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When It Comes to Deflation, You Are Walking Into a Trap

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February 22, 2010 – Comments (29)

There is a buzz going through the Interwebs. Deflation is back, they say.  The core CPI numbers declined for the first time since 1982, down 0.1%

I'm going to discuss 5 topics today so let's dive right in.

1  Why Deflationists are always wrong.
2. Why deflation, in normal circumstances, is a great thing.
3. Why the CPI is a useless statistic
4. A realistic assessment of current price levels
5. Why the Federal Reserve wants you to worry your poor little head about a 0.1% drop in price.

Why Deflationists are always wrong

Accoriding to deflationists, falling prices are right around the corner.  The inflationists, on the other hand, predict rising prices but often say that the rise may not come for some time.  You won't hear a deflationist (outside of alstry perhaps) predicting prices falling by massive amounts.  They can't tell you how long it will last or how severe it will be.  You never hear the term "mass deflation." 

Inflation is persistent rising prices.  Deflation is persistent falling prices.  The key word is "persistent."  A temporary 0.1% drop in the core CPI (if that even mattered) doesn't qualify as deflation.

Don't think this is a new debate.  It is a very old one.  The deflationists have been wrong every year since 1955.  The rise of central banking around the globe effectively destroyed deflation (persistent falling prices.)  This is bad for consumers and workers but great for big governments and big businesses.  The Left often bemoans the rise of big business but never sees the connection between inflation and their growth.  They are fools.  The Right often bemoans the rise of big government but can't see the connection between inflation and their growth.  They are also fools. 

Courtesy of Austrian School economist/investor Gary North, here are 10 questions to ask any Deflationist.  Check the answers you get and decide for yourself.   A good idea would be to bookmark this article for future reference the next time a government official, hack economist, or blogger tries to warn you about deflation.

Why deflation, in normal circumstances, is a great thing.

America suffered from persistent falling prices from the late 1700's until 1914 when the Federal Reserve opened for business.  These falling prices were only temporarily interrupted when the government or the Bank of the United States created new money, usually to pay for war. The result was always inflation.  Once fiscal sanity resumed, a recession followed.  They were all brief.  Speculation during these inflationary periods resulted in a boom that led to a bust. The markets were allowed to correct themsleves and they always did, quickly.  Anyone who tells you otherwise hasn't read a history book.  Case in point, most Leftists and mercantilist Republicans believe the 1870s was a "Long Depression."  They believe this because economically ignorant history teachers point to persistent price deflation during the decade.  However, price deflation caused by an increase in prodution is a good thing and it turns out the 1870s are among the longest and largest periods of persistent economic growth in American history. 

Capitalism works best when left alone.  An increase in capital investment leads to a higher productivity of labor.  More machines means more production.  More production means more goods made. More goods chasing a stable amount of dollars means persistent falling prices.  This is good.  Your dollar now buys more stuff.  Your standard of living has gone up.  This is how America became the most powerful nation on Earth.  Mild deflation is a wonderful thing. 

Even panic stricken mass deflation caused by the popping of an inflationary bubble is bad only for those who have leveraged themselves too much during the boom.  The quick fall in prices clears out the fools that stretched themselves too thin.  In their place, people like me, those who saved and avoided taking on debt like Twilight fans avoid sunlight, prosper. We can buy assets cheap and put those economic fools in their rightful places, i.e. working for a living. 

But since those fools have friends in high places, the same places where the money machine is being worked over like Martin Brodeur in last night's USA vs. Canada hockey game, they get bailed out.  If the fools who prospered during the boom fail, the big boys on Capitol Hill fail as well.  They are mutually invested.  This is why no one goes to jail despite the obvious fraud and theft.

Deflation, indeed, is liberty.

Why the CPI is a useless statistic

The original intent of the CPI was just fine.  They wanted to measure price changes on a year to year basis.  A steak in 2010 should be measured against a steak in 2009.   But then, as always, a good idea in the hands of government bureaucrats and economists becomes a political tool. 

Why measure a steak versus a steak, says the crank, when we can measure a hamburger this year against a steak last year? 

Huh? 

Well, let me explain, simple minded fool, as you are not familiar with my algorithms and fancy graphs.  If prices rise, a subsitution effect will take place.  The man who could buy the steak in 2009 can't afford it anymore. What use is it to study those costs today?  Let's assume he buys a hamburger instead and measure the difference.

Why not do this?  To begin with, it ruins the whole point of the CPI.  The point was to measure price changes of useful goods demanded by society not to speculate about what they might purchase instead.  Second, sure he might buy a hamburger, but he might also restrict himself to peanut butter and jelly.  This tells us nothing except that you are a crackpot. 

As bad as this idea was, excluding items where prices are going up was even worse.  The crackpot economist says, "housing, energy, and food costs are always seem to be rising. It's not fair. It makes us look bad. Let's just take them out."  They are always rising for a reason, mainly because those are the areas where people spend the most of your inflated money. 

The CPI is worthless.  Arguing over the significance of CPI numbers is like watching disabled kids try to hump a doorknob: somewhat amusing, mostly tragic.

A realistic assessment of current price levels

What if you knew the truth?  What if you found out that inflation is currently running at about 9.8%?  Would you believe it?  I guess that depends on whether or not you go to the grocery store very much.  If you do, then you know the government economists are full of baloney.  If you are single and surviving on take out food, you probably believe the CPI.

John Williams started Shadow Stats about 30 years.  He was asked by businessmen to look beyond the faulty government statistics and give a realistic assessment of the macroeconomic picture.  The government economists do not like John Williams.  He uses a few different measurements, including the original CPI before the crackpots started tinkering with it plus a couple of experimental measurements.  He estimates that inflation is running  at about 9.8%, not negative 0.1%. 

"Adjusted to pre-Clinton (1990) methodology, annual CPI eased to roughly 6.0% growth in January from to 6.1% in December, while the SGS-Alternate Consumer Inflation Measure, which reverses gimmicked changes to official CPI reporting methodologies back to 1980, rose to about 9.8% (9.76% for those using the extra digit) in January, versus 9.7% in December."

Why the Federal Reserve wants you to worry your poor little head about a 0.1% drop in price.

It's not enough for the Fed and its buddies to convince you that we are in a deflationary period.  They know that falling prices are good for consumers.  No one is going to revolt if the price of milk goes down.  They need to do more than that.  They need to scare the crap out of you.  They need to worry you about deflation.  That way, they can justify another round of Quantitative Easing (read: theft), more inflation, a bigger government and bigger big business.  That want you to welcome this.  That is their goal. 

"The increasing use of scientific jargon has permitted the State's intellectuals to weave obscurantist apologia for State rule that would have only met with derision by the populace of a simpler age. A robber who justified his theft by saying that he really helped his victims, by his spending giving a boost to retail trade, would find few converts; but when this theory is clothed in Keynesian equations and impressive references to the "multiplier effect," it unfortunately carries more conviction. And so the assault on common sense proceeds, each age performing the task in its own ways." - Murray Rothbard, Egalitarianism As a Revolt Against Nature, Essay: Anatomy of the State

You are being duped. 

David in Qatar

29 Comments – Post Your Own

#1) On February 22, 2010 at 10:58 AM, kdakota630 (29.85) wrote:

Another excellent blog, David.  Keep up the great work in simplifying economics in a way for the average person to understand while keeping it entertaining, much like Gene Callahan with Economics for Real People, or FloridaBuilder2 does with real estate.

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#2) On February 22, 2010 at 11:32 AM, Rehydrogenated (32.31) wrote:

If you ask anyone who doesn't watch American news stations or a small business whether they see inflation or deflation everyone agrees that there is massive inflation going on everywhere except new for new cars/big ticket items, high-end/luxury goods that were primarily purchased by the middle class, and real estate.

Food, used stuff, energy, insurance and services are going through the roof.

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#3) On February 22, 2010 at 11:45 AM, AvianFlu (35.71) wrote:

Excellent post! +1 rec

I wish everyone could read this...

All deflation means is that things are getting more affordable for you and your savings has increased it's purchasing power. Does anyone complain about the deflation in big screen TVs and computers? No.

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#4) On February 22, 2010 at 1:01 PM, whereaminow (30.26) wrote:

kdakota630,

Thanks for the compliment and for reading. 

Rehydrogenated

Agreed. 9.8% is more believable if you actually need to eat, drive a car, or pay an electricity bill with your hard earned cash.

AvianFlu,

Thanks!  TV's and computers are areas where large capital investments have paid off handsomely for consumers and workers.  The high salary I receive doing IT work is a direct reflection of the capital investment made in computer technology in places like Silicon Valley years ago.  Meanwhile, consumers have benefited through a reduction in scarcity and the reduction in cost to create a computer. 

Also, if you ever find yourself in an argument with a Marxist or Trade Unionist (pray that you don't), point out to him that the workers and consumers are the same people and watch the confusion creep across his face.

David in Qatar    

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#5) On February 22, 2010 at 2:13 PM, binve (< 20) wrote:

David,

Kudos man, this is a perfect post. I agree 100% (200% if I could)!

I think most people misunderstand when those of us bloggers who talk about inflation and advocating for ways to protect against it, think that we like or agree with this. That is completely wrong! I HATE inflation. Inflation requires everybody to become speculators in order to stay ahead of currency devaluation. And non-professional speculators get *reamed* by professionals (tech and housing, for example).

I agree completely: DEFLATION IS A GOOD THING!!. When the market gets ahead of itself, or there is too much speculation, deflation cleans house and resets the playing field. Saver who do not get caught up in a speculative mania are rewarded for their patience.

And this is the best possible outcome of all, because private savings by the citizens of a country is the genesis for all economic booms

But, like you and I and so many others have talked about, as long as there is a Federal Reserve - THE OUTCOME WAS *NEVER* GOING TO BE DEFLATIONARY ... What happens to the Fed at the height of the next crisis? That is an interesting discussion and theory for another post, but until then inflation is the monster to fight.

And your last section is right on. The Fed wants everybody to be focused on CPI (which I agree is a BS metric) and a measly 0.25% hike. It wants everybody to be focused on "deflation". But what this is, like all the rest, is a "deflation *scare*".

The US government is insolvent, and the only way to keep the game going is through more Quatitative Easing. And they only way to get that done is to scare people back into treasuries. And severe stock market correction coupled with a token rate hike will do exactly that.

Fantastic post as always. Thanks for all your thoughts man!!..

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#6) On February 22, 2010 at 2:49 PM, whereaminow (30.26) wrote:

binve,

Thanks so much!  I read your work all the time.  It is meticulous and scholarly.  A compliment from you means a great deal to me.

David in Qatar 

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#7) On February 22, 2010 at 2:58 PM, nzsvz9 (< 20) wrote:

Actually, inflation and deflation are what they are, effects of certain eceonmic policies in practice. Whether they are good or evil may depend upon your position, and one other factor.

Consider the person with a great deal of fixed debt, say a large 30-year fixed mortgage. If the individual has an income, and their wages rise over time, yet their mortgage payment is fixed, they come out ahead the more the market inflates prices. A $100,000 debt at the onset is marginalized if your wages in 30 years are $1M a year. Inflation marginalizes fixed debt.

Consider the person with a great deal of fixed assets. Prices rise and the asset value rises. Homes cost more and you can get nore pieces of paper with lots more zeros on them for the same physical good. Why else is gold so expensive now? Fixed assets are more (longer term) or less (shorter term) immune to the effects of inflation.

Consider a person with floating debt. They are headed for trouble. Adjustable mortgages which reflect the rise in prices by a rise in the iterest rate; this has put more than one family into bankruptcy during the recent housing bubble. Unless their income rises fast enough to absorb the exponential growth of the increasing debt payment stream - they are in trouble.

Consider the perosn on a fixed income. Screwed by inflation they are (a little Yoda-speak there). Without a potential to earn more income, or have their wages rise, they will be eaten by the inflationary cycle.

Consider the person with savings. If the savings are in a fixed return vehicle, like a bond, and inflation comes about during the term, the fixed interest paid and the value of the bond falls as inflation comes in. If the savings are in stocks, then they could be insulated some based on the welfare of the company and the general rise in prices whcih would drive stocks higher.

In this way, there are winners and losers with inflation and deflation alike.

The missing factor which would bind your "deflation is your friend" and the friend fo liberty would only be true if there were a stable currency, and preferably a commodity based currency to back the price level retreat. Otherwise the winners and losers are more or less based upon fixed and floating devices.

Funny money makes for funny outcomes. But, I'm not laughing.

Known as fool nzsvz9

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#8) On February 22, 2010 at 3:30 PM, whereaminow (30.26) wrote:

nzsvz9,

One thing you have left out is human action.  Some people would call it greed.  Inflation, as Mises teaches, creates false savings.  People see their home prices rise, their equity increase, and confuse that with real savings.  They turn and use this "savings," which is nothing more than a paper gain due to massive malinvestment in the concerned sector, to "invest."  They build additions to their homes, buy high cost toys out of their equity, etc.  

There was little chance that an average American could see the train wreck coming.  (Austrian Business Cycle Theory isn't exaclty a hot topic in classrooms... well, until now at least.) Inflation takes reasonable people and turns them into gamblers.  They think they are investing, but we see in hindsight that they were merely riding on the back of speculation.

So sad that many professional economists can only explain this in terms of "greed" and "animal spirits."

David in Qatar 

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#9) On February 22, 2010 at 3:40 PM, outoffocus (23.35) wrote:

I read about halfway through this post, rec'd it, then read through the rest, forgot I had rec'd it and tried to rec it again.

There will be deflation in certain areas in the economy where even the Fed can't fight fundamentals (e.g. any good purchased mainly with debt such as housing, cars, even higher education). I'm sure the Fed will find some way to cover that up.  Its funny because I hear things like "housing prises rose for 2009".  Really?  With record unemployment, an already debt-stretched consumer, and stagnant wages we had a rise in housing prices?  Thats funny because thats not what I see when I check housing prices online.  What happens when the FTHB credit is gone? What happens when interest rates rise? 

It would be nice to one day have a government that didnt constantly lie to us through government statistics.  But faulty government stats are like spam email, we keep recieving them because people keep falling for it.

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#10) On February 22, 2010 at 4:16 PM, whereaminow (30.26) wrote:

outoffocus,

A forgotten rec re-rec fake out.  That's a first for me :)  Awesome analogy in the last sentence.

David in Qatar 

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#11) On February 22, 2010 at 4:23 PM, goldminingXpert (29.64) wrote:

CPI is useless. Agreed. The price of stuff I buy is going down. Viva deflation!

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#12) On February 22, 2010 at 6:04 PM, APJ4RealHoldings (33.40) wrote:

Excellent piece.  Murray Rothbard mention deserves a separate rec in itself, Murray was amazing.

I'm still awaiting your answers/responses/opinions to my questions of antitrust/oligopolies/competition I posed to you about a week ago. 

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#13) On February 22, 2010 at 6:29 PM, whereaminow (30.26) wrote:

goldminingXpert,

Always an honor to have you stop by. 

APJ4RealHoldings,

Sorry about that. I am wrestling with the blog series idea and I am still leaning towards Antitrust since it is such an amazing story.  I think you are going to really enjoy it and get all of your questions answered.  I don't want to steal my own thunder lol.

However, if I do decide to go in another direction (the idea of a series on FDR's failed policies is very tempting right now as I just finished a couple of great libertarian criticisms of the New Deal), I will do a separate one part post on Antitrust as well.   There is just too much I want to write about.

David in Qatar 

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#14) On February 22, 2010 at 9:20 PM, dbjella (< 20) wrote:

whereaminow

I am not sure this was raised, but you don't always have to see prices rise to know your getting duped.  Contents inside packaging have been getting smaller and smaller. 

 

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#15) On February 22, 2010 at 10:32 PM, outoffocus (23.35) wrote:

Contents inside packaging have been getting smaller and smaller.

Aint that the truth. I was at the supermarket this weekend and I saw a sale on orange juice 2 for $5.  At first look it appeared to be a half gallon container, except it looked noticibly thinner.  Turns out it was only 59.4 ounces.  Nice try Tropicana. But unfortunately my public school education actually taught me what a half gallon is. 

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#16) On February 22, 2010 at 11:28 PM, binve (< 20) wrote:

But unfortunately my public school education actually taught me what a half gallon is.

50 ounces right? That's a good deal!! .... :) (yuk, yuk)

 

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#17) On February 22, 2010 at 11:42 PM, tonylogan1 (28.28) wrote:

rec 46

 

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#18) On February 22, 2010 at 11:56 PM, H2Only (< 20) wrote:

I agree with the premise of the article that deflation can be a good thing for the consumer, but in order for that scenario to be true deflation needs to be present across the board in the CPI, PPI and Core CPI numbers to be of benefit to all consumers.


Clearly inflation is the predominant force right now in the CPI and PPI, and we know that any threat of persistent deflation will be quickly hed off by the Feds printing presses. But dismissing the drop in the Core CPI as being a useless statistic misses the correlation between the three indexes.


Because the Core CPI excludes food and energy (necessities) it is a good gauge of consumer buying power when compared against the CPI. A rising CPI combined with a falling Core CPI indicates depressed buying power as soaring food and energy costs eat up a larger share of the American pie.


The decline in the Core CPI is being driven by the consumer. The recent Wal-Mart filing attests to this fact. While Tech Company’s feast upon stimulus infused corporate spending, and high end retailers rake in the excess liquidity funneled through the Belt-Way bureaucrats and Wall Street fat cats, Main Street struggles to pay the electric bill.


The CPI and Core CPI can’t continue to move in opposite directions. Something has to give. The service sector can’t continue with depressed rates as long as food prices continue to rise. They will have to adjust their prices and risk loosing more business or cut wages even further. A frightening thought in this service based economy we’ve created where minimum wage is the norm. 

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#19) On February 23, 2010 at 12:07 AM, DaretothREdux (45.50) wrote:

A lot of recs here. Are people waking up? One can only hope...

Dare

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#20) On February 23, 2010 at 1:49 AM, uclayoda87 (29.37) wrote:

Excellent and timely, just like Peter Schiff's book Crash Proof helped explain the crash that was to come, your post along with the upcoming movie Generation Zero and the recent blog:  Incredible Wisdom from Charlie Munger are helping investors understand that there is more to the land of Oz than meets the eye.  Good luck in your investing, even though I believe that you are right, the irrational market is still controlled by the politically connected who will use any means necessary to punish the just in order to keep the illusion alive.  Caution:  Scared political animals spotted ahead.

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#21) On February 23, 2010 at 11:40 AM, AvianFlu (35.71) wrote:

If I see one more post that spells "losing" incorrectly as "loosing" I am gonna go nutz!!

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#22) On February 23, 2010 at 1:37 PM, turdburglar (43.73) wrote:

So did Japan experience deflation or not?

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#23) On February 23, 2010 at 1:44 PM, whereaminow (30.26) wrote:

turdburglar 

Nope. See here.  Japan never experienced a price decline greater than 2% in any year.

What Japan's central bank did create was a stable money supply, the first time a central bank ever accomplished that.  Of course, it was in a Depression, so that's not so great. 

The next central bank that creates a stable money supply during a time of growth, it will be the first.

David in Qatar

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#24) On February 26, 2010 at 12:38 PM, floridabuilder2 (99.26) wrote:

This is why builders are becoming profitable, deflation in house cost.  This significantly lowers the sales price and makes homes affordable for most hourly people who have come up with enough savings for a down payment.  There has been massive deflation in homebuilding and isn't this good for those who want to own a home and pay it down long term?  The builders can still make money even at the lower selling prices.

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#25) On February 28, 2010 at 1:24 AM, checklist34 (99.72) wrote:

nzsvz had the best set of comments in this thread.  No such thing as a free lunch, deflation is hardly a free lunch.  Inflation either. 

My sons mom and her hubby make good money, above 2x the median income for adults in the US collectively, but they are far from wealthy.  However, as they got married just a couple years ago and are quite young, there has been nearly no chance for them to save enough money to pay cash for a house...  ha!  

So they got one they can easily afford (and still save some cash) via a mortgage.

Lets say, now, that the OP gets his wish, and the country experiences prolonged deflation at 2%/year.  Flash forward 20 years and these normalish folks, these consumers, these people that the rich pick on are...  

 

...wait for it...

 

... wait for it...

 

...wait for it...

 

 

 

COMPLETELY SCREWED.  They must inevitably default on their mortgage as their wages plummet.

Not immediately, not gracefully, not smoothly, but eventually, wages follow prices.  

Please find statistics showing median income in 1955 vs now, 1970 vs now?  1979 vs 1970?  consistent growth?

How about growth relative to cost of a new house or a gallon of milk or a loaf of bread?

Live with it.  Debt is sometimes bad, but frequently a tool.  And the "false savings" or whatever was said above of a house inflating in value over time is...  NOT SOMETHING THAT NEEDS TO BE ABUSED OR RELIED ON or whatever else, that is up to the individual.

All of society has so many smart people.  Some do, some cripple themselves with overthinking, frequently circular thinking, typically anti-majority thinking coffee shop intellectual stuff.  If only we could aim them towards a productive end. 

:)

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#26) On February 28, 2010 at 1:32 AM, checklist34 (99.72) wrote:

 Best asset to hold in a prolonged deflationary environment:  bank CDs or government bonds or corporate debt.  The corporate debt would be risky because with prolonged and ultimately substantial deflation default rates would be meaningful.  Gov't bonds ... could the gov't of this nation survive a prolonged deflationary period?  Steadily dropping wages and tax revenues?  

I made a blog here on this forum long ago, months and months, where I dug up mean and median income and the cost of a gallon of milk, a new house (median), a few ford (avg price) and whatever else.  I found the data on the web so it has to be accurate (hehe).  

We are better off, and not by a little, than we were in 1955 when viewed in light of these measures.  I believe that cars had crept up in cost, but this is reasonable with all the safety laws and features they are now required to have.  In every other measure I reported we were better off.  We could buy more milk, more bread, more houses on the emdian income than long ago.

As for the current situation, its like this:

the italian sports car I bought last fall deflated 30% from 2008 (when people were willing to pay way over MSRP) to 2009.  The cost of food, as far as I have noticed, isn't up in  years.  A gallon of milk isn't $4, still $3 as its been for many years here.  Rents may be up, i haven't checked.  The condo I rent is certainly run by a greedy landlord who jacks up rent every couple months, but its only my fault that i haven't moved or shopped around or bought.

Houses are cheaper, even new construction as building materials are cheaper, and builders willing to work for less gross margin, than at any time in the last 5 years here.  AND WE HAVEN'T HAD A HOUSING CRASH.

Clothes haven't changed much, but my taste in them has drifted uphill in the last few years.  

My stock portfolio, on the ohter hand, has nearly quadrupled.

Its an investment site. Isn't THAT the point?

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#27) On March 01, 2010 at 10:53 AM, whereaminow (30.26) wrote:

checklist34,

This is a strange reply to my post as it is an argument not based on anything in the original post.  Nowhere have I wrtten that people can not be successful investors in any inflationary or deflationary environment.

I also never said we are not better off than we were in 1955.  The market economy has continued to grow, inflation or not. 

My point above, and to be honest I don't think you understood the post, is that there will be no deflation and there never has been any in over 50 years.  Even Japan has not suffered a deflationary spiral. That's a myth. 

So while you are fretting about the impact of a mortgage on a family in a deflationary environment, you are missing the entire point.  It's a con game either way when central planning drives interest rates. 

I don't think you understand what a market economy looks like without central banking.  That's true of many people.  In a non-central planning economy, higher interest rates are a signal to consumers to save.  Among the many other benefits of saving, that means higher downpayments on housing, reducing the exposure to debt. 

What's more real wages do not fall in a non-central planning market economy.  Wages RISE.  Increased savings means more investment in capital goods. which makes labor more productive.  You must be unaware of the incredible rise in wages that occured in the 1700s and 1800s.  People living in capitalist econmies overturned 4000 years of grinding poverty, increased their standard of living and real wages in unprecendeted fashion in a deflationary environment.

Finally, the price of your sports car hasn't deflated.  The definition of deflation is either "persistent" falling prices (modern econ) or a decrease in the money supply (classical econ.)  Your sports car was simply overpriced.

And can you explain the bizarre comment that we haven't had a housing crash?

David in Qatar

 

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#28) On March 17, 2010 at 7:42 PM, TMFBabo (100.00) wrote:

I'm a month behind seeing this post, but I thought it was an excellent read.  Rec #75!

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#29) On May 20, 2010 at 1:14 PM, USNHR (33.34) wrote:

3months behind... +1

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