Saturday, January 21, 2012

Inflation? Deflation? Both?

Every great power succumbs to the temptation to debase its currency. The rulers of Rome, China, Persia, Great Britain, Germany, and the US have each, in their time, seen fit to print money at a rate that outstrips the growth of their economy. So has every country whose politicians control its treasury, from Argentina to Zimbabwe in this century alone.

The inevitable result is a loss in the purchasing power of the money of the realm. Inflation.

Every consumer, individual or corporate, would like to have more money at his disposal than he currently possesses. There are three ways to do this besides earning it: beg, borrow or steal. Setting aside begging and stealing, we can focus on borrowing. A wise man once observed that "every loan is paid, usually by the borrower and the rest of the time by the lender." (If that wise man had been cynical he would have added "or the taxpayers of future generations").

When money is loaned into existence, everyone feels richer. The lender expects to get repaid with interest, and counts his loan as an asset. The borrower has the use of more money than before, and spends the money to satisfy his needs.

But when loans can not be repaid, that sense of wealth is replaced by something approaching despair. And the money supply (by many definitions) can be seen has having shrunk. Remaining money rises in purchasing power. Deflation.


Let's look at how this translates to real life in 2012. In the US, home prices have tripled from the mid 1990s to 2007, then dropped to merely double their 1996 levels. The function of housing did not triple in value, just the price.

The US Dollar held its value as measured by the USD index, so in terms of one paper currency vs another, nothing much has happened. But if you had sold your house in 1996 and taken the cash and buried it, you would have lost 2/3 of your purchasing power 11 years later. Inflation. Had you been smart enough to sell your house in 2007 and buried the cash, you would have gained 50% in housing-related purchasing power. Deflation.
Real economists will protest, if they get this far, that I have grossly oversimplified how money works. I agree. The point I am striving to make is that things we borrow money to acquire rise in price if money is easy to borrow, and drop in price if money is hard to borrow. The value (utility) of those things does not change, just the price. From the perspective of money, a dollar is worth more after deflation than after inflation.

What about things that we do NOT beg, borrow or steal to acquire? If you need a loan to put food on your table, you are in trouble (and you are probably not reading this, nor do you need me to tell you that you are in trouble). Things we buy with cash rise in price when currency is debased. "What this country needs is a good 5 cent cigar" is a familiar phrase first heard in the 1870s. Cigars are consumables, and their intrinsic value doesn't change much. But their price does.

What does all this mean in 2012? Deflation AND Inflation.
  • Expect a continued drop in the price of things that people borrow money to buy, because credit has had its bubble and is collapsing
  • Expect a continued rise in the price of things that people pay for with cash, because the value of cash has been debased for decades and is still being debased

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