Deflation, ii

The first post on this topic discussed a case where deflation is good.  I’m going to start off this post in a similar vein, introducing a case where inflation is good.  This will be a case of credit based inflation.

Imagine a place where credit does not exist.  The people inhabiting this land are rational and economically conservative, and so they keep good piles of money around in case there is an emergency.  I’ll just go ahead and mandate that in this particular economy $5000 is a good emergency fund.

One day one of the clever people in this country conceives of the idea of credit.  He walks into their congress, they all love the idea, and hours later there is a law.  Everyone suddenly has 5k of credit to use in emergencies.  Suddenly, there is no need to keep those $5000 of liquid assets around, and so the people start putting that money to better use.  Some spend like drunken shoppers, others move the money to long term investments, whatever, it does not matter.  The point is, the availability of unused credit, by its mere existence, just kicked off real monetary inflation.  This is a good thing, really, all that money held up in rainy day funds was not being used efficiently, but it causes inflationary pressure none-the-less.

Once again, inflation here is simply the tool the economy uses to return its ration of purchasing ability to goods availability back to equilibrium.  This is neither good nor bad, but is the root cause that makes it so.

Something like this did, of course, happen over history.  The common man today has far more credit available to them than did his ancestors.  It did not happen all at once, and there are diminishing returns as the dollar amounts go up, but the effect is real, and it is considered a good thing, economically, that we do all have this credit.

At least until so many people use it poorly so as to create a different problem.  But that would never happen.  🙂

Anyway …

The converse of these good cases of inflation and deflation can also be stated.  A credit crunch leads to a flight to liquidity leads to strong deflationary pressure.  Things that decrease productivity, whether that be government regulations or a perceived increase in the value of leisure time, provide inflationary pressure.

Similar stories can be told about monetary and velocity inflation/deflation.

The current economic troubles, and the reason why deflation is fared so by neo-monetarists, is precisely because of the pressure that is causing it … financial industry tumult and credit crunch followed by a flight to liquidity.  It is a specific set of events that cause the concern, rather than, say, a general theory about deflation (in this case) or inflation providing its own impetus and spiraling out of control.  The question/concern is … and here i’m going to use a phrase you’ll see in a lot of my posts, about all subjects … “what is doing the work?”

And, of course, a monetarist is also going to think that they have the perfect solution.  Credit and money are substitute goods.  They are not perfect substitutes, to use an economic technical term, but they are to a high degree substitutable.  Hammer in hand … we see a nail there.  Off-set credit push defaltionary pressure with inflation push monetary pressure.

I leave that small statement as it is.  The impetus for this post was a question about why a neo-monetarist was so afraid of deflation in late 2008 and early 2009.  There are people that think and write about that for a living and are far more capable of handling the detailed arguments … but i think this at least gives the general framework of that thinking.

 

I want to talk a bit about one more inflation/deflation nuance, however.

While we generally talk about the “rate” of inflation (or deflation), it is really not the 1st derivative that we fear most, it is the 2nd derivative.  A stable rate, even a high one, is predictable, and people and plan and adjust accordingly.  It is the change in the rate that really throws things off, to the extent that that change is unpredictable.  (Part of the “death spiral” notion of inflation/deflation comes from this. i believe).  In fact, to the extent that inflation/deflation is simply a tool by which a market returns to equilibrium, it is self correcting … as is any market … in the long run.

 

I will have one more post on this subject.  That post will specifically cover a few of the issues that can arise from deflationary pressure, especially in the financial industries.

[to be continued]