How the World Really Works

Inflation and Deflation

The theory that inflation and deflation are primarily currency problems was the basis for the concept of central bank control of the business cycle. Some modern economists argue that these two problems have more to do with structural things such as capacity. Messrs. Greenspan, Bernanke, et al have spent recent months discussing deflation as a monetary question so we'll stay on that thesis, as that is the premise under which they conduct their business.

To over-simplify again let's go with the conventional definitions. Inflation is too much money around. Deflation is too little money around. When there is too much of anything around, we tend to be careless about it. So it is with money. People tend to buy without bargaining. Prices rise. Rising prices inspire folks to pay even higher prices lest the price go even higher tomorrow. In a rapid inflation cash is trash. You want to own goods.....not green pictures of dead presidents.

In a period of deflation (monetary) cash is scarce. Like a handful of matches in a snowed-in cabin, people tend to conserve that which is scarce - even money. When people are reluctant to spend, it is tough to sell things. Whether you make shoes or sandwiches, you are willing to cut prices or give incentives to get some of that precious cash. Lower and lower prices inspire people to postpone purchases. That tends to feed on itself as sellers offer even lower prices.

Why does the Fed appear far more worried about deflation than inflation? The obvious reason is that inflation is more controllable. As Paul Volker proved in the early 80's, all you need is an iron will and the willingness to inflict a lot of pain as you choke inflation to death.

There are two other reasons why deflation is more feared. Both of these are cultural. Deflation was part and parcel of America's great economic trauma - the Depression.

The other cultural reason is that we are a nation of debtors. We owe out more than we save. From mortgages to business loans, Americans have been encouraged to build up debt through tax policies and the like.

Inflation punishes the saver and the lender. The purchasing power of the savings goes down every time prices go up. Deflation punishes the spender and the borrower. The purchasing power of the money he must repay goes up as prices go lower. Worse, the house or car he borrowed to buy no longer goes up in value. That has enormous potential for culture impact were it to hit the U.S.