Battle4Liberty

The mainstream media has been proclaiming the beginnings of an Obama economic recovery for some time, but it just hasn’t materialized yet. There is an occasional hopeful sign, but the short term still looks mediocre at best, while the crisis in Europe has temporarily boosted the dollar. Some economists are warning that deflation might be around the corner. What would this mean for the economy and what happened to the long term fear of inflation?

In a classic sense, INFLATION occurs when the money supply expands and DEFLATION occurs when it contracts. More money in circulation means that each dollar is worth less, so inflation typically translates into higher prices, sooner or later. Today, the word INFLATION usually refers more specifically to PRICE INFLATION, but there is always a lag between expansion of the money supply and price increases. The money supply has expanded recently, which means that prices down the road will be higher than they otherwise would have been. This is a fact, although we don’t know when prices will rise and by how much. There are too many other variables at work.

Just as inflation today commonly refers to a general increase in prices, deflation refers to a general decline. Prices are a function of supply and demand, so a drop in consumption results in a drop in prices as suppliers compete more aggressively for fewer buyers. This is happening in some sectors today, causing many economists to warn that the general price level—the average price for a mix of goods and services—is beginning to decline, which means deflation.

Keynesian economists urge governments to manipulate the economy so that inflation occurs but remains low, perhaps around 3%. But their greatest fear is deflation. When prices are falling, they argue that consumers are more likely to hold on to their money in hopes of cheaper and better prices in the future. This would reduce demand even further and lead to greater unemployment, more deflation, and a downward spiral.

There is a kernel of truth to the argument, but is fails to consider adjustment mechanisms already built into the market. Knowing that milk might cost a little less next year won’t keep you from buying a gallon today. The cost of an exterminator’s visit might decline in the future, but you will probably call today if you have a serious bug problem. And computers have been getting both better and cheaper for decades. We expect that $1000 will buy a better system next year than it does today, but knowledge of this fact doesn’t cause us to defer our purchases indefinitely. Computers provide value, so waiting to purchase one can cost us as well.

Keynesians also fail to recognize that deferring consumption means more savings. This increases one’s future quality of life as well as the pool of capital available for expanding businesses to borrow. Besides, deflation increases the value of your savings by expanding the purchasing power of each dollar you have, so it’s good for savers. There is no reason to fear deflation.

What about inflation? The money supply has already expanded considerably, so prices must rise at some point—exactly when is anybody’s guess. I expect low growth for a while, with some price deflation (depending on how you measure it) possible in the short term. I still expect price inflation in the long term, especially when the economy begins to show real signs of recovery. Unfortunately, we’ve been set up for a bout with stagflation that will be difficult to avoid even if we have leadership in the 2010 and 2012 elections.