There has been a lot said over the last couple of years about inflation, deflation and a little bit of conflation. Most have paid little attention to the rhetoric because they’ve been a little more concerned with basic survival in this tuff economic time. However, the *flations are important and deserve a little bit of attention, especially with the Federal Reserve’s recent debt purchase plan.

The Myth of Deflation

Most don’t even know what deflation is, as it is an economic term and phenomenon that rarely occurs in the West. Deflation is simply a fall in the general price level. Deflation is usually caused by falling demand and lower growth. The U.S.’s worst period of deflation was during the Great Depression of the 1930s. It is damaging because:

Lower Spending. When prices are falling, there is an incentive to delay purchases. Why buy a house now, when it will be cheaper in 6-12 months? Look at how the housing market is suffering because of falling prices. Nobody wants to buy with falling house prices; this is why property transactions have slumped and of course causes further falls in prices.

Liquidity Trap. A liquidity trap occurs when lower interest rates fail to stimulate spending. If prices are falling by 2%, it can be more attractive to save money in cash then spend. Therefore, cutting interest rates to 0% may be ineffective in increasing demand. In fact, this is a prime reason in why banks aren’t lending. The Emergency Economic Stabilization Act of 2008 authorized the Federal Reserve to begin paying interest on excess reserves, or bank reserves beyond what the Fed requires the bank to maintain. Normally, banks don’t get interest for this money, so they lend it because it is more profitable to do so. However, with the Fed paying interest on these funds, the banks can make money and not put those funds in jeopardy in a poor economy.

Increasing Burden of Debt. If you take out a mortgage and make mortgage payments, inflation will progressively reduce the real value of your mortgage interest payments. High inflation thus makes a mortgage more attractive, over time, it increases the disposable income of mortgage owners. However, with deflation, mortgage payments become a larger percentage of disposable income. In deflation, debt becomes an increasing burden reducing spending and economic growth, so national and personal debt during deflation becomes very damaging for an economy.

Rising Real Wages. Workers will look to prevent a cut in their wages. Therefore, with deflation, real wages rise as deflation drops prices. This can lead to real wage unemployment as the cost of production eventually exceeds the market. We’ve all seen microcosms of this; i.e. U.S. industry. The cost of making things in the U.S. has been exceeding the market price for those things for some time now. The auto industry is probably one of the best examples.

Right now, there is about $1.3 Trillion worth of private enterprise funds sitting on the sidelines. This money is on the sidelines not because of economic contraction, but because of economic uncertainty in the future cost of business:

What is going to happen with the Bush Tax cuts

What does Obamacare really cost

How is financial reform going to impact economic transactions

What Cap & Trade- whether through legislation or dictation- is going to do to energy costs

How an extremely pro-Union White House pushes Card Check

Etc, etc, etc

There is not an expectation of production costs deflating. In fact, it is quite the opposite. Commodity prices right now are surging. Coming to a grocery store near you, soon breakfast cereal, dairy, grains, fruit will all cost more. So will the cost of gas as you drive the more expensive car made from more expensive steel to the grocery store to buy more expensive food. Commodity prices are inflating, not deflating, which then brings us rudely to the importance of inflation.

The Threat of Inflation

Four factors contribute to inflation:

The supply of money goes up

The supply of goods goes down

Demand for money goes down

Demand for goods goes up

Inflation is a rise in the general level of prices of goods and services in an economy over a certain period of time. When the general price level rises, money buys fewer goods and services; consequently, inflation is also an erosion in the purchasing power of money, or a loss of real value in the internal medium of exchange and unit of account in the economy.

The weakening of the dollar is a huge issue as it drives down the demand for the dollar. Massive debt and spending are huge issues as they increase the supply of money. As globalization has amply demonstrated, the demand for resources is ever increasing and as places like China, India, Brazil and the rest of the third world develop, the demand for those goods rise while the supply of those same goods decreases.

Conflation

Conflation is becoming one of the biggest risks to our economic system. When I say conflation, I’m talking about the expanding interference- yes, interference- of the government into private enterprise. By far, the best example of the dangers of public/private conflation was seen in late 2008 as the housing market collapsed, bringing down the U.S. economy. In fact, one is hard pressed to find any example of a publicly managed enterprise in the economy being success. Postal Service? No. Fannie Mae and/or Freddie Mac? Hell no. It is even difficult to find examples of active public management rescuing private economic activity. “Stimulus” spending hasn’t worked and a study by UCLA found that government intervention by FDR actually extended the Great Depression by seven years.

There is a point at which those in leadership positions have to stop doing what they want to do and start doing what they need to do. The current debt situation is critical, the strength of the dollar is extremely important and the people have voiced their displeasure at the Administration’s failure to address both. Germany is standing as a great economic model right now. It is doing so by spending less, not more.

Yes, we need to beware *blank*flation. We need to be critical of calls of deflation and watch for the increasing signs of inflation, but most importantly, we must ward against conflation. Government micromanagement hurts, not helps, our economy and our nation.

Update: Thursday, 11 Nov 2010

A new pricing survey of products sold at the world’s largest retailer Walmart showed a 0.6 percent price increase in just the last two months, according to MKM Partners. At that rate, prices would be close to four percent higher a year from now, double the Fed’s mandate.

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