Wikinvest Wire

Deflation, alcohol abuse, and asset bubbles

Wednesday, December 03, 2008

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.


Nostradamus, apparently said...

Wow! What a great post! Thanks!!

Nick said...

I reiterate my previous point, which can be found here, and say that they are both kinda right. We are experiencing investment asset value deflation, which will likely continue for a while, until the economic environment for private investment is perceived as more healthy again (unlikely under a Democrat administration, so at least 4 years). On the other hand, as the government back-fills the shrinking private-debt hole with newly created real money in a misguided, moronic, and ultimately disastrous attempt to prevent a healthy market price correction, real inflation will likely also dramatically increase, causing a stagflation scenario. All of this is easily predictable, yet also unavoidable with the idiots in charge.

Bad times, they are a-comin.

getyourselfconnected said...

I would rather have a bottle in front of me than a frontal labotomy! During this economic downturn I do not drink anymore; of course I do not drink any less either.

Anonymous said...

When I was about to graduate from the University of Illinois at Urbana back in 1958 I took an econ course from a visiting professor from Harvard. He was great!

When he was a grad student at Harvard back about 1913 he accompanied his econ professor to the secret meeting at Jeckel Island, Georgia where the Federal Reserve Act was crafted by the bankers for the bankers. He was all sold on it then but now (1958 and some years before then) he decried it as the creation "...of an engine of inflation."

I remembered his warning!

Anonymous said...

Excellent Tim!
From Wikipedia: "Bogeyman can be used metaphorically to denote a person or thing of which someone has an irrational fear."
How true for deflation.

Anonymous said...

"We are experiencing investment asset value deflation, which will likely continue for a while, until the economic environment for private investment is perceived as more healthy again (unlikely under a Democrat administration, so at least 4 years)"

Well, no. The evidence is that the economy always does better under a Democratic administration than Republic.


Anonymous said...

Imagine, very roughly ... say banks accumulate about $1T in excess reserves WW ... eventually you could see upwards of $10T+ in credit chasing the few economically profitable industries and sectors (i.e. stuff people really need like food, energy, healthcare), thereby blowing them into a crazed bubble. Oh yes, and I'm sure some infinitesimal sliver of that will find its way into hard monies too.

  © Blogger template Newspaper by 2008

Back to TOP