Which do you feel is more serious – inflation or deflation? The term “more serious” can refer to frequency of occurrence. Or it can refer to difficulty in prevention or cure. Or it can refer to its affect on the economy.

Stated simply, deflation is the opposite of inflation. As with inflation, deflation is expressed as a comparison of demand vs. supply. It is a reduction in the demand for, vs. the supply of, goods and services compared with the demand vs. supply of money.

Supply is a self evident concept. Demand is based on risk and reward. When applied to goods and services, the risk is further deflation. The reward is the inherent reward for obtaining the goods or services. When applied to money, the risk is inflation and the reward for owning money is interest.

In brief summary, deflation can occur when:
1. Money is perceived as becoming more valuable: The supply of money goes down and/or interest rates (reward) go up, while the perceived risk (of inflation or non-payment) goes down. The more likely combination is reduced money supply together with increased interest rates.

2. Goods and services are perceived as becoming less valuable: The supply of goods and services goes up, while the reward (quality) goes down, and or/the perceived risk (of deflation) goes up.

Put all these possibilities together and the most likely, deflation-causing combination is excess supply of goods and services compared with reduced money supply.

Inflation is fundamentally the opposite of inflation, so most of the causes of each tend to be opposites. The key difference relates to the supply of goods and services. In this world economy, it virtually is impossible for a broad number of goods and services to be in worldwide short supply, if money is available to buy them. For that reason, inflation rarely is the oft-mentioned, “Too much money chasing too few goods” – with one exception. Energy. Because energy costs and availability impact nearly every product and service, there is a modern historical relationship between oil prices and CPI.

All of the above leads to one interesting conclusion: While deflation can be caused by a shortage of money, inflation rarely is caused by an over-abundance of money.

If, in comparing seriousness, we mean frequency of occurrence, clearly inflation would be considered more serious. Deflations are rare, having occurred perhaps three times in U.S. history. Inflation is an annual occurrence.

If, in comparing seriousness, we mean difficulty in prevention or cure, I believe deflation is more serious. Inflation easily can be prevented and cured by raising interest rates, which increases the demand for money. There is no limit to how high interest rates can be raised.

By contrast, trying to use interest rates to prevent deflation runs into the obstacle of zero rates. Though negative rates may mathematically be possible, it is difficult to imagine many borrowers accepting negative rates. Thus, the sole prevention for deflation is increasing the money supply, which the debt hawks have made difficult.

If, in comparing seriousness, we mean affect on the economy, I believe deflation is far more serious. Modest inflation can be stimulative, in that it encourages consumers to buy today, rather than waiting for tomorrow. Deflation encourages delaying purchases, which negatively impacts the economy, and can cause a feedback loop of lower and lower prices, longer and longer delay.

All of the above considered, I suggest deflation is far more serious than inflation.

Interestingly, debt hawk commentators, who are fixated on easily-prevented, easily-cured inflation, seldom mention deflation as a threat. The reason may be that there is no debt-hawk prevention or solution for deflation, as the sole solution (increased federal spending) is considered out of the question. Yet here we are, struggling against deflation, while Congress and the media preach against the one action that can prevent it.

Next time I’ll discuss stagflation, every mainstream economist’s nightmare.

Rodger Malcolm Mitchell
http://www.rodgermitchell.com

No nation can tax itself into prosperity