Monday, October 25, 2010

Economics: Deflation

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To recap, inflation is the increase of the supply of money which leads to the increase of prices in goods; or put another way, inflation is the decrease in the value of money which is reflected in the rise of prices.

Essentially the exact opposite: Deflation is the contraction in the supply of money leading to prices falling; or put another way, deflation is the increase in the value of money which is reflected in the fall of prices.

Deflation is a good thing for the average citizen, particularly helping those who have been responsible and saved their money, because now the money that they've saved is worth more. However, for people holding debts, deflation is a very powerful reminder of those debts, because now it's even harder to repay them. For instance, if you own a house that hasn't been paid off, you may owe $100,000 on the mortgage, but due to deflation perhaps the price of your house falls to $80,000 before it can be sold which leaves you holding $20k in debt. I'm not saying holding $20k in debt is a good thing, but it's an accurate reflection of reality, that house was never worth $100k to begin with, it was a symptom of an over-inflated economy.

Right now our economy is beginning to see symptoms of deflation. People are paying down debt, which is leading to the money-supply evaporating, which leads to the value of our dollar increasing. At the same time, fewer people are taking out loans, so no new money is being created even though the Fed is trying to re-inflate the economy to give it another "boost". Since the first round of inflation hasn't done it's job (banks aren't loaning out new funds, opting instead to keep reserves high to hedge against future defaults; more on our fractional reserve system later), Federal Reserve Chairman Ben Bernanke is looking to do another round of inflation, which he labels "Quantitative Easing", taken from Japan (whom it didn't help either).

This is a rather dangerous game the Fed plays. On the one hand, pushing banks to loan out money in order to devalue our dollar (thereby raising prices) is an insidious way to "help" our economy (and in the process wipe out the middle class and keep the impoverished down), on the other hand if it works then the debt holders become the winner, because now that person who owns the $100,000 house can sell it for $120k and make their profit, however the responsible people who saved and showed diligence with their finances see their money shrink in purchasing power, essentially wiping out their savings a little at a time.

Those aren't even the worst-case scenarios. If banks aren't loaning out their money right now, which is potentially a couple trillion, and the Fed, wait, scratch that, let's put a name to it, and *Ben Bernanke* decides to push in a couple trillion more and banks let that money hit the market, if Ben Bernanke (in some circles known as "Helicopter Ben" from his essay about combating deflation) isn't able to reign in a lot of that cash then the problem will be hyperinflation, and likely the destruction of our dollar.

The cold reality is that the Federal Reserve is highly political, despite the attempts from Chairmen to say otherwise, because the Fed uses inflation to fund our government. Whenever the US Treasury sells foreigners US Treasury Bonds, those bonds are backed by US Dollars which can only be printed up by the Federal Reserve. Imagine a Fed chairman who decided to not print the money, they would get fired, after all it's the President of the United States who nominates the Chairman and the Senate who confirms him. Seeing as how the US is the largest debtor country in the world (probably in the history of the world) then it's easy to understand why we don't want our figurative "house" to drop in value, it means that the money we used/borrowed is of less value than the money we have to repay, the consequences of which are to cut programs and be fiscally responsible. I bet you can't find a lot of Republicans or Democrats who get excited about that idea. However, destroying the dollar through inflation means you get more programs, less responsibility and someone else holds the bag. Pretty evil stuff.
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A View of Economics
Week 1: The Coming Disaster
Week 2: What is currency?
Week 3: Inflation
Week 4: Hyperinflation
Week 5: Deflation
Week 6: Money Represents Production
Week 7: Bubbles pt 1 - Housing Bubble
Week 8: Bubbles pt 2 - Pure Credit Expansion
Week 9: Bubbles pt 3 - The Bust is a Good Thing
Week 10: Productive vs Destructive

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