There is a great movie named "Usual Suspects" starring Kevin Spacey in the role of Roger "Verbal" Kint, who is thought to be simply a petty con man. Well, lo and behold, we ultimately learn that Verbal is possibly also the notorious and ruthless criminal, Keyser Soze. Either in legend or fact, Keyser Soze is described as a "spook story that criminals and bad guys tell their kids at night," a figure of fear and legend that knows no bounds. He is the consummate "Boogeyman." Deflation, prices decreasing over time, the opposite of inflation, is the economic equivalent of Keyser Soze. I picture a cluster of central bankers and other prominent Keynesian economists huddled around a campfire exchanging graphic stories about the nefarious evilness of deflation. Unfortunately, they have it all wrong.
Deflation has been on the receiving end of an undeserved bad rap for practically 100 years. This is largely based on the experience of the 1930s (Great Depression) when deflation was synonymous with economic depression. However, correlation does not imply causation. Just because two things happen together or are related, it doesn't mean one causes the other. There are often other explanations for their relationship. The most likely cause of the Great Depression would be a Perfect Storm of massive deleveraging after the 1929 stock market crash, bank failures due to lack of liquidity, the Fed's tight monetary policy, and the ill-timed Smoot-Hawley Tariff Act of 1930. Easy credit funding excessive speculation fueled a financial bubble in the stock market. The bubble burst. The Federal Reserve Bank also made a huge mistake with the banking system. Instead of flooding the system with liquidity and back-stopping banks in their capacity as the lender of last resort, the Fed did just the opposite. Many of the banks that failed were simply illiquid, and not insolvent.
Today's regulators and policymakers remain hung-up on deflation in general and ignore the fact that deflation is normally positive and can be driven by many different factors. They erroneously believe when prices are falling, consumers and businesses choose to delay purchases, hoping for even lower prices, leading to a decrease in aggregate demand. This viewpoint assumes consumers are both disciplined and patient, something I have yet to witness in my lifetime. In addition, purchases such as food, energy, auto expenses, and housing expenses cannot be deferred. Most of the time, deflation is beneficial to an economy. It gives consumers greater purchasing power. How often have you heard somebody complain about paying a lower price for a product or a service?
Besides a decrease in total demand, which can lead to problems in an economy, deflation can be driven by a decrease in the money supply. This is an extremely rare occurance - happening four times in the history of the country. Deflation is most often associated with rapid productivity growth and positive output growth. Technological advances would be considered the Great Deflator. Deflation can also promote economic growth and stability by enhancing the function of money as a store of value and encouraging real savings. The most misunderstood aspect of deflation is probably that price deflation is not a general economic problem. Falling prices merely lead to redistribution. Sellers lose and buyers win. All in all, it is not deflation, but the inflationary period that leads to debt deflation that is dangerous for a country's economy. Debt deflation occurs after too much credit is extended for unproductive purposes, in particular for speculative investment purposes. An asset bubble is created, ultimately followed by rapid deflation when the bubble bursts. The deflationary spiral ends when the bad investments are liquidated.
Who benefits from bad-mouthing deflation and continuing inflationary policies via overly aggressive money printing? The answer to that question would be politicians, large corporations, wealthy individuals, and all debtors. Deflation increases the real value of debts, meaning that borrowers have to repay the same amount of money, which has become worth more. The biggest debtor in the world is the United States government. For this reason, the government's monetary policies are biased in having a "healthy" dose of inflation. This misdirected policy and the sheer arrogance of the central planners in believing they can fine-tune and control the economy is perilous. The alleged threat of deflation is used to justify the production of new money. Rather than accept a limited amount of deflation as a new normal, central bankers attempt to cure a problem that requires no solution. They constantly proceed to trot out lower interest rates, Quantitative Easing, and an environment of lesser credit restrictions. These measures are often counterproductive, with the resulting excess credit inflating asset bubbles or creating new bubbles in the economy.
Since we're on the subject of deflation/inflation, now would be an opportune time for me to get something off my chest. The gripe concerns a Federal Reserve Bank policy that debuted in 2012. The policy was adopted by the Federal Reserve Open Market (FOMC) during Ben Bernanke's tenure as Fed Chair. This ridiculous policy formally established an inflation target rate of 2%. In other words, the country's monetary mavens (12 individuals) unilaterally decided that it was in the country's best interest for our currency to be debased by 2% each year. Unbelievable. The origin of the "magical" 2% inflation target is even more questionable in terms of pure logic. In 1989, New Zealand wanted to codify the independence of its central bank. The applicable legislation directed the New Zealand finance minister and head of its central bank to come up with an inflation target. If this target was not met, then the head of the central bank could be sacked. In later interviews, the head of the central bank stated "The figure (2%) was plucked out of the air to influence the public's expectations." As "they" say, the rest is history. Most knowledgeable parties at the time thought it made much more sense to set a target rate for inflation in the 0 - 1% range. As mentioned earlier, the U.S. followed suit in 2012 when the 2% inflation target was established.
The Covid-19 pandemic threw a monkey wrench into the financial system in 2020 when economies worldwide shut down. It's been over five years since the rate of inflation dipped below 2%. Part of the reason for this is that the Fed waited way too long to raise the Fed Funds rate. They also adopted a policy in August 2020 that is almost comical. The strategy is called "flexible average inflation targeting." In a nutshell, this approach aims to achieve the 2% inflation target, on average, over time, allowing for periods of inflation above 2% if it has been persistently below that level. This is another example of our government's monetary bias in favor of inflation at the expense of reducing the purchasing power of Americans. Currency debasement will continue. Don't keep your head in the sand. Buy hard assets.
