You’ve probably heard about how bad deflation is for the economy. It’s usually some analyst on one of the major news networks warning that deflation would be terrible and the economy would suffer. I want to take a little time with my first post on this blog and talk about the basics of deflation and inflation from a free market perspective.
Let’s start with correctly defining what inflation is. Inflation is an increase in the money supply. The state accomplishes this (assuming the state has a monopoly on the money supply) by actually printing more dollars. Now they can just enter more zeros on a computer screen. The Federal reserve is unfortunately in a position to control the United States money supply. In recent years they have been increasing the money supply through something called Quantitative Easing. An argument you will hear today is that inflation is only 2%, but remember that’s by the government’s own measurement. They don’t count food and energy in their measurement either. It just might be a little biased. Energy prices are going up. If you shop at the grocery store you know that food prices are going up. One of the ways we are seeing this today is the reduced size of food packaging. I’m not sure what the exact price of a can of tuna is but I’m going to use it as an example. Say you were able to get a 6 oz can of tuna for $2, well now that same $2 will get you a 5 oz can. That is a symptom of inflation. Cost of living prices are going up. Inflation hurts and punishes the saver, your savings account APY (0.95%, highest I found online) is definitely not going to be high enough to keep up with even what the state says the inflation rate is. Even a decent investment might not keep up with inflation today.
According to the mainstream consensus, rising prices (a symptom of inflation) are a sign of a healthy economy. In their view, inflation is a sign of economic activity. What kind of economic activity is getting less of something for more money? True economic growth comes when an economy becomes more efficient and products cost less than they did before. Look at cell phones and technology in general. Is it a bad thing that these things are becoming accessible to more people? No, that’s efficient economic growth. It’s about becoming more productive. When the fork lift was invented it allowed one person to do the job of many. Now the people that were not needed for lifting and moving are able to do something else, where they will be more efficient in the economy. This process helps lower production costs which in turn helps prices fall; it’s a good thing. That’s economic growth.
There are multiple ways that prices can fall. Demand falling for a certain product can cause prices to fall and reduce production for that product. Increased production of goods and services can lead to falling prices. A general fall in prices can come as a result of the shrinking of the money supply. This kind of deflation that comes with an economic downturn is a response to inflationary policies from the state, or central banks. The money printing before the downturn, the building of the economic bubble is the real issue. This process misallocates money and resources by bad money (printed money, inflated money) chasing activities that don’t produce real wealth (i.e. recent housing bubble). It’s when it becomes obvious that this growth is not real and is in fact unsustainable that the bubble bursts and the economy re-adjusts. That’s when deflation can hit on a larger scale. It’s the painful correction taking place.
So why is this correction good? Well think about the housing bubble. When prices came back down, this was good for home buyers. It was not good for those looking to make a quick dollar just buying and selling houses (not fixing them up or adding any value to the home). The home prices had climbed so high, they were unaffordable for people in the market to buy. It was clearly unsustainable. The deflation following that bust is healthy. Your money can now buy you more than it could previously. One argument you’ll hear against deflation is that nobody would buy anything because everyone would be waiting for a lower price. I don’t know about you, but I’m certainly not going to starve because I think this apple could be cheaper tomorrow. I have time preferences. Yes, cell phone prices will probably drop but I still need a cell phone today. Am I not going to buy a $350 cell phone now because in the future the same phone could be $300? I’m not going to wait because I want one now, I have a preference to use it now. Let’s say deflation does have an effect on how consumers act, why would businesses and entrepreneurs not be able to anticipate this? They have to anticipate inflation and how that might affect their business plans in today’s climate.
Were the Federal Reserve’s policies not so inflationary, we wouldn’t feel the deflation so bluntly. Unfortunately we associate deflation with economic crisis thanks to the Fed. There’s a lot related to this subject and much more that can be said; inflation and war debts, fraction reserve banking, fiat currency, purchasing power and so on. I know Jon has covered some of these in previous posts and I plan to cover some of these in forthcoming posts.
1) Shostak, Frank “Is Deflation Really Bad for the Economy” – Frank Shostak N.p. Web. 11 Aug. 2010. <http://mises.org/daily/4618/Is-Deflation-Really-Bad-for-the-Economy>.
2) Hollenbeck, Frank “What’s So Scary About Deflation?” – Frank Hollenbeck N.p. Web. 26 Jun. 2013. <http://mises.org/daily/6459/Whats-So-Scary-About-Deflation>.