I recently stumbled on a great opinion piece about deflation. My aim here is to shamelessly plagiarize it and hopefully add my own two cents.
First, the basics. To understand inflation and deflation, one must first understand something about money. Money, of course, represents value. We know that any item we buy in a store has a certain value in dollars. A medium cup of coffee at my neighborhood Dunkin Donuts has a value of $2.00. However, the reverse is also true: money has value that can be expressed in terms of items. I know that a cup of coffee has a value of $2.00; therefore I know that the value of $2.00 in terms of coffee is one cup, and that $100.00 is valued at fifty cups. This is simple.
Now consider the derivation of an item's value. Typically, the value of items is based on their rarity. Diamonds are rare, so they have a high value. A food like corn is not rare, so it has a low value. Water is rare in some countries, so there it is expensive. But in a country like America water is plentiful, so its value is very low.
This is why items produced in China are so cheap. Consider t-shirts manufactured in China. The population there is very large, which means labor is not rare. The factories that make the t-shirts use materials that are not rare (cotton or synthetics). Furthermore, they make a lot of them. This means that t-shirts from China are not rare at all, which means they have a low value, which means they have a low price in dollars.
So, if money has value and value is determined by rarity, how do we determine the value of money? How can money be "rare" or "not rare"? It is just money. The answer is the same as it is with other things: the more dollars there are the less rare each one is.
Let's say that a t-shirt produced in China has a value of $5.00, and, in total, China produces ten million t-shirts each year. Now let's say one year China decides to produce twenty million t-shirts instead. Since there are now twice as many t-shirts they are each half as rare, and therefore have half the value. The price of a t-shirt would drop to $2.50.
Now the same can be applied to the money supply. Imagine that China simply keeps producing ten million t-shirts per year and they cost $5 each, and the total amount of dollars in the economy is one trillion. Now imagine that the number of dollars in the economy doubles to two trillion. Just like before, the rarity would be cut in half, and so would the value. Since the dollar would now be half as rare and half the value it was before, the price of a t-shirt would rise to $10.00.
The value of money changes when the total amount of money changes. Simple.
Which brings us to inflation. Inflation occurs when money becomes worth less. Money becomes worth less when there is more of it in existence. When money becomes worth less, prices rise. Inflation.
Deflation, you would think, should then be the exact opposite. It is, but it isn't. If the amount of money in existence did decline its rarity would increase and so would its value. This would certainly be considered deflation.
The reality, though, is that the money supply rarely decreases. In economies where gold is the basis of money, the amount of gold usually increases ever so slightly year by year as more is discovered and mined. In economies where money is entirely an imaginary entity (like ours), the government tends to print more money rather than destroy it.
But deflation can occur even if the money supply is increasing slightly. Deflation occurs naturally as technology advances. Computers are an excellent example. As humans become more and more efficient at building computers, it costs less to make them. Computers become less and less rare every year. Therefore, the price of computers is steadily declining. In this sense, the dollar (in terms of how many computers it could buy) is deflating; the value is increasing.
Now imagine an economy where the amount of money is always constant, like in the one trillion dollar economy we imagined earlier. In such an economy, there would probably be a slight deflationary trend, since the only changing factor would be technology. Most items, whether they be t-shirts or computers, would constantly become less and less rare. Therefore, each dollar would have a higher and higher value.
So there you have it, inflation and deflation and why they happen. Now the question is, which one is more desirable?
Deflation is.
If you have ever discussed economics with just about anyone, you probably scoffed at that last remark. The general consensus amongst most popular economists (and politicians, from whom most people learn their economics) is that deflation is dangerous and should be avoided. This is the conspiracy that is discussed in the article I mentioned earlier. To claim to a politician that deflation is more desirable than inflation is almost like claiming to a Viking that the Earth is round. In fact it is exactly like this, because both claims are equally true, both parties mentioned are equally wrong, and both facts are equally obvious.
Fear of deflation is quite silly. According to those who fear it, people do not buy things if their money is increasing in value. When you think about this for less than three seconds, it almost makes sense. A person may decide not to buy something today if he knows it will be cheaper tomorrow (or, more realistically, next year). If deflation ruled, everything would certainly become cheaper and cheaper all the time. So, to the skeptics, this means that if deflation occurred the economy would come to a halt.
Of course, if you have ever heard of an iPod you see the flaw in this theory. iPods get cheaper all the time and, even better, they get cooler and more advanced all the time. This doesn't mean that people simply wait endlessly because they know there is always something better around the corner. People buy iPods because they like iPods, obviously. The same applies to computers and TVs. It applies to lots of things on varying scales. When automobiles were first invented they were expensive and not very nice. Over time they continually got cheaper and better. But did people from the 30's to the 80's decide to hold off on buying a car? Of course not. They bought lots of them.
As you may have gleaned by now, it would be better for most people if deflation ruled, or, at least, if inflation weren't so rampant. People would always be buying better things, and so good things would become less valuable, opening the door to even better things and even more advanced technologies. As is pointed out in the Bloomberg article, there really is no historical precedent that suggests deflation is dangerous.
Economists and politicians defend the inflationary economy so staunchly because it benefits them the most. Prices tend to increase first, before wages do. Therefore, working people are forced into debt in order to buy the things they need. Debt is a gold mine for the elite that run the economy. Under deflation, debt is not needed as much and it is easier to pay off. It is also much easier to save money.
For the government, inflation is a way to tax without increasing tax rates. If a government prints a large amount of new money, they will inflate the economy and prices will rise. But the inflation takes some time to occur. In the mean time, the government can spend its new money at pre-inflationary prices. Later on when inflation hits, the companies that the government paid realize that their money is worth less. In order to get the same value of money as they lost by giving away items to the government, they raise prices. The consumer fills in the gap.
The sad result of this is that neither Republicans nor Democrats will ever stop inflating our money supply. Republicans tend to be friendly with big corporations that benefit from inflation. Democrats like to spend money on government programs, so they need the invisible tax caused by inflation. Even worse, most politicians don't even understand these concepts. They simply learn at some point (probably from popular economists, who often get research grants from the government) that inflation is safe and deflation is not. And in their minds, that is that.
Damn Vikings.
I have been rambling on about flation for so long because it is so very important. When you frame political issues in terms of monetary policy they start to look very different then the way they come out of Barack Obama's mouth on TV.
Everybody has heard Obama and others lament about the growing distance between the upper and lower class: the rich are getting richer and the poor are getting poorer. The middle class is disappearing. Not realizing (or not caring) that this is the result of inflation of the money supply, the president and the rest of Washington decide to solve this issue by inflating the money supply at an accelerated rate.
It changes so much that it is hard to keep track, but it is sounding like the government is going to double the national debt over the next several years, or maybe just this year. Either way, this will cause more inflation and more disparities between rich and poor. When the government buys things with imaginary money, it increases the supply of imaginary money. Money becomes less rare. It loses value. It inflates. Simple.
The ramifications of this are enormous. All of a sudden a "recovery act" that is supposed to create all kinds of jobs and wealth starts looking like an inflationary device that will simply keep debt-ridden, poor Americans exactly as they were before: debt-ridden and poor. This is the power of flation. It's not an exaggeration!
Knowing this, you can understand why Ron Paul talks about inflation (and the Federal Reserve, who facilitates most of it) so much. Almost every question he is asked, he ends up coming back to the Federal Reserve and monetary policy. To people who don't think about flation, this makes him seem like a one-line fool. But people who grasp its importance understand that our government's rampant inflation of the money supply is really the root of many of our problems. Really.
This is also why, no matter how many new regulations he puts in place, Barack Obama will not really change America. The economy will continue to work the same way as long as the government continues this behavior, and Barack Obama certainly plans to. "Regulations" are trivial compared to monetary policies that throw trillions of dollars around like they're day-old Skittles.
The most important question is, how do normal people deal with an economy they don't control? There are two answers.
One way to deal with it is to ignore it. Money isn't everything, after all. And, heck, if the country does eventually crumble in depression and get taken over by China, think of all the pork fried rice we'd be eating!
The second way to deal with it is not to vote for idiots. Okay, okay, "idiots" was the wrong word. Politicians like Barack Obama and George Bush aren't idiots, they just haven't accepted flation, and they never will. I recommend checking out Libertarians, or Libertarian-in-the-closet-Republicans, like Ron Paul. It's also a good idea to try and learn economics, which I do by checking out books recommended by Ron Paul. Seriously, that guy's just the man. (And he's so adorable!)
Either way, I suggest you buy your coffee early and often. You never know when Dunkin's gonna pull a fast one on you. That day will come, my friends.
