Inflation and Deflation Explained
Of all the questions I receive regarding economics and monetary policy, the question on what is inflation and deflation, and why it is important, is at the top of the list.
This blog post will dissect what inflation and deflation really are, and why governments and central banks love inflation…while hate deflation (albeit discreetly perhaps).
Remember, now a days, inflation and deflation have a lot to do with the funny money policies of the mercantile/keynesian school of economics…which are socialist in nature as they encourage big government and government playing a large role in the economy, to a point where they manage it and we get no true free markets.
So, the common definition of what people are taught about inflation and deflation are:
Inflation is when cost of living and prices of things go up.
Deflation is when cost of living and prices of things go down.
What are inflation and deflation really?
Inflation is when the currency of a nation weakens, that it now takes more of the weakened currency to buy something.
Deflation is when the currency of a nation strengthens, that it now takes less of the stronger currency to buy something.
This is actually pivotal right now for the US-China trade war. According to Keynesian economics, a weaker currency is great for exports, while a stronger currency is bad for exports, since nations will look to buy from the cheaper nation. China likes a weaker currency, which they actively manage, as a way to boost their exports. What they really are doing though is they are importing inflation, making it look like their economy is growing, while exporting deflation, making the other nation, in this case America, appear as if their economy is not growing. This is why China is labelled a currency manipulator as the Chinese want to keep the currency weak compared to the US Dollar. To be honest, every nation does this although they do not say they actively intervene with their currency like the Chinese.
So why inflation?
Why do central banks (western) want to target 2% inflation a year? Why do they want to raise living costs by 2% a year?
First and foremost: Inflation is Taxation.
The more expensive things get, the more tax revenue can be collected by way of sales tax and property tax etc. Something your politician that says they want to lower costs will not tell you…especially when government is large and bloated and has many social programs to pay for which requires tax revenue.
Inflation is also largely psychological in nature. It can get to an extreme point where people lose confidence in the government, banks and fiat money where we get hyperinflation as people distrust the further and extreme devaluation of the currency they are supposed to use.
When a central bank sets up an inflation target, they expect that people will say “oh man, I need to spend money now otherwise things will get more expensive next year and going forwards”. This is a way to encourage people to spend money and boost the economy. It gives the impression the economy is improving so people and business’ will spend money. Interestingly enough, at the most recent Fed meeting, Fed chair Jerome Powell talked about aiming for 3% inflation targets…attempting to spur people and business to spend money.
Inflation is great for business’ (and government) because they can borrow money to invest and payback with cheaper dollars. Let’s say rates to borrow are at 3%, and inflation is at 2%. In real terms, rates are 1%. Going forward, you will be able to payback your debts with cheaper dollars.
Western governments have a lot of debt. They want to use inflation to handle their debt loads. This is part of the reason why western central banks are cutting interest rates. To weaken their currency (inflation) so people and government can payback their interest payments with cheaper dollars, and service their debt. You can read my reasons on why central banks are cutting rates here.
This of course really has not have the effect it was supposed to have. A lot of people and business’ know the real economy is not improving. It really has all been financial engineering. It is a better bang for your buck as business to borrow money for share buybacks than investing it into the real economy by building factories and hiring new workers. All funny money.
So deflation. Why, might you ask, do government and central banks not want to make living costs and costs of things cheaper?
Very simply: Because government has not found a way to tax lower living costs….although the socialists are saying this can be done with the green taxes: tax for breathing, km driven, empty rooms, and quite frankly, a tax for just being human.
Psychologically, deflation makes it appear the economy is worsening. It can be a self fulfilling prophecy. If people know things will be getting cheaper going forward, they will wait for things to get cheaper before they purchase it, especially assets and real estate. People do not spend money, business lose money and cannot make profits, and you get a recession.
We have seen this recently in Japan and Europe. Where they have had constant deflation, where in Japan, many have become renters because they get no equity in their home, and the home loses value or stays the same year by year. To get some sort of inflation, they have resorted to negative interest rates, forcing people to pay the banks if they save money rather than spend. They thought people would spend since they are losing money in real terms.
The central banks cannot admit their funny money policies have failed, they say they have not cut deep into the negative enough, nor did they devalue the currency enough. Digital money will be coming as it will force you to keep money in the banks and pay them monthly for doing so. One can say that the people of Japan and Europe have lost faith in the central banks and their funny money policy.
Once again, this is all to do with the mercantile/keynesian soft money regime of economics. With soft money, government and banks can devalue currency for policy purposes while it generally hurts the citizen in the end.
We are at a period where central banks have run out of tools…besides lowering rates further negative and adopting digital money.
When central banks received this power to devalue post 1971, central banks became powerful, and the press conferences have turned into the media circus’ they have evolved into today. They are rock stars and have immense influence.
Just want to end with a quick thing regarding Paul Volcker who was Fed chair between 1979-1987 and passed away at the age of 92 a few weeks ago. Before central bankers became rock stars, and we did not have funny money. Mr. Volcker had to rent an apartment in Washington when he took the Federal Reserve Chairman job…his previous job as New York Fed Chair paid more than the post in Washington. His wife had to go back to work in order to live comfortably. A true civil servant.
When money and producing money becomes easy, you get people flocking to finance and banking. Banking then becomes the largest part of economies. Pre-1971 and in a hard money system, most bankers and traders needed multiple jobs to support themselves.
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