role of Credit Expansion
Actually printing money with some arbitrary monetary supply inflation number as the target (usually between 2 and 3 percent) is one way to get people to spend. Another is simply to make credit more available. While slow gradual inflation is a given with paper currencies, it is not the only way the money supply can expand. Paper and its equivalents in various accounts is just one part of it. There’s also the expansion of another money-like thing: credit.

Inflation is a given with paper money. But it comes in two forms. The first one is credit expansion in which–thanks to the fractional reserve lending laws–money is literally borrowed into existence. Banks allow people to borrow against more money than the banks have on deposit. When this credit is spent on goods and services, it transforms into actual reserves in an account somewhere. This sort of borrowing sends all sorts of false signals to markets. The most noticeable effect, however, is the price inflation for the goods and services where the credit is spent the most. In recent U.S. history this has been in the housing and electronic goods markets.

Good Deflation and Bad Deflation:
What is Good Deflation and what is Bad Deflation? (And guess which kind we’re in for!)

What is Good Deflation
Good deflation is the gentle, very gradual kind that occurs in a growing economy under an honest money system. When money is the honest kind that markets decide on instead of governments (markets tend to pick gold and silver for money), then we can have good, benign deflation. This is not the kind of deflation that governments can scare you with.

Good deflation happens when incomes stay nominally the same as the general price level gradually decreases. This makes everybody effectively richer while rewarding those who save. This happens when an economy produces more and more goods and services, but the general money supply in the system stays the same. Technological advances and other increasing efficiencies in production really do lead to a higher quality of life for most under these circumstances.

Again, savers are rewarded. But the private virtue of saving is made a vice in modern economic theory (the so-called Paradox of Thrift). The supposed problem is that if savings are rewarded too much, then no one will ever spend! This, of course, is ridiculous. Anyone who believes this hasn’t encountered very many actual human beings. Delaying gratification takes effort and people save only when they reward is high. They tend to like spending again as soon as they can.

The economy will not grind to a halt as a result of people savings. Savings are the very source of future economic growth. The government and and modern macroeconomic theory like to pretend that debt and inflation are what fuel growth, but this just isn’t the case.

What is Bad Deflation
Bad Deflation is the kind that governments and modern economists like to keep us scared of. The irony is that the bad kind of deflation governments try to get us scared about only happens with a paper currency. The government sows the seeds of the problem–in this case bad deflation–it purports to prevent or solve.

Inflation slowly destroys all currencies. That’s why there are currencies in the first place, so governments can inflate them, instead of being tied down by nuisances like gold and silver. Sometimes, as we’ve mentioned elsewhere, inflation mutates into a much more powerful and obviously destructive version of itself called hyperinflation.

Price deflation is touted as a Big Bad Thing that must be avoided at all costs. The myth goes that since falling prices rewards savers, people will start saving so much in expectation of falling prices that they would stop spending entirely. The economy would grind to a halt and we’d all end up farming or foraging for food and living in mud huts or something like that. Government argues that growing the money spurs spending because it punishes savers by eroding the value of their saved paper money. Mild inflation is made to look like a benefit, necessary to spur the growth of the economy.

But deflation can happen here and there, too. In fact, when prices in certain sectors of the economy are driven up by things bought with newly created credit, it’s guaranteed that there will be price deflation in those areas. Prices affected the most by inflation in the supply of credit will also be affected the most when that credit ultimately dries up. The clearest and most recent evidence of this is in the recent housing bubble and bust. But it can happen in any segment of the economy where low interest rates are provided to encourage purchases of a certain goods or services.

Fighting Deflation…Even If It Kills Us

The central bank is ultimately behind the credit that caused the price inflation that became most obvious in the housing sector. The economy that grew based on easy credit is collapsing as is the general price level as jobs disappear, people default on their loans and banks avoid lending. The government is going to do everything in its power to prevent this from taking place, but they really only have one arrow in their quiver. All they can do is become the borrower and spender of last resort, just like Keynes said they should.

But government has no real money of its own. All it can do is steal money from the private sector in the form of taxes, borrow money from citizens or governments or the central bank. And borrowing from the central bank essentially means printing up more currency.

The government and central bank will only ramp up their inflationary practices in order to fight the bad deflation, which itself is here because of credit expansion caused by central bank practices in the first place. This is like fighting the fire you started with more gasoline. Expect inflation really to get going eventually. We may even see the hyper version! But first, expect the bad deflation to continue slashing prices that were built upon credit, pulling the plug on businesses and reducing incomes and the family budget.

Deflationary Disaster: What Can You Do
These are the things we deal with at Whiskey & Gunpowder. Several times per week, we send our readers dispatches with the kind of honest news and analysis that you just can’t get from the mainstream media and macroeconomic apologists.

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By Gary Gibson

The Daily Reckoning