Inflation vs Deflation is not a Debate, The Answer is as Absolute as 2+2=4

I hear so much about inflation and deflation, about which is bad and which is good that the debate becomes mind numbing and confusing at best, even to those of us with very strong backgrounds in economics.  It must be absolutely overwhelming to folks who’s talents and focus are in other fields.  Yet it is important to all of us in our day to day lives.  For instance, the official CPI suggests consumer prices are inflating by about 1.5% per year (approximately).  Yet if you look at the things all consumers must have simply to survive e.g. food, shelter, clothing, medical care, heat and electricity, transportation and income we see a very different story.  I pulled the following chart from Zerohedge.  CPI So what we see is that for all things necessary for survival, with the exception of gasoline and income, prices have moved higher.  So while it becomes ever increasingly expensive for you and your family simply to stay alive you are making less and less income to cover those bills.  But on the bright side, the stock market is at all time highs and so you’ve got to feel good about that right?  Well that is unless you are in the bottom 80% of income brackets, in which case you actually have effectively no assets in the financial markets.  But maybe you know some people who do and for them you are likely very happy, so there’s that, right?

Now the central bankers and the entire media, including it’s keynsian workhorses like Paul Krugman will have you believing that without inflation there will be no economic growth possible.  And so it is essential to print money to weaken the value of the dollar in order to create economic growth.  So I took a look at this notion to see if it has any merit.  Because look, I as much as anyone am looking to crawl out of this terrible economic conundrum in which we find ourselves.  Wouldn’t it be great to have the 1990’s back again.  And so if it’s inflation that is required to get us there I’m all for it.  Because of my mistrust for all things government I think we should validate the claim that inflation is necessary. So recently I wrote a piece on comments made by the Chief Economist of Citibank.  He was claiming that gold is inherently worthless and to prove his point he put the reader through a thought exercise.  He created a model economy to prove his point.  And moving through that thought exercise I discovered it was a great tool to also study inflation and deflation.

So why don’t we walk through this model economy to see where it takes us. In this economy there are a few assumptions.  Population, technology, tax code and preferences, government spending, endowments and fiat money stock (of which there is only one currency) are all constant.  The government budget is balanced and prices are flexible.  We also have speculation in this economy and so asset bubbles are possible given prices are flexible.  Lastly, at the start of this economy every person has the same amount of money, which maximizes total demand for assets while minimizing total demand for money.  And so let’s put this economy to work and let’s see what happens to prices and economic growth.

Because we have flexible prices in this economy we are going to have price moves.  For instance weather patterns can affect crop supplies which will result in higher prices for crops.  But that begs the question what are things that can make prices move?  This is the holy grail of questions and will lead us to the 2+2=4 type of absolute answer everyone is looking for as it pertains to the inflation vs deflation debate.  Now I’m going to digress for a moment to catch up those non-economists out there.

In the real world there are only two catalysts for price fluctuations.  The first is supply and demand for the asset itself.  That means that some change in the level of demand relative to the level of supply of the asset itself will result in a price move of the asset.  So when demand increases relative to supply price will go up.  This is a result of something called marginal utility.  To understand this, we’ve all heard the term ‘price gouging’.  What this means is that during periods of supply shortages or demand spikes sellers know that consumers will have much higher marginal utilities for necessary items than they would under normal circumstances.  Think about gas before a long weekend or milk price in small stores before a hurricane hits land.  We expect prices to go up because we ourselves are willing to pay more for those items in those situations i.e. we have higher marginal utilities for those things in those situations, than under normal circumstance when we might forego those items at higher prices.

And so that’s how prices of assets move because of supply and demand for the asset itself.  When demand is high relative to supply we call it a sellers market because consumers are willing to pay more in that scenario.  However, when supply is high relative to demand we call it a buyers market.  That’s how competition works to keep prices low.  If only one person is selling apples in your state the price for apples can be high.  However, if there are a million people selling apples in just your city prices are going to be much lower because of competition between sellers.  That is a buyers market.  And it all goes back to relative supply and demand levels for the asset itself.  This type of price change is not considered inflation because it is based on true supply and demand fundamentals of the asset itself.

The second way prices can move is through relative supply and demand levels of the currency being used to purchase the asset.  The currency itself is just an asset that is being used as a universal means for transaction.  And as an asset it too is subject to price fluctuations of relative supply and demand.  So let’s imagine a society that cherishes different rock forms and so the more rare the rock the more a seller in that society is going to want that rock.  This society accepts different currencies which take the form of different rocks types.  And so a seller is selling apples.  Two consumers walk into that store looking to purchase apples.  One consumer has normal everyday rocks that one can find pretty much all over the place meaning the supply of these rocks is plentiful and very easy to come by.  The other consumer has ruby rocks and these rocks are very difficult to find and even when you find them they are very difficult to actually get out of the ground.  So the seller of the apples is going to be willing to trade a basket of apples for 100 of the everyday normal rocks, meaning the price of a basket of apples is 100 normal everyday rocks.  But that same seller is going to be willing to trade a basket of apples for just 1 of the ruby rocks, meaning the price of a basket of apples is also 1 ruby rock.  And this is so because the relative supply and demand for these different rocks is universal.  That is all sellers are going to want the ruby rock much more than the everyday normal rock.  The significance is that the seller knows he will be able to buy the steak he wants for supper with either the 1 ruby rock or he can buy it with 100 normal everyday rocks.   That is the universal marginal utility for the currency.

You can see in that example we didn’t talk about supply or demand of the apples at all.  But only about supply and demand of the money form, which in this model economy are rocks. Now imagine in this economy someone discovers essentially an infinite deposit of ruby rocks that are very easy to get out of the ground.  Well as more and more ruby rocks are being used to transact, the sellers’ marginal utility for the ruby rocks is going to decline because now they are very common.  So while it used to cost 1 ruby rock for a basket of apples the seller now wants 100 ruby rocks for the same basket of apples.  Meaning the price of a basket of apples has gone up from 1 ruby rock to 100 ruby rocks, however, the price of rocks in normal everyday dollars is still 100 normal everyday rocks. This type of price increase is what we call inflation because it has nothing to do with supply and demand for the underlying asset and has only changed in the one currency.

In our real world the supply and demand for money is largely a function of monetary policies with fiscal policies also playing a role.  Specifically, the supply of money in the marketplace is controlled by the Fed.   How much debt we carry can also impact demand for currency.  But mostly monetary policy determines a currency’s value. So back to our initial economy where everything is constant accept for prices.  Prices can change in this economy but only by way of supply and demand of underlying assets.  Meaning inflation cannot happen because supply of money cannot increase.  However, there is one scenario that deflation can take place.   So let’s look at this economy in more detail.

To see price changes that can take place let’s walk through a couple scenarios.  First supply and demand of underlying assets.  Let’s say a speculator thought the price of chestnuts would go up because he became aware of a disease that was killing off oak trees and so he purchased all the chestnuts he could find.  And sure enough that was the case.  So prices of chestnuts went through the roof because demand now was much higher than a normal day as people tried to get some of the last ever chestnuts.  So this speculator made large profits.  We can see price of chestnuts changed due to supply and demand of underlying assets i.e. the chestnuts themselves.  And we know from our discussion above that kind of price increase is not inflation (if there was more than one currency it price would have gone up in that currency as well).

But we also saw that the speculator in this economy, with its constant stock of money, now has a higher proportion of that money stock than other people.  In fact, the speculator made so much money he now has more money than he can spend.  While people who bought the chestnuts have much less money than they need.  The result of this is that the speculator is going to spend some of his money but will put the rest of it under the mattress.  In effect, although the total money stock remains the same much of it has been effectively taken out of the economy.  And because there are many people with very little money, total consumption declines.  That is because when people don’t have money they don’t buy things.  Yet, demand for money has gone way up.  Because when you don’t have enough money, each additional dollar you can get is extremely valuable.  Much more valuable to them than is each additional dollar under the mattress to the speculator.  This in effect, is deflation.

Deflation being when supply and demand of the money used to purchase things changes resulting in price declines of underlying assets.  Although the money stock is actually the same, the effective money stock has declined and thus each dollar has become more valuable to consumers.  There is no way to increase the effective money stock beyond our initial starting point which was where money stock was evenly split amongst the fixed population.  So we see without the ability to increase money supply we simply cannot have inflation while there is still a chance of deflationary type effects. Ok so we see that in an economy with a constant money stock inflation is impossible but prices can change with supply and demand of underlying assets.  But what about economic growth then?  Central banks tell us that inflation is necessary for economic growth?  Doesn’t the fact that inflation is impossible mean this economy simply will never see growth?  Well let’s see if that is the case.  If it is, then we know that the central bank theory of inflation as a necessary ingredient to economic growth is true and we can all take a deep sigh of relieve that we’ve been on the right path.

However, what we find is that absolutely we can have economic growth in our model economy.  Economic growth could be achieved through increased productivity and innovation which would result in higher output without an increase in money supply.  Higher output means economic growth.  A very interesting result of this type of economic growth is that because it results in supply increases to assets, without increasing the supply of money, we actually get price declines of assets.  We know from our discussion above more supply of assets relative to demand reduces price. And so it would seem that we can have economic growth and declining prices in a given economy.  In fact, they seem very much to go hand in hand.

This means the central banking theory that economic growth is predicated on inflation is a complete myth.  It has no basis in reality.  It is a lie perpetuated to make you think you need a central bank to continuously be printing more money.  Each dollar of which has interest attached to it that you must pay.  Each dollar of which is being used to prop up stock prices from which the vast majority of benefit goes to .1% of the population.  The same .1% that those policymakers and their stakeholders just happen to belong to. And so there is a huge conflict of interest for these policymakers to be implementing a policy that has been proven over the past 6 years to only benefit them and theirs.

The only impact on the economy that has come by way of the money printing and backstopped stock prices is a gross misallocation of funds away from economic boosting investments into non-economic investments that materially benefit only the very wealthy while devastating the working class.  And so what we’ve done here is legitimately put the debate to bed that inflation is even relevant, let alone necessary, to economic growth.  And further that price declines are not only relevant but go hand in hand with economic growth.  While working and living in London I remember a friend over there telling me that if it’s coming from the mouth of a politician best to believe the opposite.  I have found this to be an incredibly accurate method of ascertaining what’s real and what’s not in society today.