Inflation Vs. Deflation - Not So Simple

In college, I wrote my senior paper on the gold standard and its historical connection to free trade. To truly understand what inflation and deflation are, one must understand how the creation of the Federal Reserve Bank transformed our economy from a free-market economy to something entirely different.

See, in ECON 101 we learn how supply and demand interact to determine price. On the micro level, we can look at this for a particular commodity, say gold, or oil if you prefer. Looked at in this way, markets are fairly simple, extremely rational, and in my opinion, a reflection of the natural laws of the universe.

So if you really start thinking, you can see that there is a market for money itself, the price for which in a free market, would be set by supply and demand. Interest rates are the "price" of money.

You can see how if economic activity is low, the demand for money will be very low. If you have little need or desire to exchange goods, you don't need very much money. When economic activity picks up, more money is needed to carry out the demanded transactions.

Inflation and rising prices are not the same thing by definition, though many (including myself in the past) tend to believe this fallacy. Inflation occurs when there is a rise in prices brought about by an increase in the supply of money in circulation itself. When this "oversupply" of money floods the system, the value of the money falls, if there is not a corresponding increase in the level of economic activity desired by the populace to offset the increase in money supply. Hence, each dollar in your pocket buys less than it used to. This is inflation, otherwise known as currency devaluation. Rising prices that are not accompanied by a devaluation of currency are demand driven and reflect an increase in economic activity and increased prosperity. They are not accompanied by reduced purchasing power of a currency, and as such, are not considered inflation.

Now, why did I go into all of that? Because, it helps us understand what is going on today. Two basic forces are at work. The first is massive downward pressure on the general price level (deflation) caused by a collapse in aggregate demand (busting of the credit and housing bubbles). The second is monetary inflation (currency devaluation) driven by the Federal Reserve Bank and the Treasury.

The Government believes it can "stimulate" aggregate demand by making more money available (credit) in the system. It wants you to keep living beyond your means to keep the level of economic activity in our country high.

When economists debate about whether deflation, or inflation is the biggest threat facing us, the real question is this: Can currency manipulation (in this case devaluation) stop deflation without causing inflation?

I think the answer is multi-fold. It depends on many factors. Can you fill up debt holes with fiat currency? Can you inflate your way out of debt? The answer: yes, but not without devaluing your currency. Now, I think this is what Captain Capitalism is referring to when he says we are headed for an inflationary period, and I understand the argument.

http://captaincapitalism.blogspot.com/2009/11/chinese-should-listen-to-cappy-cap.html

But I think the deflationary force of aggregate demand falling off a cliff and the massive debt holes that need to be filled in are going to offset rising prices. (A great counter-force if you will.) I also think that the slow velocity of money (the rate at which it circulates through the economy) will keep inflation in check in the near term. In addition, the debt holes absorb currency much like black holes absorb light. Velocity won't kick in until the debt is paid down by substantial amounts. This may take a very long time, considering the size of the holes.

http://econmom.blogspot.com/2009/01/inflation-risk.html

There is much for me to learn on this subject. The confusion of having a money supply manipulated by the government throws a huge wrench in the cogs of classical economic theory.

It seems that we are entering a period much like the Great Depression, only on a larger scale. So in the near term, deflationary pressures will be very strong. In March 1933, Roosevelt effectively did away with the gold standard (confiscated private gold holdings) in an attempt to inflate the currency and stop the deflation. Did it work? That is debatable. It still took the U.S. 10 years to emerge from the depression and twice that long for the stock market to recover. Did massive hyperinflation take hold? No, not in the U.S. But it did in Wiemar Germany.

I am not sure which path we are headed down, but I really hope our government will learn to accept the correction that a deflationary period can bring. It may be painful, but I really don't want the U.S. to be remembered like Wiemar Germany.

So which way are we headed? Will inflation or deflation be the predominent force in our economy this decade? Well, perhaps both are occurring at the same time. I still think demand will not recover for a very long time, and I don't believe the government is going to have to print so much money that we will have a massive devaluation of our currency.

In the near term (3-6mos) I would be long the dollar and short the market.