Why Not Deflation?

Consider the following scenario:

You want to buy a new car. But you know that if you wait a few months, the price of that car will come down considerably. Do you buy the new car or do you wait until the price has dropped to buy it?

In fact, when new model cars come out each fall, the prices are higher than they will be in nine or ten months when they start clearing the remaining stock out to make room for next year's models. So why would anyone buy one now when they can save a bundle by waiting ten months?

Why? Because they want it now! They want the latest thing when it is fresh and new. When owning one confers some sort of status.

The same goes for any product that has a limited shelf life because of tech change, new styles, different tastes.

This includes cars, clothes, computers, televisions, and every other good that is constantly improved or sees style change on a regular basis.

But for some reason, economists and politicians fear the idea of this being a regular occurrence for all goods and services. Sure, it's okay for limited shelf life goods to become cheaper towards the end of their style cycle. But if all goods became cheaper over time, well, that would be disaster. That would be deflation!

What is deflation? Talk to different economists and you'll get different answers, but the most commonly accepted definition "is a decrease in the general price level of goods and services". It is considered to be the opposite of inflation, which is an increase in general price levels.

The cause of inflation or deflation is monetary policy. A government creates inflation by increasing the money supply. This is well known and little disputed. It is manifestly obvious in hyperinflations such as the one in France during the French revolution, the German inflation of the twenties, the post-war Hungarian inflation and many more after the war.

The Library of Economics and Liberty says "hyperinflations are caused by extremely rapid growth in the supply of 'paper' money. They occur when the monetary and fiscal authorities of a nation regularly issue large quantities of money to pay for a large stream of government expenditures. In effect, inflation is a form of taxation in which the government gains at the expense of those who hold money while its value is declining. Hyperinflations are very large taxation schemes."

Inflation Explained

Simple inflation was well explained by Harry Browne in his 1970 book, How to Profit from the Coming Devaluation.

In a brilliant chapter called What is Inflation?, Browne introduces the hypothetical case of a couple of perfect counterfeiters (he suggests it is the reader and himself in partnership). They go into a town and spend $20,000 in crisp new $20 bills. They leave town with $20,000 of goods. The townsfolk thank the visitors for their extravagant spending and think their lot improved by the passing through of the strangers. But has it?

As Browne puts it, "It’s obvious we have benefited from the situation. We traded paper dollars that have no real value for products that have real value." But "assuming that no one ever learns our little secret," he asks, "has our gain actually hurt anyone else?"

Think about it a bit. Who loses? The merchants don’t. The bills are perfect and are just passed on to others in purchases, change or deposits in the bank. If we as the counterfeiters aren’t hurt and the merchants themselves aren’t directly hurt, who, if anyone is?

The answer is everyone is hurt a little bit. Think of it this way, says Browne. Before we came to town, it had a certain amount of goods owned by the people of the town. After we leave it has fewer goods, and more money to bid for those goods. Less supply (fewer goods) and more demand (more money) means prices will rise. Inflation! That is the cost of perfect counterfeiting.

The conclusion is obvious. When governments inflate the money supply (i.e. - issue paper money in excess of actual value stored) we have inflation. Prices rise. You can see why I like Browne’s book. The theory is elegant, straight forward, logical and is just plain common sense.

But even under a gold standard, an inflation would arise if there were a large new gold discovery that greatly increased the amount of available gold. Or if, in some future time, the alchemist's dream came true and a way to turn lead into gold was discovered.

What is Deflation?

By contrast, a deflation is a contraction or decrease in the money supply. Or it could simply be the result of a fixed money supply while population and available goods and services grow in number.

Economist Ludwig von Mises disputes the notion that inflation and deflation are even valid economic terms. "They were not created by economists, but by the mundane speech of the public and of politicians. They implied the popular fallacy that there is such a thing as a neutral money or money of stable purchasing power and that sound money should be neutral and stable in purchasing power."

Mises continues, "Those applying these terms are not aware of the fact that purchasing power never remains unchanged and that consequently there is always either inflation or deflation. They ignore these necessarily perpetual fluctuations as far as they are only small and inconspicuous, and reserve the use of the terms to big changes in purchasing power."

In other words, prices are fluid and always changing, as in our example of automobile prices above.

That said, when governments turn away from real money and institute fiat money, they can and often do run amok, turning on the spigots to support this or that pet project. At the height of the German inflation, prices were rising 41 percent a day. A day! From August 1922 to the end in November 1923 the price index jumped by a factor of 1.02 x 10 to the power of 10! In other words, something that cost a mark in August 1922 would have cost 10,200,000,000 marks in November 1923. Those stories of people pushing wheelbarrows of money to the grocery stores are not just apocryphal.

In any event, we live in an era of fiat money. Government central banks control the money supply. And after the flirtation with hyperinflation in the seventies, (Japanese inflation peaked at 23.1% in 1974, Australia's at 15.8% in 1974, the U.S.A.s at 13.5% in 1980, and Canada's at 12.5% in 1981), Western governments have been more prudent in managing the money supply and inflation.

The Bank of Canada has a target rate of two percent. As long as price inflation stays under two percent, extraordinary measures aren't needed. As a policy tool, the Bank uses interest rates to affect the money supply, raising rates to tighten and lowering rates to loosen.

The Case for Deflation

In an extraordinary article published in the National Post in 2010, then Tory MP Maxime Bernier wrote about "How the Central Bank Eats Your Money". Bernier laments the government's intrusion into the money supply, suggesting that "in a monetary free market, the interest rate would be determined by the demand for credit and the supply of savings, just like any other price in the economy."

Noting that the money supply had increased by an average of 6 - 14 percent annually for the last dozen years, he argues that "the effects of constantly creating new money out of thin air have been a debasement of our money and a dramatic increase in prices. The reason why overall prices go up is not because businesses are greedy, or because wages go up, or because the price of oil goes up. Ultimately, only the central bank is responsible for creating the conditions for prices to rise by printing more and more money."

Attacking the central bank's two percent target rate, he says, "when you add up 2% of depreciation of the monetary unit year after year, you end up with large numbers. Total inflation in Canada from 1990 to today adds up to 45%. This means that your dollar can now buy the equivalent of less than 70 cents if you compare it to 20 years ago."

And the people most affected by these policies are those on fixed income, usually the poor and seniors. People who can ill afford to see their buying power steadily eroded.

Bernier goes on to discuss sub-prime loans that snookered poor people into protracted debt, which ended in the debt bubble bursting in 2008. And he concludes with an appeal for a stable money supply and deflation.

"Every year however, we become a little bit more productive. We create new goods and services. We find new methods to produce them more efficiently. Technology gets better. And if there is population growth, there are also more people working.

"So there are always more and more goods and services available in the economy, but we have the same quantity of money to buy them. Prices will obviously have to adjust by going down. If the economy grows, let’s say, by 3% a year, while the money supply grows by 0%, then we will necessarily get price deflation."

If we have to have a target, let's make it zero percent, he suggests. Though he is clearly not averse to deflation.

It is interesting to note that the cyber currency, Bitcoin, is designed to be limited to a set amount. Currently new Bitcoins are created by a process called mining. Miners are rewarded with 25 Bitcoins for some specialized work called "adding a block to the blockchain" that is over my head to fully understand. But what is of note for this article is that "the bitcoin protocol specifies that the reward for adding a block will be halved approximately every four years. Eventually, the reward will decrease to zero, and the limit of 21 million bitcoins will be reached circa 2140; the record keeping will then be rewarded by transaction fees solely."

In other words, Bitcoin will eventually become a stable fixed money supply. In fact, it will become a deflationary currency. As population and wealth goes up, the value or purchasing power of each Bitcoin will also go up.

There is no reason modern governments can't adopt a similar plan - a fixed money supply. It would create some interesting new dynamics.

Currently, the price of goods set by supply and demand is much like an auction. The stock market is a great way to understand the dynamics of supply and demand. A constant auction goes on where buyers and sellers interact, bidding for or offering shares for sale.

In a deflationary economy, would it have more of a Dutch auction dynamic?

In a conventional auction, buyers sit in a grandstand and the auctioneer puts an item up for sale. Higher and higher bids are offered until no one bids higher. The person with the highest bid wins and buys the item.

A Dutch auction is how flowers are sold. In a Dutch auction, the buyers still sit in a grandstand to observe the proceedings, but there will be only one bid. An item is brought out and a price clock starts to tick down, starting at a high price and going lower and lower until a bidder yells out he'll take it. The object of the buyer is to get the lowest price possible without waiting too long and losing out to another bidder.

Currently we have a society burdened with debt. Not just governments, but citizens as well. It was well chronicled in Bill Bonner and Addison Wiggins book, Empire of Debt. And people on fixed income are losing out as every year our dollar buys less and less.

A deflationary policy would alleviate those problems. It would provide incentives to save. And it would not only preserve, but increase the purchasing power of the poor and seniors on fixed income.

Links of Interest

• A Short History of Deflation
• How the Central Bank Eats Your Money by Maxime Bernier
• Index to My Vocal Articles

• My Vocal Profile – a complete listing of my articles on a variety of topics as well as my short fiction and poems on Vocal