Don't Buy Into the Deflation Delusion

“If one-half of the commodities in the market rise in exchange value, the very terms imply a fall of the other half; and reciprocally, the fall implies a rise.” – John Stuart Mill, Principles of Political Economy

Despite the fact that the dollar’s value versus gold and other major currencies remains near modern historical lows, the word “deflation” has crept into the economic discussion. Indeed, having fallen hook, line and sinker for the oxymoronic notion that governments can somehow create wealth out of thin air with money redistributed from wealth creators, Nouriel Roubini, today’s economist of the moment, has generated reams of new publicity with his deflation argument. The problem there is that what he assumes once again cannot be.

The mistake Roubini and other economists make is in tying changes in consumer prices to changes in the broad price level. More realistically, the price level can only change as a result of a decline or increase in the value of the monetary standard, and with the dollar still historically weak, all signs point to inflation. But to show why simple changes in consumer prices can’t in and of themselves alter the price level, it’s best to look at rising prices first.

A few years ago Nintendo released its revolutionary Wii game consul. Having failed to account for frenzied demand in the U.S., Nintendo didn’t manufacture enough, and the consoles quickly sold out. If one had been desperate to buy a Wii, they were available for resale, but at prices much greater than the original advertized price.

Was this a signal of inflation? Not at all, and the reasons why are very clear. If demand for certain items is driving their prices up, it must be that demand in other areas is falling. By the same token, if hotel-room rates quadruple in Washington, DC during the Obama inaugural, visitors to the District will have that much less money to spend on other items once in town.

The basic point here is that demand-driven price increases are in no way inflationary. If consumer demand is causing price spikes in certain categories, there must be a falloff in others. In this sense, the price level remains unchanged over time owing to the reality that all prices must adjust to changes in consumer preference.

When we look at consumer-price decreases, the same phenomenon applies. If for instance production enhancements make formerly expensive flat-screen televisions cheap, there’s no deflation to speak of. That is so because falling prices in certain areas merely expands the range of purchasable goods within reach of the consumer. Thanks to money saved on the flat screen, the average consumer now has more money to buy other goods previously unnattainable. Once again, the net effect on the price level is zero.

Oil's lower price is frequently cited as further evidence of deflation, but at $44/barrel, oil has simply reached its normal, historical price per one ounce of gold. And just like the flat-screen example, if cheaper oil means lower gasoline prices, the consumer now has greater access to other goods previously too expensive.

Some economists who believe economic weakness drives down prices would still disagree. They would and do contend that when an economy is flagging, the prices of goods fall to match lower demand.

The above sounds nice, but the thinking is rooted in the faulty assumption that one can consume without producing first. In short, economists suppose a logical impossibility.

In the real world, we trade products for products. We’re only able to demand things to the extent that we’ve produced first.

And given the basic truth that supply is the path to demand, any falloff in the latter is by definition a decrease in supply. In that sense, falling demand for all consumer goods means there’s been a commensurate drop in supply.

This is why classical economists have regularly noted that money itself is insignificant except as a means of exchange. When we’re earning less money it really means we’re producing less in such a way that we possess less demand. As a result, there’s no broad pricing change when demand shrinks.

So when true deflation and inflation are considered, both are a change in the value of the monetary unit (in our case, the dollar) that over time impacts the prices of all goods measured in the currency. While commodities reacted to the debased 1970s dollar almost instantaneously in the form oil “shocks”, other consumer prices took years to adjust to the weaker greenback. The CPI inflation measure is truly faulty, but it continued to rise into the early ‘80s despite a much stronger dollar thanks to prices of lagging goods still adjusting to the old value.

Looked at today, we know we don’t have deflation by virtue of looking at the value of the dollar. To compare it to other foreign currencies isn’t terribly effective owing to the fact that we live in a world of currencies that lack any objective definition. But gold still serves its useful purpose as an historically stable measure of value. And with the dollar worth 1/770th of an ounce of gold today versus 1/253rd per gold ounce in 2001, it’s fair to say we don’t have a deflation problem. Quite the opposite.

People in the Roubini camp point to “debt deflation”, but unless most Americans took out big loans last July, it’s far more true that they’re making out like bandits for paying back dollars significantly weaker than what they borrowed. We’ve had deflation before in this country, but not now.

Why this isn’t more obvious has to do with how certain economists read economic weakness. When we inflate, the economy recedes thanks to investors going on strike. With capital moving into hard assets, the entrepreneurial economy suffers, production drops, and retailers put on big sales to move inventory in an economy lacking demand due to a lack of supply.

So while the economy is presently deflated thanks to inflationary monetary policy this decade, don’t fall for the popular and empirically untrue delusion that is deflation. That is something else altogether, and will only reveal itself when the dollar is significantly stronger than it is at present.