September 28, 2014
Both the U.S. and the European Union registered a hint of deflation in recent weeks.For the U.S., the sharp drop in inflation was a turnaround from a bout of higher price levels in early summer. The reason inflation seemed to slow quickly is that petroleum prices remained surprisingly stable given all the international turmoil. With wars in the Middle East and Russia, we typically expect big oil price spikes that lead to higher price levels. But here in the U.S., oil production has grown so steeply that we now produce oil at about the same level as Saudi Arabia. More oil production in more stable places reduces volatility and ultimately keeps prices lower. This is welcome news for most folks.
It is important to remember though that rising oil prices are not inflation. Inflation is caused solely by too much money in the economy chasing too few goods. So, the drop in oil prices, which trickles down to most commodities, is not deflation, just lower costs for producing goods. This is not a merely academic distinction as I will shortly explain.
Europe is on the brink of real deflation. Economic growth has slowed to the brink of recession and not just in the beleaguered southern nations, but in strong places like Germany, the UK (blessedly still united) and Scandinavia. Slowing economic growth places downward pressure on prices and in a rush to prevent deflation, the European Central Bank will aggressively boost money supplies in the coming months. But this begs the question, why is deflation bad, but lower prices good? Here’s why.
Better machinery, better educated workers, more abundant raw materials and a more free movement of goods all reduce the cost of goods and services. Abundance in raw materials is fleeting, while all the other factors have at their core the wisdom and talents of people. This is where economic growth ultimately comes from, and with it a lower cost for the production of many goods and services. More costly substitutes become obsolete and are relegated to wistful memory (see buggies and manual typewriters for examples). This is a good process, relieving want and allowing us greater choices along with cheaper goods.
Deflation is different. A deflationary world is one where consumers and business have too little money to chase too many goods. This causes the price of goods to decline, leading consumers and businesses to delay their purchases. The canonical economic models tell us that deflation leads the economy quickly into recession, then perhaps depression. It is probable that deflation, not the stock market crash, is the real cause of the Great Depression.
Inflation and deflation should not be tricky matters to understand. Too much or too little money in circulation are their direct causes. Inflation transfers wealth from savers to borrowers, while deflation does the reverse. Because most of us engage in both activities over our life, reasonably stable prices are in our long-term interest. Insuring stable prices is why we have central bankers.
About the Author
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