Brent Dax (brentdax) wrote,
Brent Dax

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This began as a reply to a post on bgmaster's journal that outgrew its playpen.


To have any sensible discussion about inflation and deflation, you need to decouple two concepts that a lot of people jumble up: price level and money supply. The money supply is the quantity of money in circulation, taking into account the multiplicative effects of banks. The price level is how much goods cost. The price level is partly dependent on the money supply, but it's also based on the aggregate supply and demand for goods.

Inflation and deflation are terms relating to the supply of money, but they're often measured by looking at the price level. That's a nice, easy measure, but we must remember not to confuse the force with the instrument. Inflation is not rising prices, though rising prices may be caused by inflation. Deflation is not falling prices, though falling prices may be caused by deflation.

Inflation and deflation are both bad because they represent a disruption in the unit of account and store of value. They're bad for the same reason bad accounting is bad: they distort expectations and hide economic truths. But rising prices and falling prices aren't necessarily so. They're bad if they're caused by inflation or deflation, but not if they're caused by shifts in aggregate supply and demand.


Armed with this understanding, we can now take a look at what's happening today.The price-level reduction ("deflation") we're seeing today is the result of two things. One is deleveraging and tightening of credit, which reduces the money supply and thus is genuinely deflation. This is bad in theory, but in practice, there was far too much credit during the bubble, and the money supply reduction is being matched by a fall in inflated asset prices (houses, mortgage-backed securities, bank debt and stocks).

The other, though, is a fall in aggregate demand as people restrict their spending to what they can actually afford. This is painful for companies that produced to meet the bubble's expected demand, but it won't continue unabated: the market will destroy marginal suppliers only until supply meets the new demand. That's why we see brinksmanship-playing Wall Street firms, poorly managed car companies, and teetering newspapers dying out: these were all unhealthy companies even during the boom, so in the bust they're the first to go. (The Wall Street firms had a false veneer of health, but fundamentally they had the financial equivalent of osteoporosis.)

Aggregate demand spirals do end if supply is allowed to fall to meet demand. Even when people expect prices to fall, they can only hold off their demand so long—they need to eat, they need to clothe themselves, they need to buy natural gas and heating oil and water and electricity and gasoline; these purchases won't wait. And even discretionary purchases won't wait. In eighteen months you can buy a computer just as fast as the ones on sale today at half the price. Does that keep you from buying? Of course not—a computer in eighteen months is less valuable to you than a computer today. You buy when it's cheap enough, not when it's as cheap as possible. That terminates the spiral. If that weren't true, the computer industry would be a wasteland of deferred demand, not a shining example of innovation and progress and profitability.

But if supply can't meet demand because government bails out marginal suppliers, something else happens. Propping up marginal firms just shifts them a little further away from the margin. The margin then shifts too as it seeks supply to destroy, and suddenly it finds twice as many firms: the ones you saved and the ones that were slightly healthier than those. Now you have twice as many firms to save, and some of them would never have been threatened if you hadn't tried to rescue the others in the first place. The bailouts become more expensive, and even so they don't really save the bailed firms; they just add even more firms to the margin. That is precisely the sort of "deflationary spiral" that Keynes worried about, but note that it wouldn't have happened without the bailout that propped up the original margin.


Earlier I spoke of an inflation-free economy where the money supply neither expands nor contracts. I said that in such an environment prices would slowly fall as firms found more efficient ways to produce; thus, even if you earned the same wages you could buy more with them in the future. As I hope I've made clear, this is not deflation because the falling prices aren't the result of a change in money supply. They don't represent a distortion in the unit of account; they can be predicted to some degree and they happen slowly and naturally, not arbitrarily and quickly in the way changes in the money supply happen. It's debatable whether this is a change in real wages, because it's not clear if "real" is a term that factors out changes in money supply or changes in price level. It certainly does mean that the same wage buys more, though.

But it buys more for a perfectly healthy reason: things are cheaper to make. If things don't get cheaper, then prices don't fall, and we end up with no changes in the price level. There's no external force driving this, just productivity gains. It isn't changing because we suddenly took half the money out of circulation, soaked it in gasoline, and set it on fire, which would be deflation.

Can an inflation-free money supply happen? Absolutely. All you have to do is create a currency whose supply is constrained by some outside force, keep banks disciplined with high reserve requirements, and most importantly, resist the temptation to debase the currency in hard times. Not easy, but within the reach of mere mortals.
Tags: economics, politics
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