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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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STAGnant growth in jobs or real GDP because "lower prices reflect an inability of producers to sell their goods profitably. Lack of profitability prompts employers to reduce their payrolls. Increased unemployment means decreased demand."
While at the same time or shortly thereafter the value of the dollar will drop because the government will print money to pay the massive debt generated by the so-called "stimulus" package. The printed dollars are valueless because they are not backed by production; they mix with the rest of the currency driving the value of our savings and investments down in real terms (inFLATION).
The combination is Stagflation. Experienced this in the Carter years. The Obama years will be far worse.
The second concern is that deflation raises the real value of outstanding debts, because creditors must be repaid with more valuable dollars (e.g., farmers have to sell more corn to make their mortgage payments). But deflationary periods are associated with lower nominal interest rates, which alleviate the problem for those able to renegotiate their loans.
In any case, the Federal Reserve seems easily panicked by the mere mention of deflation (even in 2002-2003), suggesting longer-term risk in the opposite direction.
Does anyone know of an article that talks about the babyboomer impact on the economy during the next 8 years? if so post link to this site in a comment. I suspect this can answer some questions on inflation and deflation.
Also remember - what ever the main stream media keeps on showing (dollars printed, big bailouts for companies - all points to INFLATION) that's when the sucker punch comes and it was DEFLATION all of the time. - Basically (the mainstream media always has it wrong (maybe by accident maybe not) So if they say INFLATION - buy some dollars, when they say wow DEFLATION is coming - sell the dollars - do opposite and you will do fine.
Either way - Love your family that is the best asset and one you can invest in everyday and get great ROI on it.
In answer to the Inflation or Deflation question, I’m guessing both. But not necessarily in that order.
It’s too early to tell whether current trends will continue into a deflationary spiral. But it’s a pretty sure bet that the bailout dollars recently created will result in a period of major inflation.
Mr Liang, I appreciate your insights. They might leave me asking myself a few additional questions, but that's fine with me.
http://www.thecomingdepression.blogspot.com
The definition of inflation can be thought of as a rise in the general price level as a result of expansion in the supply of money. The "ups and downs" caused by normal market forces (low rainfall may cause food prices to rise; OPEC restrains production causing fuel prices to rise; etc.) are not inflationary or deflationary. They are market activity.
The subtlety of inflation is that when the Fed sells treasury bonds (that they create out of thin air), the money that it receives is spent. This created money is, perhaps, the most significant way in which the money supply is inflated.
Ultimately, this is a "sneaky" form of additional taxation, since the population constantly pays more for things, as reflected in the rise in the various pricing indexes. This loss to the consumers comes from the dilution of the money supply by the funds that the Fed created and spent.
We have now seen a very recent huge spike in the amount of deficit spending, which will ultimately result in the expansion of the money supply. Unless the Fed figures out a way to counteract its actions in the future, my estimate is that we will most likely be exposed to a good-sized dose of inflation.
These phenomena take many months to filter through the economy. My guess is the inflation increase that I believe will occur will happen 1-2 years from the time that the Fed creates treasury bonds and receives money for them.
Hang on to your hats--especially those of you on fixed incomes.
For example, money as defined by what the banks know about their real assets and tangible receivable obligations seem to be pretty darned nebulous and unaccountable quantities, but money as defined by our Federal government when it comes to calculating interest on the national debt (which will be going up pretty soon) is pretty tangible and rigid (and obligatory).
When I loan money to someone who puts up his word as collateral (say, if I loaned it to Scurrilous Willie), I have only the most nebulous idea how much money I am going to get back, but I need to account for it. If he goes back on his word (as I would expect), I have effectively suffered Deflation. If I borrow the money from a bank with a set fixed schedule, I do have a solid idea how much I am going to need to pay. If I find my asset base shrinks (like if I get fired for insulting an ex-federal official), I have experienced effective Inflation. The amount of money may be the same.
So... there's nebulous money, and there's solid money. This would seem to make a huge difference in whether inflation or deflation is coming.
It says inflation is coming.
Could you extend the monetary base chart back as far as possible?
I wonder what it says about the possibility of runaway inflation.
I wonder how one could adjust to the possibilities.
If you can't answer the question why bother with writing the article?
Next time you do not have the answer to your question, why not just take the day off and forget about writing.
"Relative deflation" (defined later) happened in the seventies and eighties, as measured by the Harwood Index of Inflating. The explanation given in the Research Bulletins at that time was that the marketplace canceled out excess purchasing media. That index would provide a broader definition of deflation, more relevant to the events of recent past.
As it happens, assets are being canceled out on a daily basis, possibly in excess of the money being created by the FED. Shouldn't this be taken into account?