Inflation is something we all know. We experience inflation as a rise in prices though that is not the definition of inflation. Deflation is not something we hear often in the press or from the wizards in government or the Fed. The “D” word has a bad connotation and I submit that most have little understanding of deflation. In my book, I spent two chapters outlining both inflation and deflation.
Inflation is an increase in the supply of money or credit. We feel the effects of inflation through increases in prices. But prices can also increase for other reasons. For example, if there is a bad crop, there will be less of that crop and with a constant demand, the price of that crop will increase. In the U.S. we experienced this condition with the summer drought. If we remove the effects of mother nature, as in the earlier example, prices increase since there is more money or credit chasing goods in the economy. The seminal example of this condition in our economy was housing. Not only was credit more plentiful for home buyers, it became a national imperative as part of the American Dream. The source of credit creating this supply is the banking system. Once we have this new credit sloshing around the economy, the debtors have to pay back the loans plus interest. The source of interest payments is newly created credit from the banking system.
Deflation is a decrease in the supply of money or credit. Credit contracts when debts are paid or there is default. Additionally, when there is less borrowing and lending, it can also put pressure on the credit supply since new borrowing and lending is often used to pay old credit (see the U.S. Government). During deflationary periods, the existing money and credit in the system becomes more valuable, which means it has more purchasing power. The best example of this effect is once again in housing. Real estate prices peaked in 2005, a whopping seven years ago! That means that, for investment purposes, if one had deposited money in the bank in 2005 and purchased a home in 2012, the purchasing power of that money increased substantially – you can buy more home for the same money.
The Fed wizards are quite fearful of deflation. How do we know this? In response to the housing bubble collapse, the Federal Reserve increased the supply of money in the economy. They did not start a printing press and throw money out of helicopters. Rather, the Fed bought assets that the market did not want. This is done with a sleight of hand through the instantaneous creation of credit.
Imagine having a stock and bond portfolio that fell in price during the time you owned it. Your net worth was strongly tied to this portfolio. There are others in the market who own the same assets that experienced the same fall in value. You realize that selling these assets in the market will be difficult since there will be no buyers and those that do exist, will heavily discount your portfolio. Your situation seems hopeless. In steps the Fed wizard who agrees to buy your entire portfolio for what you deem a good price. In that instant, the Fed credits your bank account for what they just purchased. The economy has more money/credit in the system since now there is your old stock/bond portfolio plus the amount the Fed put in your bank account. This is what the Fed has done since 2008. They have purchased the portfolios of others and credited their bank accounts (to the tune of nearly $2 trillion).
The government wizards have also been at work. The Keynesian formula of reviving a moribund economy is to throw more spending at it. Since 2008 Federal Government debt is now up to $16 trillion, more than the country produces in a year. It’s not as if the government had a reserve fund of previously saved money to throw at the economy. Every year they run a deficit, they must borrow this money. The creator of this credit can be the Federal Reserve or the banking system. These deficits bring yet more money into the economy.
The Fed and the government have been hard at work putting more money/credit in the economy. They are doing this not for fear of inflation but rather deflation. What would have happened if neither the Fed nor government had taken this action? The easy answer is that there would be less credit floating around in the economy. This would have made the economy feel “poorer” and caused a sizable economic contraction. There are those that feel that all this credit creation will lead to a raging hyperinflation. To date it has not, not even close. Helicopter Ben (the Fed wizard) is not afraid of hyperinflation but rather deflation and he and his fellow wizards will take every step necessary to defend against the “D” word.
Fed and government action cannot continue perpetually. The market is coming to the realization that the spells put on the economy by the Fed wizard (QE I, II) have not had the desired effect. Government spending will not continue at its current trajectory for two reasons. First, there is less appetite for it and secondly higher interest rates will begin to consume more of the Federal budget. Another important consideration is the psychological condition extant during a deflationary period. Deflation encourages less borrowing by saturated debtors and less lending by fearful creditors. Deflation is what the market is telling us. The Fed and government realize this and are doing everything in their power to forestall it. The market is quite transparent in what it wants to do. The wizards continue to ignore these signals at their own peril.
Jim is the author of Escaping Oz: Protecting your wealth during the financial crisis.