The Need for Deflation

In a follow-up on Tarran’s excellent Primer on Money, I’d like to take the opportunity to bring the lessons to bear on our current financial situation.

Tarran correctly points out what has happened with the US Government and its ability to control the money supply:

Today, the United States government has engaged in massive amounts of spending. They are not getting this money through taxation. Rather they are borrowing it, and a good portion of what is being borrowed is money created by the Federal Reserve.

As Milton Friedman pointed out, inflation is always a monetary phenomenon. Here’s my quick and dirty example of inflation:

Imagine if you were in a poker game with four other people. You each put $50 in. That means there’s $250 on the table. Now, you’re playing with chips instead of cash. The banker makes sure each of you get the equivalent of $50 in chips. So far, so good, right?

After a while, the guy sitting to your left starts losing chips on some bad bets. He’s not wiped out yet, but he’s not doing great either. You start watching him more carefully as he continues to lose money. Suddenly, through the buzz you’ve got going after four beers, you realize that he should have run out of money two hands ago. He’s been adding chips to the game! Worse, they look identical to the chips used by the banker.

You call the guy on it, and the rest of you decide it’s time to cash out. There’s a problem, though, because now there are more chips than there is real money. In other words, your chip supply has been inflated beyond whatever value was backing it. So, to cash out of the game, you would have to adjust the value of the chips so that all the chips added together equals $250, now making each chip worth less than it was before.

In this example, by introducing more chips into the game, our cheat was able to steal a little bit of money from each of the other players in the game to continue his play after the point he should’ve been bust. His deliberate inflation of the chip supply was theft.

Now, take this example and apply it to what happens when the US Government demands freshly-printed money from the Federal Reserve for spending. All the other dollars in circulation lose a little value upon the creation of that new money. In other words, the US Government has gotten the Federal Reserve to steal a little bit of buying power from your wallet, bank accounts, and investments by forcing them to print new money. That’s theft!

It’s theft in reality, but because of the party committing the theft, we have a special name for it: a tax. So, in the case of the US Government, inflation is taxation.

But, that’s not all that’s been going on. The Federal Reserve has been spurring on the appearance of economic activity by loosening lending standards and fueling a credit bubble. Consumers make decisions based on the total amount of money available to them, both earned and borrowed. So, when lenders are encouraged through regulation and a loose Federal Reserve money supply to lend more than they normally would, that also causes inflation. In this case, it’s a tax paid by all to make some appear more prosperous than they really are. Another example of the inflation as taxation.

Consider a common complaint from the left about the Bush presidency, voiced here by none other than Barack Obama:

“We have now lived through the first so-called economic ‘expansion’ on record where typical families saw their incomes fall, and working-age households lost more than $2,000 from their paychecks,” said Mr. Obama, referring to inflation-adjusted figures compiled by the Census Bureau.

Productivity expanded, but workers lost money from their paychecks. How could that happen? Workers had that money taxed away from them by the inflation caused by the borrowing to cover the Bush Administration’s profligate spending. How does Obama propose to address the impact of the inflation tax on ordinary workers? He wants to increase the inflation tax by spending even more:

Eager to jolt a worsening economy back to life, President-elect Barack Obama’s aides are assembling a two-year stimulus package that could cost $850 billion, dwarfing last spring’s tax rebates and rivaling drastic government actions to fight the Great Depression.

That, of course, is exactly the wrong thing to do. Sadly, Barack Obama and his comrades in the Democratic Party have no concept of an inflation tax and can therefore never realize the harm it is doing. (Then again, neither can most Republicans.)

The real solution is indicated in the positive economic signs pointed out by Tom Blumer:

The hopeful signs are these:

  • As of December 19, oil is down over 70% from its summer peak. Many drivers are spending over $150 per month less on gas than they were just five months ago.
  • The Fed has taken interest rate reduction as far as it can go, which has taken mortgage rates to historic lows. Refinancing activity has picked up, disproving the notions that credit isn’t available to worthy borrowers and that most of us are a bad hair day away from homelessness. This is an ideal opportunity for those who have good credit but poorly structured adjustable-rate or interest-only mortgages to get out of them, and for those carrying 6% or higher fixed-rate mortgages to lower their monthly payments or draw out equity. (Yes, Virginia, people in most states still have plenty of home equity.)
  • A falling Consumer Price Index of -1.7% led to real earnings growth of 2.3% in November. A repeat performance but with smaller numbers looks likely in December.
  • Christmas shopping season retail sales, while still far less than impressive, might not be as bad as originally predicted.

Look at the third sign, the falling Consumer Price Index (CPI) leading to an increase in real earnings growth. This means that, with falling prices, companies have had more buying power. No doubt the same is true of consumers, as the better than expected Christmas shopping numbers indicate. Personally, I’ve been able to stretch my paychecks much more in the last couple of months than I’ve been able to in a long time.

In other words, we’re experiencing a holiday from the inflation tax. Suddenly, the value of the dollars in our wallets and bank accounts isn’t eroding. In fact, it’s increasing. Workers are finally seeing an increase in the buying power of their paychecks. The trend the left has been whining about for almost a decade has come to a stop.

This is deflation at work. We need deflation to put economic power back in the hands of the little guy and the small business, neither of whom can curry favor with Washington D.C. the way the rich and big business can. We need deflation to allow the young who are making their way into the world to have a shot at an independent life.

While the holiday season is coming to a close, we need this holiday from the inflation tax to continue until the monetary bubble of the last two decades is but a memory. This means no bailouts, no stimulus packages, and no manipulation of the money supply to create sham prosperity. The left is fond of telling us that dissent is patriotic. In this case, it’s true. Opposing the Keynesian orgy of spending and inflation that is sure to arrive after January 20, 2009 is the most patriotic thing any American can do in the coming year.

  • Don Lloyd


    Your premise that we need deflation is false.

    Where you are correct is in opposing attempts to prevent the deflation that is already baked in the cake.

    But deflation itself is not something that is to be desired, but merely a symptom of a credit contraction on the one hand, and an excess supply of goods on the other.

    While it is true that a price deflation can allow you to stretch your paycheck, that assumes that you will continue to have a paycheck to stretch, an unlikely assumption for many auto salesmen and retail workers, to name just two.

    There is no overall benefit in trying to undo a past monetary supply inflation with a monetary supply deflation. The health of any economy is not dependent on either absolute price levels or any given supply of money. What matters is that relative prices are consistent between output and input factors.

    Regards, Don

  • tkc

    Deflation, while undesirable, is what is needed. It is the bad tasting medicine that will cure the problem.
    Yet the government is throwing trillions into the mix with less than stellar results. There is a very real possibility that these trillions won’t grow the economy and turn into run-away inflation.

    History has examples of this. Recently, Zimbabwe. Not so recently, the Weimar Republic.

  • Miraj Patel

    Deflation is what we need, but the kind that is happening currently isn’t because of a stronger dollar. As Don Quincy said, this deflation is caused more by falling demand and increasing supply or products. It makes it appear as if the dollar is stronger because there is more buying power, but as soon as demand goes up we will see that that is not the case. As countries start to get out of the recession we will see prices go up and naturally, the dollar will weaken. The unfortunate part is that the dollar will be hit especially hard because when prices start to go up we will also start to really notice the effect of the massive printing of the money that you wrote about.

    The best that we can do is oppose future bailouts and unnecessary government spending as you proposed because that will keep the dollar from falling even further. In the long run, we just need to stop printing money backed by nothing and make our currency sound once more.

  • Miraj Patel

    Sorry for the mix up, I meant to say “as Don Lloyd said…”

  • Quincy

    Don –

    You write:

    There is no overall benefit in trying to undo a past monetary supply inflation with a monetary supply deflation. The health of any economy is not dependent on either absolute price levels or any given supply of money. What matters is that relative prices are consistent between output and input factors.

    The problem is with the runaway money and credit supplies of the last ten years running so far ahead of actual economic output that almost everything is overvalued in dollars. While I’m not in favor of deliberately contracting the money supply, as was done in 1929, I believe we need to allow the natural deflation caused by the credit contraction to occur.

    Loosening lending standards and trying to prolong the constant inflation of recent times is a recipe for surefire disaster. Our monetary authorities, so long as they insist on having a monopoly on the currency, have a duty to act responsibly towards the currency they shepherd and the citizens they shepherd it for. The Federal Reserve has been a complete failure in this regard.

  • Quincy

    Deflation is what we need, but the kind that is happening currently isn’t because of a stronger dollar. As Don [Lloyd] said, this deflation is caused more by falling demand and increasing supply or products. It makes it appear as if the dollar is stronger because there is more buying power, but as soon as demand goes up we will see that that is not the case. As countries start to get out of the recession we will see prices go up and naturally, the dollar will weaken.

    Miraj –

    This is neither true nor what Don said. You’re repeating a fallacy put forward by ignorant economists and media hacks. Inflation and deflation are clear, simple phenomena. When the number of monetary units in circulation increases relative to what is backing them, that is inflation. When the number of monetary units in circulation decreases relative to what is backing it, that is deflation.

    What is happening right now is that the number of dollars available to spend is decreasing faster than economic output. The reason for this is that lenders have tightened standards in response to losses incurred in the credit crisis. This is a deflationary signal sent by the market.

    The thing I find worrisome is that Bernanke and his crew at the Fed are trying to bring the credit supply back to the point it was before the credit crisis began in the name of staving off deflation. Such a move is economic suicide since it tempts lenders into going against their own better judgment, which is what leads to a sound credit system.

    Personally, I’m an advocate of mildly overproducing money to cushion the blow of the strong credit contraction. Allow deflation to happen too quickly, and you have a shock to the economic system. Never allow it to happen, and you have nothing to keep the value of the currency in line with reality.

  • Akston

    Perhaps they should just close the money hole.

  • Quincy

    Akston –

    Thanks, that was awesome!

  • Persnickety Curmudgeon

    Gentlemen another great article from great website and great debate. Consider this – we have neither INflation nor DEflation but CHANGEFLATION.

    If the flation we have was IN, ALL prices would be rising. If the flation we have was DE – ALL prices would be falling.

    Instead what is flating is changing. Big Ticket items – homes, cars, electronics etc. are falling. Everyday items – food, clothes, education are rising. [ Energy is up and down as usual though it appears we are in a short term down cycle within a long term uptrend – and let’s not get into Healthcare]

    In any event, what we have is long term changes to patterns of consumption due to demographic changes and the satiation of current demand for the deflating items. Everyone who wants and can afford 2 cars, 2 houses, a big screen tv, a computer etc. already has them.

    Look. Baby Boomers don’t need any more of that stuff – they have all the money and the good jobs and may even be looking to sell what they do have and downsize and they don’t want to buy non of that stuff no more.

    We are good at making stuff but no one will buy our stuff BECAUSE – we don’t need the stuff we needed yesterday.So now either we pay unempolyment or we subsizdize obsolete industries which were needed in the past, may be needed in the future, but are not needed now (ie. automakers at current capacity).

    On a divergent note – want a quick fix to the housing problem? Start tearing down old houses. Then we have jobs to tear down and jobs to rebuild(green jobs too) as the new houses will be more energy efficient than the old [apparently the energy used to tear down and rebuild is never counted in such calculations so just work with me on this one].

  • Miraj Patel

    @Quincy I understand that the supply of money has an effect on inflation/deflation, but you need to realize that the supply and demand for products also plays a part into it. The definition of inflation according to merriam-webster dictionary is “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services” ( The keywords here are “relative to available goods.” The amount of goods that are available has an effect on the price and hence plays a part in inflation/deflation.

    Don’t get me wrong, I agree with you on limiting the amount of money printed because that too plays a part in inflation. I also agree that bringing the credit level back to what it was before this economic downturn is also very dangerous.

  • Quincy

    Miraj –

    Put simply, the dictionary is wrong. It’s using a definition put forth by certain schools of economics to try and obfuscate the effect manipulation of the monetary supply has on the economy.

    To learn why the definition of inflation you quote is bad, consider the fundamental purpose of the price system. It communicates supply and demand through a proxy–the price people at which people are willing to buy or sell. Therefore, information in prices about supply and demand is desired information. If prices are rising due to increased demand, the price rise is genuine.

    Inflation and deflation, correctly defined, are pollution in the price system. They produce price fluctuations *not* driven by supply and demand. The dictionary definition you quote lumps both monetary fluctuations and genuine supply and demand increases into the definition of inflation. It’s mixing desired information and undesired information and calling it a single thing. This does not aid understanding of the economic picture, while the definitions I’ve stated previously do.

    Part of the problem, though, is the way the US Government chooses to measure inflation. The Consumer Price Index also conflates desired and non-desired information, thereby obfuscating the effect of fluctuations in the money supply. This aids in the ability of Keynesian economists to hide the damage their policies do.

    Consider, for a moment, the 1970s as an economic period in the US. Prices rose due to rampant inflation, but economic output stagnated as consumer demand languished. If monetary fluctuations and supply and demand were genuinely linked, as some economists would like us to believe (and as stated in the definition above), the 1970s could never have occurred. But they did, providing evidence that inflation should be considered an entirely separate phenomenon from increases in demand relative to supply.

    Milton Friedman has yet to be proven wrong on his assertion that inflation is everywhere and always a monetary phenomenon. It’s the only interpretation that fits the facts.

  • Quincy

    Persnickety –

    Based on my comment to Miraj above, I would ask that you consider what you term “changeflation” as the combination of monetary fluctuation and supply and demand for various goods.

    Take, for example, gas prices. The dollar is deflating due to a contraction in the money supply, so gas prices go down. However, the precipitous drop we’ve seen is not satisfactorily explained by deflation alone. Only when deflation is considered in conjunction with the sharp decline in demand for gasoline can one begin to explain the price drop.

    Take, for another example, the drop in price of a 42″ plasma TV since George W. Bush was first elected. These devices got significantly cheaper even though the money supply was constantly being inflated during that time and demand for them was increasing. Why? Supply was increasing so fast that it drove the price down in the face of high demand, and manufacturing costs continued to drop as well due to better technology and productivity on the part of manufacturers. Inflation was occurring at the money supply level, but supply and demand for this product was the governing force.

    Most of what you’re talking about under the name changeflation is actually changing patterns of supply and demand due to market saturation and changing demographics. That’s not to say that those things are not concerning, but they have nothing to do with inflation or deflation.

    As for this:

    On a divergent note – want a quick fix to the housing problem? Start tearing down old houses. Then we have jobs to tear down and jobs to rebuild(green jobs too) as the new houses will be more energy efficient than the old [apparently the energy used to tear down and rebuild is never counted in such calculations so just work with me on this one].

    Bastiat has already blown the theory apart.

  • Miraj Patel

    @Quincy Well I completely agree with you on your ideas, its just the definitions that caused the disagreement. “Inflation” is simply a word, so if you define it your way then you are completely right and if you define it the dictionary’s way, I am also completely right. I was never suggesting that monetary fluctuations and supply/demand are linked, I was simply suggesting that both play a part in inflation (if you use the definition I was using.)

    You bring up an interesting point on why your definition for inflation is more supportive of an Austrian economic theory whereas the dictionary’s definition is more conducive to Keynesian theory. As a believer in Austrian economic theory, I may start using your definition of inflation. The only problem I see with that is I would probably have to explain what I meant by “inflation” before talking to anyone who believes in other economic theories.

  • persnickety curmudgeon


    Last comment first, – re tearing down and rebuilding houses – that was somewhat tongue-in-cheek. HOWEVER here in Michigan it is the state sport when times are tough. Make work jobs which make use of Federal Money stolen (err taxed) from us – laundered through Washington and returned only after much begging by our congresspeople. All it ever gets us is some short term paychecks for unskilled labor and destruction of valuable edifi.

    On the rest of your comment – I think we are mainly agreeing here. My word is CHANGEFLATION but the point is the economy has become so efficient that capital and capacity swamp any perceived profit center with tsunami like force and speed. Govt regulations can’t keep up – nor can tax policy nor a lot of the labor force.

    I’m not making a value judgment nor was it the point of my post but these efficiencies require a flexible mobile workforce and we are up against a Baby Boom demographic used to a whole different way of life. They will protect their status quo and will hold sway for quite a few more years still.We will have economic disruption as they shift from spending their money on IRA’s, cars, houses, work clothes, business lunches and go to leisure, clothes, healthcare, travel etc.

    I was just pointing out that some things are inflating while others are deflating. Capacity or supply will eventually squash each bubble in turn but will also leave over capacity or supply in place at the previous bubble which government will then protect.

    As for inflation v deflation, the general trend of our economy is still inflationary because our govt. cannot function without it and they will see that we have it. And so, noticing a glut of cars and houses and tv’s, a prudent lender might say since no one needs those things for the next 5 years or so lets get that capital and put it into computers, and health care, and energy production and infrastructure or whatever. BUT NO! Our government does not want capital redeployed it will just print more money for those new growth industries and not require the old economy to relinquish theirs.

    This is why there is a good case for allowing some general deflation. It’s the best way to rest some power from the hands of government and the old economy. FORCE the more rapid deployment of capital to efficient sectors of the economy. Can’t afford to support money losing endeavors for long if their is less debt monetizing and currency bastardization going on.

    Or am I off base?

  • Quincy

    Miraj –

    The reason I’m so persnickety (with apologies to the curmudgeon) about using a definition of inflation/deflation that completely separates it from supply and demand is because the consensus definition, that includes supply and demand as part of the equation, is a construct of the Keynesians specifically designed to make their theories work.

    In this case, inflation and deflation are more than just words. Explain them Austrian way and you reveal that the US Government has been placing a shadow tax on its citizens for decades. Explain them the Keynesian way and you convince people inflation is just some fact of economic life. This kind of manipulation of language is straight out of Orwell’s 1984.

    The left knows that if you change the definition of words, you can change the idea underlying them. Take away a word, you take away the ability to express that thought. A century ago, the people writing this site would’ve been called liberals, and those hearing the word would’ve known that this meant people who supported liberty. Now, liberals are pro-government socialists who see liberty as an obstacle. Liberalism now has nothing to do with liberty. We poor souls who believe in liberty are stuck with the moniker “libertarian”, which the left has managed to convince the populace means “whackos who support drug use and are willing to let the poor die in the streets in the name of free markets”. (I exaggerate, but not by much.)

    Words matter, especially when someone is trying to steal a word to hide the truth.

    persnickety curmudgeon –

    I find the idea behind changeflation very true, and indeed that’s exactly what’s happening now.

    Your thoughts on what the US Government will do to keep up the sham of perpetual prosperity are also right on. The market could no longer bear the insanity of the perpetual prosperity sham and so forced the credit supply into its current contraction.

    The contraction needs to occur so that lenders can gain some control about which credit risks are on their books and in what amounts. It also needs to occur to force things that are overvalued down in value and clean some pollution from the price system.

    You’re right on base with the idea that the deflation will force redeployment of capital in a more efficient manner, and that this is a good thing.

  • Akston

    I just read the quote below and it reminded me of this thread:

    To preserve our independence, we must not let our rulers load us with perpetual debt. We must make our election between economy and liberty, or profusion and servitude. . .I place economy among the first and most important of republican virtues, and public debt as the greatest of the dangers to be feared.

    – Thomas Jefferson

  • Miraj Patel

    @Quincy When I said inflation is just a word, I didn’t mean that it didn’t matter, but instead that what really matters is how u define the word (sorry to be unclear on that.)

    I understand why you use the original definition of inflation as it was first and it shows the flaws of Keynesian theory, but the meanings of words do evolve. You gave me an example of it with “liberal.” Back in the day you would’ve been labeled a liberal, but now you wouldn’t. So would you call yourself a liberal today, since it was the original definition of what you stand for? In the same way maybe the word “inflation” has evolved (whether or not the left did it for their benefit doesn’t matter because it has evolved.) If you use the original definition of inflation, then I think it should be clear what you mean by it so that people don’t get confused and take your piece in the context of the “new” definition of inflation, like I mistakenly did.

  • Quincy

    Miraj –

    There’s a difference between the natural evolution of language and the deliberate manipulation of it for political ends. The former is desirable, as it shapes the language for the reality of the day. Look at the French, who try to preserve their language against such evolution but fail. The latter is a way for those who favor certain ideas to rob the other side of the ability to debate them, and that is the reason it must be resisted.

  • Miraj Patel

    @Quincy I agree with you that manipulation and evolution is different, but the manipulation can be seen as a means of evolution (even though its not desirable for everyone.) All I am saying is it may have been better to explain that you are using the true definition of inflation in this post because not all of your visitors will know of that definition, meaning your post might be misleading. Heck, even I thought you were using the new definition of the word and I am even a supporter of Austrian economics- what about all those visitors who are of Keynesian, Marxist, or some other thought who don’t define inflation as you do?

    I think more people use the new, manipulated definition, no matter what their economic beliefs are so it might be better to use that definition- either that or just write a quick sentence or two saying that inflation has nothing to do with supply/demand.

    I am on your side here, just trying to help get the message through to everyone :)

  • Quincy

    Miraj –

    I know you’re on my side, the whole change the language change the debate thing is a sore spot with me. Hopefully people who read the post, and the comments can learn the pitfalls of the false definition of inflation and deflation.

    Thanks for a great debate, and please keep the good comments coming!

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  • Miraj Patel

    @Quincy Yes, it was a good debate and I will be sticking around, so hopefully we’ll have more in the future :)