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Deflation Good. Inflation Bad
Deflation Good. Inflation Bad by Capitalist Hero
Incredibly, Ben Bernanke and the Feds greatest fear these days is deflation. The "official" reason deflation is public enemy number one is its supposed reduction of aggregate demand. As the theory goes, people will defer the purchase of goods and services today if the expect the price to be lower tomorrow. This decline in the price of goods and services leads to a decline in the profits of the suppliers of these goods and services. These lower profits then lead to layoffs which increases unemployment which leads to further decline in aggregate demand. This decline in demand leads to lower profits and the cycle progresses leading the the so-called spiral of death. This argument is certainly compelling but it is empirically false. The basic tenet of this theory is that lower prices leads to decrease demand. The real world is replete with examples of the opposite.
The death spiral theory violates the most fundamental law of economics, the law of supply and demand. The law of supply and demand states that the demand for a good will be greater at a lower price than a higher price. For example, when flat screen tv's were first introduced, they cost about $20,000. A few wealthy videophiles paid these exoberant prices, but most people waited because they new the price would come down. Every year the price of flat screen tv's came down and every year more and more people purchased them. The price of flat screens has declined so much that even people on welfare own them. If the flat screen producers had kept prices at $20,000, then demand would have dropped every year as everyone who wanted to own them at this high price would already have one. Obviously flat screen manufacturers, make a larger profits and employ more workers while selling a million units at the $1000 than they would selling a thousand units at $20,000.
Deflation is what is supposed to happen in capitalism. As economies of scale are realized, producers' input cost per unit produced is reduced; this means higher profits, lower prices, and increased standards of living for everybody. Deflation also signals confidence in the government that is backing the currency. If a dollar increases in value, then the holders of dollar must expect the government to be around in the future to back that dollar. During times of deflation the purchasing power of the dollar increase which means holders of the dollar make a risk and tax free return. If deflation is so great, why does the Fed and the federal government fear it so?
The federal government hates and fears deflation because it reduces its income. During times of deflation, the price of assets like real estate and stocks decline. The government cries its crocodile tears for the holders of these assets, but they're really crying because of all the revenue their missing. Even though asset prices may decline, the owners of these assets do not necessarily lose wealth. If your stock portfolio value decreases by 5% but the general prices decline by 10% then your real return is 5% (-5% - (-10%) = 5%). Even though your value as measured in dollars has decreased, your value as measured by purchasing power has increased; and that real gain in wealth is tax free because in the eyes of the tax code, you've lost money. In fact you can even tax deduct your nominal loses increasing your real gain! Conversely, if inflation is 10% and you stock portfolio increases 5% you have suffered a real loss of 5% (5% - 10% = -5%). The government will tax you on this real loss compounding the decline of your wealth.
The government also makes a positive return when it borrows. The government sells its Treasury Bills with about a 3% yield but inflation is closer to 6% (good rule of thumb is to add 3% to the CPI to get the rate of inflation). That means the government's real borrowing interest rate is -3%. The government actually makes money when it borrows money and when individuals, corporations, or nations lend the U.S. Federal Government money they have a negative real return. The government then will tax these negative returns compounding the individual's loss and increasing their positive real return. Why people continue to buy U.S. Treasury Bills is beyond me, but I completely understand the government's interest in keeping deflation at bay.
Deflation is good for everyone except debtors. The United States, both the federal government and private individuals, are the largest debtors the world has ever known. Every point of deflation adds a point to the real interest a debtor must pay on his debt. The United States both public and private have no hope of repaying our debt. We either default or inflate our way out. Clearly our leaders have opted for the latter. The specter of deflation is really just a fantasy. It will never happen, and I seriously doubt that it is even possible to deflate fiat currency. The Federal Reserve and federal government will continue its inflationary policies. To do otherwise would invite national default.
As we begin our slow descent from the first to the third world, you have the opportunity to transfer out of dollars and into hard assets. If you decide to stay long in dollars, all is not lost. You can still use your Benjamins as packing material as you ship off your possessions to Asia in exchange for Yuan.
Incredibly, Ben Bernanke and the Feds greatest fear these days is deflation. The "official" reason deflation is public enemy number one is its supposed reduction of aggregate demand. As the theory goes, people will defer the purchase of goods and services today if the expect the price to be lower tomorrow. This decline in the price of goods and services leads to a decline in the profits of the suppliers of these goods and services. These lower profits then lead to layoffs which increases unemployment which leads to further decline in aggregate demand. This decline in demand leads to lower profits and the cycle progresses leading the the so-called spiral of death. This argument is certainly compelling but it is empirically false. The basic tenet of this theory is that lower prices leads to decrease demand. The real world is replete with examples of the opposite.
The death spiral theory violates the most fundamental law of economics, the law of supply and demand. The law of supply and demand states that the demand for a good will be greater at a lower price than a higher price. For example, when flat screen tv's were first introduced, they cost about $20,000. A few wealthy videophiles paid these exoberant prices, but most people waited because they new the price would come down. Every year the price of flat screen tv's came down and every year more and more people purchased them. The price of flat screens has declined so much that even people on welfare own them. If the flat screen producers had kept prices at $20,000, then demand would have dropped every year as everyone who wanted to own them at this high price would already have one. Obviously flat screen manufacturers, make a larger profits and employ more workers while selling a million units at the $1000 than they would selling a thousand units at $20,000.
Deflation is what is supposed to happen in capitalism. As economies of scale are realized, producers' input cost per unit produced is reduced; this means higher profits, lower prices, and increased standards of living for everybody. Deflation also signals confidence in the government that is backing the currency. If a dollar increases in value, then the holders of dollar must expect the government to be around in the future to back that dollar. During times of deflation the purchasing power of the dollar increase which means holders of the dollar make a risk and tax free return. If deflation is so great, why does the Fed and the federal government fear it so?
The federal government hates and fears deflation because it reduces its income. During times of deflation, the price of assets like real estate and stocks decline. The government cries its crocodile tears for the holders of these assets, but they're really crying because of all the revenue their missing. Even though asset prices may decline, the owners of these assets do not necessarily lose wealth. If your stock portfolio value decreases by 5% but the general prices decline by 10% then your real return is 5% (-5% - (-10%) = 5%). Even though your value as measured in dollars has decreased, your value as measured by purchasing power has increased; and that real gain in wealth is tax free because in the eyes of the tax code, you've lost money. In fact you can even tax deduct your nominal loses increasing your real gain! Conversely, if inflation is 10% and you stock portfolio increases 5% you have suffered a real loss of 5% (5% - 10% = -5%). The government will tax you on this real loss compounding the decline of your wealth.
The government also makes a positive return when it borrows. The government sells its Treasury Bills with about a 3% yield but inflation is closer to 6% (good rule of thumb is to add 3% to the CPI to get the rate of inflation). That means the government's real borrowing interest rate is -3%. The government actually makes money when it borrows money and when individuals, corporations, or nations lend the U.S. Federal Government money they have a negative real return. The government then will tax these negative returns compounding the individual's loss and increasing their positive real return. Why people continue to buy U.S. Treasury Bills is beyond me, but I completely understand the government's interest in keeping deflation at bay.
Deflation is good for everyone except debtors. The United States, both the federal government and private individuals, are the largest debtors the world has ever known. Every point of deflation adds a point to the real interest a debtor must pay on his debt. The United States both public and private have no hope of repaying our debt. We either default or inflate our way out. Clearly our leaders have opted for the latter. The specter of deflation is really just a fantasy. It will never happen, and I seriously doubt that it is even possible to deflate fiat currency. The Federal Reserve and federal government will continue its inflationary policies. To do otherwise would invite national default.
As we begin our slow descent from the first to the third world, you have the opportunity to transfer out of dollars and into hard assets. If you decide to stay long in dollars, all is not lost. You can still use your Benjamins as packing material as you ship off your possessions to Asia in exchange for Yuan.
Copyright . Roger Martinez. All rights reserved.
