There is good deflation. During the centuries of the gold standard where there was free trade, balanced budgets, and free markets, gold was exchanged between countries to pay for goods. Nations that ran trade surpluses experienced an influx of money. As their money supply increased so did their price level. Conversely, nations that imported goods saw money leave their country, their money supplies decreased, and they experienced a mild decrease in prices.
During the years of the gold standard, prices in America and most other nations swung from an increase in the price level of about 2%, to a decrease of about 2%. This swing between inflation and deflation took decades and was virtually imperceptible to the average citizen. It was never an issue.
During the technological revolution of the 80's and 90's, and to this day, innovation, creativity, and efficiency combined to create new products that increased the quality of life while decreasing the price of many products. Productivity increased, time was saved, and information became freely available. Technological advances drove many prices down over time; stock commissions fell from hundreds of dollars per transaction to 7 or 8 dollars, and articles and all forms of information became free. This was deflation, and it benefited the economy like never before.
Then there is bad deflation. During the financial crisis we recently endured, debt was destroyed. Because leverage increased to the tune of 40 to 100 dollars loaned for every one dollar owned, money supply in the form of credit became wildly out of line with historic norms. During the gold standard, leverage was about 4 to 1. When crises occurred during that era, they were severe but short. Banks and companies and individuals went bankrupt, but when the dust cleared, everything returned to normal and the economy moved on.
During the financial crisis debt was liquidated, trillions of dollars literally disappeared from the economy as the stock market crashed along with real estate. Deflation began to take hold but before the contagion could spread out of control The Federal Reserve intervened to supply money to crumbling banks, financial institutions, and large corporations. Many went bankrupt, but the injection of funds by the Fed arrested the deflation which was caused by a severe contraction of the money supply. The increase in new money simply replaced the money that had been destroyed.
The process is called "de-leveraging", but it is deflation pure and simple. Anytime debt is destroyed or defaulted on, money disappears. Anytime assets drop, money disappears. Today, the world is in an era of de-leveraging that has lasted the best part of a decade. The Fed has been battling de-leveraging for years now.
The Fed is charged with being the bank of last resort, maintaining price stability, and promoting an economic environment conducive to full employment. If inflation threatens, the Fed must by law take steps to combat it and return the prices to a low and stable level. And if deflation threatens, they must combat that also and return the price level to normal. For years the battle that most central banks around the world have been fighting is a deflationary recessionary bias in their economies.
The tool of choice to fight the recessionary/deflationary menace is low interest rates. Yet the best that has been achieved is a draw. We’ve had a basically 1% inflation rate and a 2% economy. The monetary policy employed has been anti-deflationary in nature, and that’s fine. What has been lost sight of, however, is the supply of money chasing goods within the economy. When Ben Bernanke came to the rescue of the American economy, he did so by supplying sufficient reserves into banks and financial institutions to avoid a run on the banks that would create financial contagion. Such a contagion is what implosions are made of, and no wants the implosion of an entire economy and its financial system.
The injection worked. Loans were made, the contagion was arrested, and the loans were paid back without a monetary and economic collapse. But deflationary forces have continued to plague America and the world to this day. Stagnation has been the best that central banks have been able to produce with their policies of quantitative easing. The reason is two-fold. First, the money lent went into reserves of banks in order to raise their capital ratio to debt. The second reason was Dodd-Frank legislation which forced them to do so. The consequence was a deficiency of money within the actual economy. The normal loan process of banks to consumers was and is broken, and loans are at an historic low.
Banks were not unsympathetic to the new law since they would have become extinct had they not received additional capital to pay down their leveraged debt. To this day, low interest rates have not been able to create new demand for loans or products. The reason is monetary policy did not translate into increased actual money growth in the economy. Velocity of money (money chasing goods) is the lowest in history. Demand for commodities is falling and today are lower than they were in 2002. We’re going backwards.
Stock markets are crashing, destroying trillions of dollars of buying power in their wake, and loans being made and credit being demanded are puny at best. Through all this we debate how soon and how fast the Fed should raise interest rates. During normal times, the Fed raises interest rates to fight inflation. Today the treat is not inflation -- it is deflation as continued de-leveraging, falling commodity prices, and stocks spiral downward.
What to do?
QE has not worked except to keep deflation at bay. The Fed is at this time creating no new money. That ended last year with the end of QE3. M2 (cash on hand, checking, and savings accounts) is the same today as it was last April. Zero increases in the nation’s money supply is deflationary. Falling stock prices is deflationary. Falling commodity prices led by oil and copper is screaming deflation. And gold has been falling leading the deflationary trend since 2011. This kind of negative deflation invites recession and even monetary collapse.
Some are just now calling for a new round of QE. Others are insisting that we must raise interest rates in September. My view is that the present low interest rates will not stop this deflationary trend; a rise in interest rates will only aggravate deflation, and a new round of QE4 will also be impotent to arrest the recessionary deflationary trend in place. Bond buying does not lead to higher monetary growth, just higher debt.
What must be done is for the Fed to switch focus from interest rates and bond purchases which have not worked, to increasing money in circulation. The Fed needs to take a page out of Milton Friedman’s work and apply it. If the Fed announced this week-end that they will not raise interest rates until inflation has moved above 2% for some time, and that they intend to increase the money in circulation to accomplish this, I have no doubt that stocks, commodities, and even interest rates, will all rise with increased monetary demand, increased growth, and increased inflation.
Then, and only then should we begin to fight inflation, something we have proved we can do time and time again over the last 25 years.