Daily Article by
Matthew Beller | Posted on 7/24/2008 12:00:00 AM
Inflation Deflation Red-flation Blue-flation - Matthew Beller - Mises Institute
A debate has been raging for some time among those in the finance industry about whether the United States is currently experiencing inflation, deflation, stagflation, reflation, hyperinflation, or maybe even some other sort of "-flation" that only Dr. Seuss could imagine.
Unfortunately, much of this debate is unproductive because the participants use varying definitions of these terms, and even when they use the same ones, deciding on one simple label might not be sufficient to describe the deeper economic forces at work and what their effects are likely to be. Given the confusion, this article will add some color to the debate by offering usable definitions of the terms
inflation and
deflation and then attempt to show what is occurring in today's economy
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One reason that Austrian economists place so much emphasis on the phenomenon of inflation is that it often causes boom-bust cycles. It is a specific type of inflation, however, that causes unsustainable booms, which I term "bad inflation." This is the type of inflation that occurs in fractional-reserve banking, where money that is intended to be used for current consumption is loaned out to businesses, sending false signals about people's preferences for current vs. future consumption, which makes it impossible for businesses to properly allocate resources. To the extent that market participants are not aware of the money creation or are not able to determine its rate or otherwise adjust for it, they will undertake business ventures and adopt consumption patterns that are unsustainable. In precisely the same way that Ponzi schemes can operate seemingly healthily for years or more before collapsing, the unsustainable booms caused by "bad inflation" might persist for a while, but will eventually go bust when reality surfaces, prices adjust, and previously profitable enterprises go out of business.
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Those who insist that Federal Reserve policymakers have the ability to simply print up as much money as they want are completely right in one sense, but they perhaps fail to realize that the bulk of the money supply is in the form of circulation credit, which banks, rather than the Fed, produce. The Fed directly controls only the monetary base, which is basically comprised of physical currency and bank reserves. When the Fed purchases securities through its open-market operations, the monetary base increases by a corresponding amount, but it is ultimately the banks and their customers who determine the amount of circulation credit built on top of the monetary base. This is where the idea of the Fed "pushing on a string" takes its meaning. The Fed can let out slack to the banks by buying securities from them to increase their reserves, but it cannot force them to take up that slack by loaning those reserves to businesses.
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Most people are led to believe that deflation is a bad thing, but it is not. In fact, it is precisely what the economy requires to eliminate the malinvestment created by the Fed's inflationary policies. Unfortunately, deflation tends to be politically unpalatable because it causes, among other things, a temporary increase in unemployment as capital resources are reallocated to more productive sectors. Accordingly, it can be expected that the Fed will do anything it can to avoid deflation, not to mention the fact that its chairman, Ben Bernanke, has
gone on record discussing the importance of preventing "deflation" (he uses a definition of falling prices).