It seems that really no one, from the lowliest beat writer at the Wall Street Journal, to the exalted head of the Federal Reserve, understands deflation.  Or, for that matter, the other side of the monetary coin, inflation.  If you understand one, you necessarily understand the other.

Milton Friedman understood it, yet even his acolytes (including his two most famous ones–Greenspan and Bernanke) don’t often get it.

Very simply, as Friedman most succinctly put it, “Inflation [deflation] is everywhere and always a monetary phenomenon.” 

What does it mean that something is a monetary phenomenon?  It means, that if it were possible to hold steady all variables except two–the supply of goods and services and the supply of money–it would be clear to see that, since money exists as a representation of something else (economic goods and services), if the supply of money changes relative to the supply of goods and services,  there will either be increased or decreased prices, solely because of a change in the relationship between money and what it represents. 

Let’s take an example.  Imagine a closed economic system where there is but one product, say, corn.  Imagine each year there are produced one hundred bushels of corn.  Imagine each bushel of corn, once produced, has a tag attached to it, the bottom portion of which can be torn away.  Imagine the people of the economic system agree that whoever owns the bottom portion of the corn tag owns the bushel of corn which it represents.  It’s obvious to see that the corn tag has become what we consider money.

Now, imagine that one year the corn harvest is especially good and a hundred and ten bushels of corn are produced.  Imagine that there is sufficient demand to consume this supply excess over the prior year (there is a very elastic demand curve), but there is one problem.  The economic system is on a fixed quota of corn tags.  It gets only one hundred per year, no more, no less.  If the tags are to still be used to represent the amount of corn produced, they will have to be apportioned equally among the total amount of corn, thus each corn tag will now represent 1.1 bushels of corn.  This is deflation.  The corn tag gained in value relative to the goods and services it is meant to represent.  There is more corn in each bushel that the corn tag represents.

Now imagine the corn harvest comes in low, at only 90 bushels, but as before, the corn tags are set at one hundred and each must be used (perhaps because the monetary authorities of our imaginary economy believe it to be required for stable prices).  Now it is clear to see that each bushel of corn will have only 90% of the corn it had last year.  This is inflation.  The corn tag represents a decreased quantity of corn than before.

Either of these problems could easily be solved through changing the number of corn tags when the quantity of corn supplied changes.  This is what it means to say that inflation and deflation are monetary phenomena.

Now let’s take the first example (deflation) and imagine that there is not a sufficient market at the price of one corn tag per bushel.  110 bushels have been produced, but there is only demand for 100, so the price must decline if the bushels are all to be sold.  What happens?  If all bushels of corn are to be sold, it looks exactly the same thing as in deflation.  The corn tag effectively become more valuable, each representing 1.1 bushels of corn.  A price decline due to excess supply in an economic system with a fixed quantity of money will look identical to a price decline due to deflation. 

What happens if the economic system has no upper or lower limit on its corn tags?  If the corn harvest comes in at 110 bushels and 110 corn tags are issued, then the market clears at the higher quantity (and same price) only if demand increases by the amount (10 bushels) of increased production.  What if the market only expands to clear half of the additional bushels?  Either there will be an excess supply to start the new growing season, or prices will have to decline.  Perhaps each corn tag comes to represent more corn in each bushel, as in our deflationary scenario.  Perhaps something extra (e.g., corn seasoning) is “given” away with each corn tag sold.  In any event, supply in excess of the amount demanded at the old corn price will cause the price to drop, even if corn tags are increased to represent the excess supply.  There is no monetary solution to this dilemma.  If the economic system increases the amount of corn tags to keep the price from falling, it not only won’t resolve the problem of excess supply, it will make things worse by keeping prices that wish to fall at artificially high levels.  The excess won’t be cleared.

What happens if a calamity befalls the community, and demand falls to only 90 bushels of corn?  If the same 100 bushels were produced as before, with the same one corn tag per bushel ratio, to sell the extra ten bushels would also require a drop in prices.    If the economic system decides it doesn’t like the drop in corn prices and prints more corn tags to push prices up, what will happen?  At first, even fewer bushels will be sold than before, as the higher prices weave their way into the economic fabric.  Then prices will have to fall even further in order to clear the corn bushel market.

In an age of technological innovation that allows greater production at lower cost, such as the industrial age in America during the early twentieth century, or the information age these last few decades, prices should fall– not as an indication of deflation, but as an indication of lowered costs and greater production efficiencies–unless demand growth and money supply growth each exceed the growth rate of supply due to productivity gains.  But the history of technological innovation is one of production efficiencies far outstripping demand growth.  Thus even when the money supply is expanded to account for the additional supply, prices should fall.

Which gets us to today’s CPI report from the Bureau of Labor Statistics:

The Consumer Price Index for All Urban Consumers (CPI-U) increased
0.3 percent in July on a seasonally adjusted basis, the U.S. Bureau
of Labor Statistics reported today. (Before seasonal adjustment, the
all items index was unchanged for the month.) Over the last 12
months, the index increased 1.2 percent before seasonal adjustment.

The energy index posted its first increase since January and
accounted for over two thirds of the seasonally adjusted all items
increase. Both the gasoline and household energy indexes turned up in
July after a series of declines. The food index, in contrast,
declined in July, largely due to the fourth consecutive decline in
the fruits and vegetables index.

The index for all items less food and energy rose 0.1 percent in July
after increasing 0.2 percent in June. The indexes for shelter,
apparel, used cars and trucks, and tobacco all continued to increase
in July. In contrast, the indexes for medical care and recreation
turned down in July and the indexes for airline fares and household
furnishings and operations continued to decline. The 12-month change
in the index for all items less food and energy remained at 0.9
percent for the fourth month in a row.

Read that last sentence again.  0.9% over twelve months is the lowest its been for as extended a period since the inception of the series in 1966.  It can hardly be attributable to a miserly supply of corn tags.  Massive amounts of money have been created in the last two years.  The Federal Reserve has tripled its balance sheet until it now stands a little less than 20% of gross domestic product.  But this isn’t deflation.  In fact, given the overall contraction in quantity demanded, prices should be declining and they aren’t.  Low as CPI growth is, it points instead to inflation. 

Prices will continue to hold stable or barely rise, given all the monetary stimulus, which will create the illusion of steady or growing demand.  Which will tell producers to keep producing, though their markets are actually contracting save the monetary illusion.   Thus when the illusion wears off, prices will crash.  Two bushels of corn will be had for one corn tag.  Until the excess supply is consumed and corn producers begin producing less, declining prices–not due to deflation, but due to oversupply–will grip the land.

In short, there is no monetary prescription for what ails us.  More money, more “quantitative easing”, will do nothing but exacerbate the problem.

Advertisements