Inflation, Deflation, and You

Every day, people come up to me and say things like:

Frank, what are these inflation and deflation things that I keep hearing about? Are they something I will enjoy? Do I need any special skills to participate?

Inflation is when the prices of everything go up. Put another way, it is when the value of money, US dollars for example, goes down, so it takes more of it to buy the same old stuff. Deflation is the opposite, when prices go down and the value of money goes up.

That sounds like fun for the whole family! What causes inflation and deflation? Are they something I can make at home?

Folks (by which I mean economics professors) used to think that inflation/deflation was caused by changes in things like the level of production and unemployment. Currently, the consensus is that it is a “monetary phenomenon” which means that it is really all about money itself. Inflation is caused by one of two things: an increase in the supply of money in the economy or an increase in the “velocity” of money, how fast it is changing hands in the economy. Deflation is the opposite, caused by a drop in the money supply and/or a fall in the velocity.

The money supply is what people usually watch to predict inflation/deflation because velocity is pretty constant over time. It really only drops in very extreme circumstances, such as the early 1930s and right now.

That sounds awesome. How can I spot inflation or deflation myself? What are some of the exciting things that will happen to me because of it?

Spotting inflation/deflation is easy. Look for prices of the things you buy to go up/down.

Under inflation, what will probably most concern you is that although the prices you pay have gone up, what you get paid may not go up as quickly.

In the long-run, the more significant effect is on the value of dollar-denominated assets you own and debts you owe. Since the value of dollars is decreasing, the value of bank deposits you have and bonds you own will decrease, possibly faster than the interest paid is growing them. On the other hand, the value of your debt also goes down in the same way. In principle, the value of “real” assets, such as your house and shares of stock in companies, do not decline under inflation. In practice, this is not so easy to see because periods of inflation are also often bad times for the economy so the value of assets tends to go down.

Deflation is similar but worse. You will notice things getting cheaper and the amount you get paid may not immediately go down, which will be fun while it lasts. But it is hard for companies to cut salaries. The last time we had meaningful deflation, at the start of the Great Depression, instead of cutting everybody’s salary companies laid off some people and stopped hiring. If you were one of the lucky who still had a job, then things were fairly good since you could buy more with your salary. If you were one of the one third of Americans out of work, things were not good.

The same effect on dollar denominated assets happens under deflation as inflation, but backwards. The value of your bank deposits and bonds increases, but so does the value of your debts. If you have money in the bank you should be rooting for deflation, if you owe money you should be rooting for inflation.

They both sound like a blast. Is there a reason to pick one over the other?

Go with inflation. Deflation has really nasty effects on the economy. If the value of your dollars is increasing every day, you have less incentive to spend or invest them. And if today’s dollars are worth a lot less than the dollars of a few years from now, borrowing money becomes expensive, even at zero percent interest. This can lead to a vicious spiral, with people hoarding money because of deflation, which causes a drop in velocity, which causes more deflation.

Okay, I’m ready to play. What should I expect first, inflation or deflation?

For the moment, we appear to be in a period of deflation. The fiasco in the financial system has caused a lot of people and companies in the economy to hold on to their cash, which has greatly reduced the velocity of money. But the Fed and the government have made it clear that they will go to whatever extremes necessary to keep deflation from setting in for long. Fed Chairman Bernanke has hinted that if he has to he will fly over cities in helicopters dropping cash. Bernanke believes that the Fed caused the Great Depression by not increasing the money supply when it should have (in fact it decreased it) and he has made it his life’s mission that that particular debacle not be repeated.

The medium- and long-term effect of the massive increase in the money supply now under way should be obvious. Velocity will stabilize and/or rise and we will get inflation. Lots of it. Inflation is good news for debtors, those that owe dollar-denominated debts. And who is the largest dollar-denominated debtor in the world? Not at all coincidentally, the US Federal Government. Runner up are American homeowners, who could use a break.

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