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Many commentators are
of the view that the biggest threat to the economy is deflation rather than
inflation, because of the present economic slack. The United States used only 69.6% of its industrial capacity in August, against 77.6% in August
last year and the historical average of 81.1% since January 1967. In Q2 this
year, the real GDP stood 7.6% below the potential real GDP. This gap stood at
6.8% in Q1 and 1.6% in Q2 last year.
 
Those economists who
are concerned about deflation in this environment define it as a general
decline in prices of goods, the opposite of inflation. Indeed, year on year,
the US consumer price index fell by 1.5% in August after falling by 2.1% in
the month before. This was the sixth consecutive monthly decline.
For most experts,
deflation is bad news since it generates expectations for a further decline
in prices. As a result, they believe, consumers postpone their buying of
goods at present since they expect to buy these goods at a lower prices in
the future. This weakens the overall flow of spending and in turn weakens the
economy. Hence, such commentators believe that policies that counter
deflation will also counter the slump.
But does it make
sense that a fall in prices should actually cause people to postpone buying
goods? To maintain their life and wellbeing individuals must live at present,
hence they buy goods at present regardless of the fact that prices are
falling.
From December 1997 to
August 2009, the prices of personal computers have fallen by 93%. Did this
fall in prices cause people to postpone buying personal computers? On the
contrary, since December 1997 consumer outlays on personal computers have
increased massively. These outlays stood at $83.2 billion in August 2009 as
compared to $3.4 billion in December 1997.
Nonetheless,
following the logic of the popular way of thinking, if deflation leads to an
economic slump then policies that reverse deflation should be good for the
economy. Reversing deflation would imply introducing policies that support
general increases in the prices of goods, i.e., inflation. This means that
inflation could actually be an agent of economic growth.
According to most
experts, a little bit of inflation can actually be a good thing. Mainstream
thinkers believe that inflation of 2% is not harmful to economic growth, but
that inflation of 10% could be bad news.
We suggest that at a
rate of inflation of 10% it is likely that consumers are going to form rising
inflation expectations. According to popular thinking, in response to a high
rate of inflation, consumers will speed up their expenditure on goods at
present, which should boost economic growth. So why then is a rate of
inflation of 10% or higher regarded by experts as a bad thing?
Clearly there is a
problem with the popular definitions of inflation and deflation.
Inflation is Not
Essentially a Rise in Prices
Inflation is not
about general increases in prices as such, but about the increase in the
money supply. As a rule the increase in money supply sets in motion general
increases in prices. This, however, need not always be the case.
The price of a good
is the amount of money asked per unit of it. For a constant amount of money
and an expanding quantity of goods, prices will actually fall.
Prices will also fall
when the rate of increase in the supply of goods exceeds the rate of increase
in the money supply. For instance, if the money supply increases by 5% and
the quantity of goods increases by 10%, prices will fall by 5%. A fall in
prices cannot conceal the fact that we have an inflation of 5% here on
account of the increase in money supply.
The reason why
inflation is bad news is not because of increases in prices as such, but because
of the damage inflation inflicts to the wealth-formation process. Here is
why.
The chief role of
money is as the medium of exchange. Money enables us to exchange something we
have for something we want. Before an exchange can take place, an individual
must have something useful that he can exchange for money. Once he secures
the money, he can then exchange it for a good he wants.
But now consider a
situation in which the money is created out of "thin air,"
increasing the money supply. This new money is no different from counterfeit
money. The counterfeiter exchanges the printed money for goods without
producing anything useful.
"The reason why inflation
is bad news is not because of increases in prices as such, but because of the
damage inflation inflicts to the wealth-formation process."
He in fact exchanges
nothing for something. He takes from the pool of real goods without making
any contribution to the pool. The economic effect of money that was created
out of thin air is exactly the same as that of counterfeit money — it
impoverishes wealth generators.
The money created out
of thin air diverts real wealth, or real, saved, final goods, towards the
holders of new money. As a result, less real savings become available to fund
wealth-generating activities. This in turn leads to a weakening in economic
growth.
Note that as a result
of the increase in the money supply what we have here is more money per unit
of goods, and thus, higher prices. What matters however is not price rises as
such but the increase in money supply that sets in motion the exchange of
nothing for something or "the counterfeit effect."
The exchange of
nothing for something, as we have seen, weakens the process of real wealth
formation. Therefore, anything that promotes increases in the money supply
can only make things much worse.
So while inflation is
an increase in the money supply, deflation is a decrease in the money supply.
Falling Prices and
Bubble Activities — What Is the Link?
Loose monetary policy
from January 2001 to June 2004 has allowed the emergence of nonproductive, or
bubble activities. We suggest that the present fall in prices is related to
goods that are associated with these nonproductive activities. Businesspeople
produced goods and services that consumers did not desire enough to make them
worth the real costs of production.
These activities came
under pressure in response to the tighter monetary policy from June 2004 to
September 2007. Various projects that were supported by the loose monetary
policy could not be finished and had to be shut down. Workers employed in
these projects became unemployed. Prices for the goods and services produced
by these projects are falling.
For the time being,
however, US money supply shows strong increases. The yearly rate of growth of
our monetary measure AMS
stood at 14.6% in August 2009 against 1.8% in August 2008. As long as the
money supply continues to expand, we have inflation regardless of what the
prices of some goods are doing.
If one were to
include the prices of stocks and the prices of commodities in the calculation
of so-called price inflation then it would be obvious even to popular
thinkers that we in fact currently have inflation and not deflation. From the
end of March to the end of September, the S&P500 stock price index
increased by 32.5%. Since January this year the price of gold increased by
12.2%, and the price of copper jumped by over 92%. Also since January the
Commodity Research Bureau's commodity price index increased by over 17%.
Some components of
the consumer price index have actually been rising. For instance, the yearly
rate of growth of the cost of medical care stood at 3.3% in August against
2.6% in January this year. Year on year, the rate of growth of the cost of
education stood at 5.4% in August, with a similar figure in January.
Due to a strong
increase in money supply between August last year and August this year, the
prices of various goods and services are poised to visibly strengthen, after
some time lag. We suggest that this increase could become quite visible in
the second half of next year.
"As long as the money
supply continues to expand, we have inflation regardless of what the prices
of some goods are doing."
Now, the best way to
eliminate the slack, such as the unemployment of labor, is to allow wealth
generators to move quickly in their task to rebuild wealth. This, coupled
with a free labor market, will enable the quick absorption of unemployed
individuals.
But what we have
instead are the Fed and government's policies that are aimed at supporting
nonproductive activities. This of course prevents laying the foundation for
sustainable real economic growth.
Nonproductive
activities only further weaken the ability of the economy to generate real wealth.
Policies aimed at countering a fall in prices, which are supposedly aimed at
fighting deflation, do nothing more than provide support for nonproductive
activities.
Such policies can
produce the illusion of success as long as there are enough wealth generators
to fund nonproductive activities. Once the percentage of wealth-generating
activities falls sharply, though, there will not be enough real funding to
support an expansion in economic activity.
The economy then
falls into a prolonged slump. Under these conditions, the more the central
bank and the government try to fix the symptoms, the worse things become.
Once, however,
nonproductive activities are allowed to go belly-up, and the sources of the
increase in money supply are sealed off, one can expect a genuine,
real-wealth expansion to ensue. With the expansion of real wealth for a
constant stock of money, we will have a fall in prices.
Whether prices fall
on account of the liquidation of nonproductive activities or on account of
real-wealth expansion, it is always good news. In the first case, it
indicates that more funding is now available for wealth generation, while in
the second case, it indicates that more wealth is actually being generated.
Conclusions
"Policies aimed at
countering a fall in prices, which are supposedly aimed at fighting
deflation, do nothing more than provide support for nonproductive
activities."
Since inflation is
about increases in money supply, obviously an increase in spare economic
capacity cannot reduce the rate of inflation as most commentators are saying.
Only the Fed's monetary policy can exercise control over the money supply. Hence,
regardless of the economic slack, the more money the Fed creates, the more
damage it inflicts.
Against the current
background of a still-subdued economy and falling prices, most experts are
concerned that deflation poses a serious threat to the US economy. Hence they are of the view that the US central bank should consider measures
to counter deflation. We suggest that a fall in many goods' prices, which is
erroneously labeled as deflation, is actually the result of the liquidation
of various nonproductive activities that are undermining real wealth
generators.
Consequently, a
policy that aims at countering deflation in fact reinforces nonproductive
activities and delays the chances for a durable economic recovery. The major
threat to the economy is not deflation but the Fed and the Federal
Government's policies aimed at countering it.
Frank Shostak
Frank Shostak is a former professor of
economics and M. F. Global's chief
economist.
Also
by Frank Shostak
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