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Does Deflation Pose a Threat to the US Economy?

Many commentators are of the view that the biggest threat to the economy is deflation rather than inflation, because of the present economic slack. The United States used only 69.6% of its industrial capacity in August, against 77.6% in August last year and the historical average of 81.1% since January 1967. In Q2 this year, the real GDP stood 7.6% below the potential real GDP. This gap stood at 6.8% in Q1 and 1.6% in Q2 last year.

Those economists who are concerned about deflation in this environment define it as a general decline in prices of goods, the opposite of inflation. Indeed, year on year, the US consumer price index fell by 1.5% in August after falling by 2.1% in the month before. This was the sixth consecutive monthly decline.

For most experts, deflation is bad news since it generates expectations for a further decline in prices. As a result, they believe, consumers postpone their buying of goods at present since they expect to buy these goods at a lower prices in the future. This weakens the overall flow of spending and in turn weakens the economy. Hence, such commentators believe that policies that counter deflation will also counter the slump.

But does it make sense that a fall in prices should actually cause people to postpone buying goods? To maintain their life and wellbeing individuals must live at present, hence they buy goods at present regardless of the fact that prices are falling.

From December 1997 to August 2009, the prices of personal computers have fallen by 93%. Did this fall in prices cause people to postpone buying personal computers? On the contrary, since December 1997 consumer outlays on personal computers have increased massively. These outlays stood at $83.2 billion in August 2009 as compared to $3.4 billion in December 1997.

Nonetheless, following the logic of the popular way of thinking, if deflation leads to an economic slump then policies that reverse deflation should be good for the economy. Reversing deflation would imply introducing policies that support general increases in the prices of goods, i.e., inflation. This means that inflation could actually be an agent of economic growth.

According to most experts, a little bit of inflation can actually be a good thing. Mainstream thinkers believe that inflation of 2% is not harmful to economic growth, but that inflation of 10% could be bad news.

We suggest that at a rate of inflation of 10% it is likely that consumers are going to form rising inflation expectations. According to popular thinking, in response to a high rate of inflation, consumers will speed up their expenditure on goods at present, which should boost economic growth. So why then is a rate of inflation of 10% or higher regarded by experts as a bad thing?

Clearly there is a problem with the popular definitions of inflation and deflation.

Inflation is Not Essentially a Rise in Prices

Inflation is not about general increases in prices as such, but about the increase in the money supply. As a rule the increase in money supply sets in motion general increases in prices. This, however, need not always be the case.

The price of a good is the amount of money asked per unit of it. For a constant amount of money and an expanding quantity of goods, prices will actually fall.

Prices will also fall when the rate of increase in the supply of goods exceeds the rate of increase in the money supply. For instance, if the money supply increases by 5% and the quantity of goods increases by 10%, prices will fall by 5%. A fall in prices cannot conceal the fact that we have an inflation of 5% here on account of the increase in money supply.

The reason why inflation is bad news is not because of increases in prices as such, but because of the damage inflation inflicts to the wealth-formation process. Here is why.

The chief role of money is as the medium of exchange. Money enables us to exchange something we have for something we want. Before an exchange can take place, an individual must have something useful that he can exchange for money. Once he secures the money, he can then exchange it for a good he wants.

But now consider a situation in which the money is created out of "thin air," increasing the money supply. This new money is no different from counterfeit money. The counterfeiter exchanges the printed money for goods without producing anything useful.

He in fact exchanges nothing for something. He takes from the pool of real goods without making any contribution to the pool. The economic effect of money that was created out of thin air is exactly the same as that of counterfeit money -- it impoverishes wealth generators.

The money created out of thin air diverts real wealth, or real, saved, final goods, towards the holders of new money. As a result, less real savings become available to fund wealth-generating activities. This in turn leads to a weakening in economic growth.

Note that as a result of the increase in the money supply what we have here is more money per unit of goods, and thus, higher prices. What matters however is not price rises as such but the increase in money supply that sets in motion the exchange of nothing for something or "the counterfeit effect."

The exchange of nothing for something, as we have seen, weakens the process of real wealth formation. Therefore, anything that promotes increases in the money supply can only make things much worse.

So while inflation is an increase in the money supply, deflation is a decrease in the money supply.

Falling Prices and Bubble Activities -- What Is the Link?

Loose monetary policy from January 2001 to June 2004 has allowed the emergence of nonproductive, or bubble activities. We suggest that the present fall in prices is related to goods that are associated with these nonproductive activities. Businesspeople produced goods and services that consumers did not desire enough to make them worth the real costs of production.

These activities came under pressure in response to the tighter monetary policy from June 2004 to September 2007. Various projects that were supported by the loose monetary policy could not be finished and had to be shut down. Workers employed in these projects became unemployed. Prices for the goods and services produced by these projects are falling.

For the time being, however, US money supply shows strong increases. The yearly rate of growth of our monetary measure AMS stood at 14.6% in August 2009 against 1.8% in August 2008. As long as the money supply continues to expand, we have inflation regardless of what the prices of some goods are doing.

If one were to include the prices of stocks and the prices of commodities in the calculation of so-called price inflation then it would be obvious even to popular thinkers that we in fact currently have inflation and not deflation. From the end of March to the end of September, the S&P500 stock price index increased by 32.5%. Since January this year the price of gold increased by 12.2%, and the price of copper jumped by over 92%. Also since January the Commodity Research Bureau's commodity price index increased by over 17%.

Some components of the consumer price index have actually been rising. For instance, the yearly rate of growth of the cost of medical care stood at 3.3% in August against 2.6% in January this year. Year on year, the rate of growth of the cost of education stood at 5.4% in August, with a similar figure in January.

Due to a strong increase in money supply between August last year and August this year, the prices of various goods and services are poised to visibly strengthen, after some time lag. We suggest that this increase could become quite visible in the second half of next year.

Now, the best way to eliminate the slack, such as the unemployment of labor, is to allow wealth generators to move quickly in their task to rebuild wealth. This, coupled with a free labor market, will enable the quick absorption of unemployed individuals.

But what we have instead are the Fed and government's policies that are aimed at supporting nonproductive activities. This of course prevents laying the foundation for sustainable real economic growth.

Nonproductive activities only further weaken the ability of the economy to generate real wealth. Policies aimed at countering a fall in prices, which are supposedly aimed at fighting deflation, do nothing more than provide support for nonproductive activities.

Such policies can produce the illusion of success as long as there are enough wealth generators to fund nonproductive activities. Once the percentage of wealth-generating activities falls sharply, though, there will not be enough real funding to support an expansion in economic activity.

The economy then falls into a prolonged slump. Under these conditions, the more the central bank and the government try to fix the symptoms, the worse things become.

Once, however, nonproductive activities are allowed to go belly-up, and the sources of the increase in money supply are sealed off, one can expect a genuine, real-wealth expansion to ensue. With the expansion of real wealth for a constant stock of money, we will have a fall in prices.

Whether prices fall on account of the liquidation of nonproductive activities or on account of real-wealth expansion, it is always good news. In the first case, it indicates that more funding is now available for wealth generation, while in the second case, it indicates that more wealth is actually being generated.

Conclusions

Since inflation is about increases in money supply, obviously an increase in spare economic capacity cannot reduce the rate of inflation as most commentators are saying. Only the Fed's monetary policy can exercise control over the money supply. Hence, regardless of the economic slack, the more money the Fed creates, the more damage it inflicts.

Against the current background of a still-subdued economy and falling prices, most experts are concerned that deflation poses a serious threat to the US economy. Hence they are of the view that the US central bank should consider measures to counter deflation. We suggest that a fall in many goods' prices, which is erroneously labeled as deflation, is actually the result of the liquidation of various nonproductive activities that are undermining real wealth generators.

Consequently, a policy that aims at countering deflation in fact reinforces nonproductive activities and delays the chances for a durable economic recovery. The major threat to the economy is not deflation but the Fed and the Federal Government's policies aimed at countering it. Share/Save/Bookmark

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© 2009 Frank Shostak

ABOUT THE AUTHOR

Frank Shostak Frank Shostak is a former professor of economics who is now M. F. Global's chief economist.
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and I encourage you to complete your own due diligence when making an investment decision.

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