Demystifying Deflation

To the powers-that-be in Washington, deflation is Public Enemy No. 1.

Why is deflation -- in layman's terms, "widespread declining prices" -- so feared? First, we must distinguish between benign deflation and traumatic deflation.

In a truly free market with a monetary gold standard, a benign deflation would be the norm. Human productivity, unfettered by government intervention, typically increases total wealth by several percent per year. By contrast, it is geologically impossible for the supply of gold (money) to increase that much, except in the rare years when there is a freakishly massive new gold discovery. As the supply of goods increases more rapidly than the stock of money, the natural outcome is a general downward adjustment in prices.

This type of deflation prevailed during the last quarter of the 19th century in the U.S. Although wages trended downward, consumer prices fell more rapidly; thus, workers' standards of living rose. That compares favorably to the plight of many workers in the late 1970s (I was one of them) whose nominal wages rose, but not as rapidly as consumer prices, resulting in falling standards of living. Unfortunately, the natural, gentle kind of deflation is impossible today, given government's ubiquitous interventions and our easily inflatable fiat currency.

The deflation that is feared today (and which does, indeed, hover over us as a very real possibility) is deflation of the traumatic variety. Such a deflation involves a rapid decline in prices and spending. These would trigger an accelerating, self-reinforcing cycle of widespread bankruptcies (both personal and business) and soaring unemployment. Mountains of debt would be vaporized by a chain reaction of defaults. 

Make no mistake about it: We are talking here about very hard times. You can see why policymakers in Washington are scared to death of this kind of deflation. No politician wants to face the wrath of the voters by having such a devastating deflationary cycle happen on his or her watch; on the contrary, he or she will support the efforts of Bernanke and the Fed to pull out all the inflationary stops to avert a traumatic deflation.

Before you hail the Fed and Uncle Sam as our economic saviors, there are two things you should understand about the wrenching deflation we face: 1) The conditions which make us ripe for a severe deflation were caused by the very institutions that now propose to save us from it, and 2) it is the lesser of two evils.

Wrenching deflation is the inevitable aftermath of prior massive inflationary bubbles. A bubble can't burst if a bubble doesn't exist. The sole cause of economic bubbles is government. Inflationary monetary policies by the central bank -- such as the Fed holding interest rates artificially low, thereby overstimulating fundamentally uneconomic investments -- are the primary cause of bubbles. 

Government's fiscal policies of tax and spend also distort production into unnatural, uneconomic patterns. The inherent flaw in using government spending to guide and shape production is the same one that plagues socialist economies -- namely, that the government cannot know what the people want as clearly as the people themselves know. Inevitably, government overstimulates production of things that people wouldn't freely choose while depressing production of what the people do want; hence, government makes society poorer than it otherwise would be. 

In short, we wouldn't be faced with a potentially cataclysmic deflation today had it not been for decades of foolish government policies that created bubbles.

Economically speaking, inflation is like heroin addiction. We enjoy the "highs" when the bubble inflates and the good times roll, but underneath the surface, our health is eroding. The addict needs to suffer the wrenching pains of withdrawal in order to recover his health. Similarly, in order to get reestablished on a sound economic footing, our society needs to endure the short-term pain that accompanies absurdly overpriced assets crashing back to earth, while the economy is purged of decades' worth of malinvestments, uneconomic patterns of production, and unfathomably massive amounts of unpayable debts.

Another apt analogy is the catastrophic fire that burned half of Yellowstone National Park in 1988. Forests periodically need fires to clear out rotten, moribund growth to make way for vibrant, vigorous growth. Decades of intervention, during which government officials intervened repeatedly to suppress relatively small fires, created the conditions that led to the massive 1988 conflagration. Likewise, government intervention repeatedly has prevented necessary deflationary adjustments from taking their course over recent decades. This has set the stage for a much more severe and widespread deflation.

Right now, the U.S. economy is a dead man walking. If we don't bite the proverbial bullet and go through a painful, cleansing, economically healing period of deflation, the ultimate price we pay will be even worse. Like the heroin addict who can't kick his habit and eventually ODs, someday, the Fed will go too far in its inflationary policies, igniting a hyperinflation -- thereby annihilating the dollar, wiping out the middle class, and totally collapsing the economy. A deflationary correction is the painful but necessary process that would restore our economy to a healthy, sound condition. 

Look, I don't relish going through the deflationary ringer. I'm not a sadist cheering for economic hard times. I'm simply reporting the sad economic truth that the longer we postpone paying the piper for past government follies, the higher the price we will have to pay in the future.

The Federal Reserve is committed to unlimited Quantitative Easing.  Congress and the White House will continue to spend hundreds of billions of dollars of money in a desperate attempt to preserve the moribund, brittle superstructure of debt and malinvestments-the twin dead-weights that are stifling economic growth.  Those debts and malinvestments must be liquidated in order for a solid economic recovery to happen.  However, instead of letting the debt to be purged and the malinvestments to be liquidated through painful but rational market readjustments, Bernanke & Co. will try to prop them up with a flood of newly created money.

The powers-that-be in Washington will continue to apply the same quack policies that have brought us to our present parlous predicament. They will thwart the market's natural healing process -- deflation -- and instead unnecessarily prolong economic misery by steering us into an inflationary depression. They are committed to devaluing, and perhaps destroying, the dollar in a futile attempt to avoid the inevitable consequences of excess debt and the uneconomic misallocation of the factors of production (misallocations caused by their own prior interferences with markets). This is the path to economic ruin. 

Got gold?

Mark W. Hendrickson, Ph.D. teaches at Grove City College.
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