The notion that the U.S. economy is now experiencing, or will shortly enter, a period of “deflation” is making headlines and is the subject of much comment in the media. Few who are discussing this appear to have much understanding of what they are talking about.

The word “deflation” has been used to describe an economic or financial development during the past 50 years or so, but nearly everyone would agree that a deflation occurred during the Great Depression of 1929-33.

A brief review of some aspects of that episode clearly shows that it was a far greater disaster than anything that has happened since. From their 1929 highs to their 1933 lows (among other things):

· member bank reserve balances at Federal Reserve Banks decreased about 25 percent

(as did the total of demand and time deposits at member banks)

· the general price level decreased roughly 25 percent;

· the physical volume of durable goods production decreased about 60 percent;

· the physical volume of non-durable goods production decreased roughly 15 percent;

· construction decreased nearly 70 percent;

· the volume of foreign trade decreased roughly 50 percent;

· common stocks lost more than 90 percent of their nominal dollar values; and

· unemployment reached 25 percent, which meant that for every three persons employed,

another person was looking for work. 

From the standpoint of monetary economics, only the first item on this list qualifies as “deflation”—everything else was a symptom of the contraction of purchasing media in circulation. Given the lack of any link between currencies and anything tangible, such as gold, the possibility of a classic “deflation” involving a contraction of money and credit would appear to be close to nil.

No lesser authority than a Governor of the Federal Reserve re-iterated the proposition that the Fed can, and is ready to, create any amount of reserves, or dollars, out of “thin air” at its potentially unconstrained discretion.

The chart shows the rate of change in the monetary base (as reported by the Board of Governors over 12- and 36-month spans. This series includes currency in circulation, vault cash in banks, and member bank deposits with the Fed. It is not a measure of purchasing media in use in the United States, but rather of how many dollars the Fed has created at its own discretion (or how fast the Fed is running the “printing press”). The extent to which changes in the monetary base leads to changes in the amount used as purchasing media in the U.S. economy is influenced by reserve requirements and the demand for currency here and abroad. Briefly, the portion of the monetary base held as member bank deposits and vault cash can “support” a much large amount of demand deposits held by the public, while currency held abroad is (obviously) not in use here.

 Source: Federal Reserve Board of Governors, not seasonally adjusted and not break adjusted

The ability of the Fed to create dollars very rapidly is suggested by the recent upward “spikes” in the chart. These reflect rapid “injections” of liquidity in anticipation of problems with the payment system resulting from “Y2K” difficulties, again after “9/11” and in the recent financial crisis. (The “spikes down” reflect the “injections” leaving the span used in the calculation.)  In any event, the chart reveals that the recent pace of monetary creation by the Fed is extraordinary.

Nevertheless, we are told again and again that recent phenomena such as the decrease in common stock prices and especially the “perilously close” to zero increases in various price indexes indicate that “deflation” is, or soon will be, here. But lower prices do not constitute deflation.

As consumers, or as purchasing agents of an enterprise, we seek out lower prices and are gratified when we find them. In fact, absent the chronic debasement and inflating of currencies, the normal tendency of prices is to decrease as a result of improving technology and efficiency.

This is especially so for primary commodities and goods. Technology has had a smaller impact on the efficiency of services (for example, the output of a government bureaucrat is measured as an hour of work, so productivity cannot increase at all!), and the cost of services tends to increase with the general standard of living.  In short, lower prices are often a sign of progress.

The fear seems to be that lower prices may not reflect improved efficiency but rather market competition. It could be that lower prices reflect an inability of producers to sell their goods profitably (i.e., the functioning of competitive markets rather lower costs from improved technology). Lack of profitability could prompt employers to reduce their payrolls. Increased unemployment could, in turn, mean decreased demand that would force prices even lower.

Some observers believe that such a “downward spiral” may have begun, citing higher unemployment and disappointing profits.

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