It all depends on the type of Deflation. There are actually two types. The deflation that most people are familiar with is the result of a market collapse such as we saw in 2008. Prices of assets (like stocks) fall because of some sort of “accident,” such as the mispricing of mortgage-backed securities and derivatives. When assets lose value quickly, panic sets in, leverage must be liquidated, causing other assets to be sold, creating a “snowball effect” causing a “risk-off” mindset. Consumers cut back on unnecessary purchases, businesses lay-off workers, unemployment skyrockets, and the economy stagnates, etc.
But looking even deeper, we find that the “mispricing’ was caused by too much liquidity pumped into the system in the first place, resulting in excess money flowing into crazy misallocations. So, this type of deflation is actually the result of too much inflation.
“Good Deflation”
But there is another type of deflation that the U.S. experienced in the late 1800s. In that case, deflation resulted from a stable money supply and increasing productivity. There was very little debt, prices fell as the Industrial Revolution increased productivity, so everyone was better off. Why complain when your dollar goes further, unemployment is low, and new innovations are appearing almost daily?
These days our money supply is “managed”. And rather than prices falling because of increased productivity, the FED inflates the money supply so prices increase. If GDP increased and the money supply increased by the same amount, prices would remain stable. But instead, the FED targets 2% inflation, which means that they purposely increased the money supply by 2% too much. Why? Because the biggest debtor in the country is the government, and inflation allows them to repay their debt with cheaper dollars. But this is really just a hidden 2% tax on all consumers. So, in effect, the government is stealing the benefits of increased productivity plus 2% more.
So, which is more harmful to the economy?
Do you prefer the band-aid to be ripped off quickly or slowly?
#1 Deflation due to a market crash steals wealth quickly by crashing asset prices such as stocks and real estate but generally resets the economy by wiping out bad debt, creating the foundation for the next bull run.
#2 Inflation steals wealth slowly through higher prices but benefits debtors by making repaying debt easier through “cheaper dollars”.
#3 The best choice is a stable money supply and increased productivity, which gradually deflates prices and raises wages, benefiting productive citizens rather than debtors or the government.
So, choices 1 and 2 are both bad. While #3 is not bad but rather good. So, the best scenario is “good deflation,” which is the basis of a strong healthy economy without boom and bust cycles caused by excessive money printing.
If we had to choose between #1 or #2… In many ways, although very painful at the time, deflation is usually rather short-lived and if allowed to extinguish debt, has the seeds of prosperity. #2, on the other hand, can go on for decades, getting progressively worse and hollowing out the hidden structure of the economy until either #1 occurs or hyperinflation eliminates the debt, reestablishing the firm foundation.
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