This post was born as a huge comment to Myrhaf’s post here.
As Milton Friedman correctly wrote, inflation is always and everywhere a monetary phenomenon. By extension, therefore, so is deflation — which is why, contrary to mainstream economists, we are not in a truly deflationary period at present, insofar as there is no reduction in the supply of *money* that has happened over the last two years. Rather, it is demand destruction that has been happening, and that’s a horse of a different color.
The root of the confusion is ignorance of Say’s Law. Essentially, Say’s Law says that production of goods constitutes the demand for the other goods in an economy.
If I produce a widget that others in the market find desireable, I can trade it for the things they have that I want. The more desireable my widget is, the greater the value, and the greater the demand my production represents.
“Money” is not special as far as Say’s Law is concerned. Money is a particular commodity that, by virtue of certain characteristics — durability, high value (compactness), fungibility, divisibility etc. — serves as a store of value and as a medium of exchange, and is therefore chosen as common denominator of value.
Apart from that, prices are understood as the exchange ratio between the particular commodity designated as “money”, to all the other goods in the economy, are determined by supply and demand of *each* of the goods involved in a transaction.
Where things go off the rails, is that fiat money is an artificial commodity; that is, it has no innate utility, and extremely fluid supply. Wood, for example, has utility independently of its market value; if wood were sufficiently common, it would have no market value — it’s price would be “free” — but it nevertheless retains value as construction material, fuel for fires etc. All “real” commodities have utility, including gold; this is the root of gold bugs’ claims that gold can never drop to zero value.
According to Say’s Law, if I create widgets of a given utility, I am presenting increased demand to the market. If I make a lot of them, this has two effects, each the mirror image of the other.
The first is that my increased production, qua increased *demand*, pushes up prices of all other goods in the economy; to the extent that more goods are traded for my widgets, there are less goods available to be traded for other things in the market.
The second is that my increased *supply* of these widgets, drives my price down; my profit per widget is reduced.
However, the actual utility of each widget DOES NOT CHANGE. The $10 widget of today is the same as the newfangled $100 widget of last year. (This is not accounting for innovations that increase the utility, or decrease the cost, of the widgets). The net result is that all market participants are better off for having my widget, and this is the net increase in *genuine wealth* that I have brought about by means of producing items of genuine utility; that utility is what drove demand for my product.
Fiat currency, however, while it behaves the same in the market, has no utility (apart from the physical commodities involved in coins and bills) — and that is what makes it so dangerous as a store of value.
Normally, if someone produces something that has no utility or value, nobody will want it. It adds no wealth to the economy, and so there is no market for it. This is what the government is doing — producing something of no utility: dollars.
However, it has forced the issue via legal tender laws. By forcibly inserting this artificial commodity into contracts as money — as the denominator of value — the government attempts to repudiate and subvert Say’s Law. Legal tender laws are an attempted substitute for utility.
Now, once that is done, fiat currency can and does work just fine as money (as a means of exchange, to be specific). To the extent that each one of us trades goods or services for dollars, those dollars do in fact stand for the value of these goods and serves, *so long as the market demand for them does not appreciably change between the point of acquisition and the point of spending. That is the problem with fiat currency, which the mainstream insists is a feature, not a bug: the government has the power to radically ramp up supply of its “good” by multiple orders of magnitude more speed than the rest of us can ramp up the supply of *our* actual goods in the economy!
This has multiple consequences.
The first one is confiscation, as detailed by Ayn Rand in “Egalitarianism and Inflation”. Imagine that gold was money, but that the government had the magical ability to suck it away from you, right out of your vault. Every year, there would be 4% or so of it gone. This is what inflation is doing; when the government boosts the money supply by 4%, it comes out ahead by the amount of the wealth “purchased” by that increased “demand”, while the value of the dollars that you have in your possession shrink by the same amount.
Note that the amount of value that you put into earning those dollars, however, did not change! You still put in 8 hours, or sold X amount of a good, to get it. The government has essentially stolen 4% of your created wealth. That is the function of fiat currency, the “back door” created by the legal tender laws. All the supposed benefits of fiat inflation — in particular the reduction of dollar-denominated debt — is in fact the amelioration of debt and the artificial increase of market demand, at the expense of savers.
It should be noted that, since it is dollars that are being devalued, that those who are able to hold hard assets as hedges against inflation are NOT in fact coming out “ahead”. If they saved in gold, for example, they have X ounces now, just as they did then. The price of those ounces went up, but so did the prices of whatever they can buy with those extra dollars they would realize from the sale. This is how gold and hard assets protect wealth; they lack the “back door” of fiat currency, and are immune to confiscation by inflation. (The government has to use more overt and direct means in those cases).
The second one is just as bad; this is where Say’s Law avenges itself. This is why we are hearing all about “deflation” today, and why that is horribly wrong.
Remember that all the goods in the economy actually are goods — i.e. they are things with utility — except one: the fiat currency. The market does not acknowledge the difference (it is forbidden to do so); the fiat currency acts as an artificial commodity, as a demand factor just like all the other goods in the economy. This, however, is a subterfuge: the fiat currency, unlike all genuine goods, does not find its genesis in the creation of actual wealth. It does not, therefore, satisfy the conditions of Say’s Law. New fiat currency represents artificial demand; it masquerades as wealth, but in fact there is nothing there. The government does not create wealth when it creates money.
While market participants are legally forbidden from refusing fiat currency, they are nonetheless free to adjust to the supply changes. Its only way to account for the loss of wealth is via inflation — i.e. by the transfer of wealth from holders of older dollars paid for by actual wealth creation, to those who hold “new” dollars created from nothing. This is the dilution that underlies inflation, and the source of the “false demand signal” that causes misallocation and misdirection of wealth in the economy. This is why now, as in the Depression, we have the symptom which mainstream economists see as the problem: frozen wealth in the form of excess inventory of certain goods.
Now examine our current situation. What has been happening is that the bursting of the housing bubble has been destroying real wealth. Essentially, if you traded a net amount of real wealth for a house, then the value of that house dropped by half, you have lost half your net worth by misallocation — you paid too much, and half of that wealth is now “frozen” in the house (which retains its utility). Essentially, the false demand signals that came from earlier inflation by government, drove perceived value of houses far above their proper level, in regard to the actual value a house represents. Artificial demand, in the form of new dollars released by cheap credit, bid up the prices of houses, attracting a flood of both new and old dollars (which represented real wealth created by those who earned them) into the real estate market, by far the best performer at the time the new dollars entered the economy after 9/11.
When the bubble burst, while the amount of dollars around remained the same, the amount of real wealth dropped precipitously — frozen in the physical form of excess houses. Frozen wealth is essentially wealth whose utility is far less than its price — so nobody buys it; it presents no demand for any goods. This is demand destruction, the subtraction of the demand emanating from *real wealth*, from the economy.
Demand destruction is the root of the current recession; it represents the economy suddenly realizing that there is far less wealth — and therefore less real demand — than was previously thought. It is essentially a correction of the error induced by the false demand signal caused by the earlier creation of money by the government.
Because of Say’s Law, this destruction of real wealth translates into a reduction in real demand. This is why prices have not risen — and that is why mainstream economists are calling our current situation *deflationary*. Now remember that mainstream economics, unlike those of the Austrian school, do not distinguish between real wealth generation and the creation of fiat currency.
This failure is why people are applying the term “deflation” — a reduction in the money supply — to what is actually a reduction in real wealth. This is why individuals across the political “spectrum”, from Reason’s Steve Chapman and Glenn Reynolds to conservative and leftists economists alike — are calling for actual inflation — an increase in the money supply. They are blind to the fact that an increase in the money supply is not an increase in real wealth, and therefore is not an offset to what they are calling “deflation”.
This is why prices must rise, and why we are in for at least a decade of impoverishment — via 1970’s inflation at a minimum. They are essentially attempting to replace real demand (from real wealth production, now lost and/or frozen) with the artificial demand of new dollars. Since new dollars have no utility, the amount of real wealth in the entire economy will remain reduced — but the apparent market demand, augmented by the new dollars, will be higher than it should. This is what started the whole thing!
Do you see the insanity now, of the make-work projects and deliberate supply reductions of the New Deal? Do you see why the only difference between then and now, is the presence of fiat currency — that we’ll see inflation instead of depression, but the net impoverishment across the whole economy will be the same?
More dollars chasing fewer goods (because of lowered production of goods and services following from the earlier demand destruction) will boost prices, suck more wealth from savers into consumption — which is more actual wealth destruction — eventually leaving us all much poorer.
A final addendum, in regards to the extent that government does not inflate, it can borrow, or raise taxes.
Borrowing only serves to delay the inflation, since the fund must be repaid, eventually — and the greater debt is an added incentive to inflate. It is worth noting that the German hyperinflation of 1923 arose because of the German government’s obligations to foreign governments under the Versailles Treaty; it simply printed marks to make payments.
Taxation speeds the impoverishment up, by direct confiscation.
The end results are the same.