Thursday, November 17, 2005

Deflationary fears

I was flipping thru the Wall Street Journal from last Sunday and came across a rather annoying quote. I dont remember who said it but he stated he was worried about deflation occuring next year. Leaving aside the whole Federal Reserve (which has kept us above 3% inflation since before I was born) I want to tackle the issue of deflation.

For the purpose of this and probable future posts I am going to define some terms.
Deflation: Less money, each unit worth more
Recession: A drop in the GDP for two or more consecutive quarters
Inflation: More money, each unit worth less
Stagnation: High unemployment
Stagflation: High inflation coupled with high unemployment (stagnation)
Depression: A period where business activity drops signifigantly

Currently the Fed is pursuing a policy of constant "controlled" inflation. Inflation is where you add to the supply of money which, after a few transactions, devalues all of the money in the supply. Your parents will tell you that they could fill a whole paper bag full of candy for $1 but because of inflation that isnt possible now. Inflation is due entirely to banks. Individuals cannot cause inflation.

Now deflation is basically the opposite. As the money supply contracts each unit of money becomes worth more. Were deflation to take place you might one day tell your kids it used to cost $25 to fill a bag of candy whereas they might be able to fill it for $1. Where inflation cannot be caused by individuals, deflation can be. A reduction in spending and/or an increase in savings. Banks can also cause deflation by printing money at less than the replacement level. Deflation can lead to a temporary reduction in jobs as the market adjusts to the higher purchasing power of each dollor. (Look at it from the boss's perspective. The income could be less than last year even tho more units and real profit could have been made. After all, it is numbers not actual value they are looking at.)

Deflation is basically unheard of. There is no way the people who benefit most from inflation would stop it. Who is it that benefits most from inflation? The Federal Gov. The FedGov is the first "person" to get to spend that money, before it causes a devaluation of the whole supply. They also do it to the tune of billions weekly, but I digress.

Adopting a policy of controlled deflation would be a great thing for our economy, or even just keeping the money at a replacement level. With "I-believe-inflation-is-good" Bernanke taking the helm of the Fed soon all those with unfounded fears of deflation can breath a sigh of relief.