Deflation

I’ve been hearing the word deflation thrown around a lot lately. Nearly everyone is afraid of it, BUT, what is deflation? That depends a bit on how you view the concept of the velocity of money.

Deflation is defined as the contraction of the money supply. The way we have been printing money, this clearly isn’t occurring, but if you print money and no one is there to spend it, does it go ker-ching? The money that has been made available to the banks (not printed technically) is still with those banks. In a fiat system, we can speculate on how much potential currency is in the system, but since the whole system is made up as we go along, it is really more about perception than reality. In this case we could say that we are in deflation if (and because) we think we are in deflation. The good news is, it may be that as soon as we decide we aren’t, we won’t be, but it has to be a majority decision. Added to the mix is that we base the value of our money on its relation to the value of other currencies, so it could also be said that deflation is the expansion of foreign currencies.

Deflation manifests itself in the economy as decreasing prices and an increase in the value of currency, but this doesn’t mean that a decrease in prices and a strengthening dollar are deflation; those can also manifest because of a decrease in demand or employment. Complicating things still further is the concept of credit. This is virtual money that has the potential to exist, but does not. What caused our current appearance of deflation was in large part a reduction in the availability of credit. It doesn’t matter how low interest rates are if no one will lend you money.

What does this all mean today? We doubled our monetary base in 2008.

2009 is starting with the largest government stimulus in history. In a few months when that money makes it into the economy proper, deflation will be the least of our worries as government tries to figure out how to unprint money. Buy gold.