Whats Wrong With Deflation?

Whats wrong with deflation?

When goods and services are deflated, everything is cheaper. You get more for your dollars.

What could be wrong with that?

There are some compelling arguments both ways—but be careful; the game is rigged!

Argument for deflation – Whats wrong with deflation

• One argument used in favor of deflation is that deflated goods are good for the economy. The computer industry has been deflating their costs for decades. You get a lot more for your money today then last year, and so forth. Companies like Microsoft and Apple are doing just fine.

• Another argument is that during deflationary times people tend to save more since their money will be worth more later. This savings is for emergencies, retirement, children’s education and more.

In other words, people are more financially stable. They can more easily weather a downturn in the economy. This saver philosophy is good for individuals and good for a stable commodity backed monetary system.

The problem is that we don’t have a commodity backed monetary system.


Argument against deflation – Whats wrong with deflation

The Federal Reserve (FED) has created every dollar in existence (of the current money supply) out of debt. This creates several problems:

1. A decrease in the debt (by deflation) decreases the money supply.
2. A decreased money supply slows down economic activity.
3. The FED wants a growing economy. Consequently, they want debt to continually increase.

In other words we have a debt driven society. This is an ugly spiral that doesn’t end well.

During deflationary times people still spend, but not as much. This slowdown in spending is worrisome to the FED.

During deflationary times people still pay their mortgage; buy food, clothing, pay for education and more. They tend to purchase goods and services as they need them rather than as they want them using credit. Also, people’s savings stimulates the economy, but not as much as when they go into debt.

In our debt driven society many people have huge debts and low reserves. This makes many families financially fragile. An economic downturn can create devastating results for these individuals. This leads to many bankruptcies and a weakened economy.

Expanding on that last statement, this is the elephant in the room. That elephant is the power of a deflating economy to cause massive economic damage.

As noted earlier, the financial game is rigged. This rigging demands that people go further and further into debt to drive the economy.

Eventually the debt can’t be serviced on an individual, or on a national scale. That leads to dramatic downturn in the economy, and can lead to financial ruin on a massive scale.

This is the reason The Federal Reserve is terrified of a countrywide deflationary period.


Here is the scenario – Whats wrong with deflation

Round number will be used to present this example.

Assume you make $1,000 month. Your fixed costs are $500 (including house payment, car payments, insurance, credit payments etc). $350 a month pays for your variable expenses like food, clothing, utilities, insurance, phones, cable, gasoline etc. $150 is left over for savings and disposable income like entertainment and vacations. Things are pretty good.

During a deflationary time everything declines---including wages. For example, during the great depression nominal income dropped by 53% (assuming you were able to keep your job).

For our example we will use a 50% deflation rate for everything including wages.

The problem is that although your variable costs decreased by 50%, your wages, fixed costs and debts stay the same. If you don’t have sizeable financial reserves to help you weather the storm during the hard economic times, you will be in a world of hurt in a short time.

Your income would go down to $500 a month. However, your fixed costs would stay at $500/month. If your variable costs all went down by 50% you will still be paying $175/month.

You now have no disposable income, you are going into debt to the tune of $175 a month with no relief in site and your job may be in jeopardy. This is not a good position to be in.

Many people would lose their home, car and go bankrupt in a situation like this one. That is one of the primary reasons the FED is so scared of deflation.

Note: The deflationary period used for this example was 50%. Many people live paycheck to paycheck. A deflationary period would not have to be anywhere near that percentage to cause serious damage to the economy.


Seem far fetched?
Whats wrong with deflation
Consider this: Since 1929 there have only been nine years of a deflation and six of those were from 1930 to 1939 during the great depression.

From 1940 thru 2011 (72 years) there were only three years of deflation and the total of all three was a paltry -1.57%. The last deflationary year was in 2009 with a deflation rate of -.34%.

Only 3 years of deflation out of 73 years is compelling evidence that the FED (who controls the money supply) hates deflation. They are willing to go to extreme lengths to stop it. This philosophy has led to inflation and financial bubbles that have serious damaging effects on the economy.

An Out of Control Spiral - Whats wrong with deflation
Our debt driven economy has significant dangers. Consider this scenario:

• The economy slows and threats deflation. The FED pumps money into the economy to get positive growth.

• Inflation occurs however the economy doesn’t grow as much as the FED would like.

• In a knee-jerk reaction the FED contracts the money supply to ensure we don’t have high inflation, or worse hyperinflation.

• The economy slows and heads towards deflation again.

• In another knee-jerk reaction the FED pumps a lot more money into the economy but the economy stays stagnant.

At some point this spiral goes out of control (as more and more money is pumped into the economy with less and less growth). In other words creating fiat money to stimulate the economy has reached the point of diminishing returns).

With the massive amounts of fiat currency in the system the economy heads into hyperinflation. There may come a time when and the FED can’t control the spiral of hyperinflation.

The FED’s fear of an hyperinflation causing an implosion of the economy is well founded. Fiat currency failures have occurred too many times throughout history to ignore.


Final Thoughts on Whats wrong with deflation
Whats wrong with deflation? The answer is that question is that there is a lot wrong with it the way our current monetary system is set up.

The Federal Reserve Bank (FED) calls the monetary shots by raising and lowering the money supply and interest rates. It doesn’t allow the free enterprise system to work its magic as the Austrian school of economics recommends.

When the financial system slows down, more money is pumped into the economy that eventually increases inflation (or financial bubbles) and the spiral continues.

The economy and FED are a little like a patient/doctor relationship. The economy being the patient and the FED being the doctor in this case.

A good doctor will treat a patient with the right mix of medicines and if things are serious enough he will operate. However a good doctor will get out of the way and allow nature to take its course and heal the patient. This philosophy has worked for thousands of years.

On the other hand bad doctors continually meddle with their patient’s health. They may prolong a patient’s recovery (frequently creating more harm than good).

Like a bad doctor, the FED is constantly adjusting the economic knobs of money supply and interest rates to fine tune the economy instead of allowing natural economic laws (and the free enterprise system) to heal the economy.

Nature is a powerful force. When the arrogance of men (in this case the FED) think they can outsmart nature, they are in for a rude awakening. Unfortunately, the public pays a dear price for the FED's arrogant mistakes.


Further Reading on Whats Wrong with Deflation
For another perspective of Whats wrong with deflation see the article :

What is so bad about Deflation?

To learn more about the Federal Reserve and what they have done to the financial system read:

The Creature from Jekyll Island: A Second Look at the Federal Reserve by G. Edward Griffin. This book knocks it out of the park.

A word of caution. You may never look at money or the world monetary system the same again after reading this book.

Return from Whats Wrong With Deflation to the Basics of Money