http://money.cnn.com/2009/
Inflation is often referred to as an increase is prices. That's correct in a way, because in inflationary times, more money is required to buy goods. But a contrapositive proves this definition is false: If you keep the money supply the same and STILL increase prices, that's not inflation. It's actually movement of the demand and supply curves.
Economics is really the study of choice, and we are always forced to make choices because real things are finite, even specie! So if all prices went up, and the money supply was fixed, it would mean consumption fell, which is by definition movement of the demand curve. How does that realistically happen? When productivity falls. Imagine a major war ends, and all the factories are fine, but many people are injured and can't work. Output per person goes way down, prices go up (since less is being made), quantity demanded goes down, and supply goes down in step, but both at higher prices. Voila, you have movement of the curves, with no more and no less money in the short term.
True inflation is nothing more than an increase money when the quantity of goods and services demanded and supplied stays the same. All of a sudden there are more dollars floating around, with the same number of items to spend them on. Soon, people start charging more and spending more for the same things, and as an output, prices rise.
So what's happening to prices today?? Well, if it's not deflation, which it can't be, it's movement of demand, or more tangibly, change by consumers in how they value things.
The way goods are valued to each other is relative and flexible. Sometimes, when times are good consumers want to buy houses, for instance, on speculation that prices will rise. Other times, they prefer cash and bonds when they think a recession is coming. Sometimes commodities go up because businesses expect to grow, and sometimes they fall because investors think there is too much in inventory. Those are changes in investor preferences. Both of those examples have little to do with the money supply. Such a shift by individuals in the value of certain items relative to other items can always be identified by the failure of almost all goods to fall in price at the same time. For example, if gold and other stores of value stay the same price or go up while stocks fall, deflation is not occurring.
In other situations, businesses have excess inventory, for instance cars, that they need to sell. They may need to sell these cars because the business did not prudently manage cash, and is running out due to progression of the business cycle. A decision like that to clear out inventory does not signify deflation. It means there is temporary oversupply.
If all that did not convince you that deflation is not happening, consider this: Everything in economics happens over a time frame - short term, long term, etc. It's particularly hard to draw long term conclusions like deflation in the short term, because things happen too fast. The measure used to detect recession, deflation, and the like come out only few times a year, and are revised again months later. So anyone telling you we had deflation last month is pulling one over on you. This time frame problem is the most problematic issue for the deflationists, as the results change when you expand the time frame. Let's say commodities fell 30% from July'08 to December '08, and someone argues that's deflation. Well, if you went back 5 years and found that commodities went up 100% (doubled) the first four years, then fell 30% in the last six months, did deflation occur, or did an asset class (commodities) bubble in value and then correct to normal, inflation adjusted prices? Even the DJIA at 8,000 seems pretty good compared to the 7,000 it hit in 2002... The only asset class that's down substantially over the medium term is real estate which has massive oversupply and is at levels comparable to 1995... the last real estate recession. Are we starting to see a business cycle here?
What does that all that mean for the current economic situation? Well, it means that deflation is not occurring, for one. Deflation is the opposite of inflation - it is a reduction in the money supply, in which case the opposite of inflation takes place - it requires less money to buy everything, because money is now scarce, and there are still a lot of goods. Imagine if everyone required paper currency to buy bread, and it was one bill per loaf. Then all of a sudden, the presses broke and the government couldn't print new bills to replace those that wore out. Soon there'd be half as many bills, everyone would get together and agree, it's now $2 to buy a loaf. Oh, and buy the way, those of you who made $200 a day are now going to make $100, since the bills are worth twice as much.
That is what happens in deflation, and is basically what happened to Japan in the 90's. What scares the finance community about deflation ironically is not falling prices. In deflation, prices fall, but wages do too, as there's less money to go around, and it's a wash. The real problem is that as wages fall, loans stay the same, as the vast majority of all loans are written with a fixed loan amount. So if your mortgage is $200k and your wages fall in half, you are in real trouble. You now owe effectively double what you did before, with no means to pay the difference.
With inflation, the opposite occurs. The amount of money in circulation increases, with the amount of real assets staying the same. Prices for everything (including houses) rise, and people with debt feel wealthier because loans have stayed the same. Time to get that home equity line of credit!
Economists and other who talk about deflation worry about what's called the deflationary spiral, in which prices fall, then wages fall, then prices fall some more, and so on. In this situation, that's not a material risk, because only certain assets are falling, such as cars, houses. The biggest red flag that happens to be correlated with deflation is high unemployment. Unemployment is up, although not at historically high levels. But the concern nonetheless is that persistent high unemployment will lead to more falling demand AND lower wages. Lower demand does not lead to deflation, just smaller factories. But lower wages do. Lower wages are an input in production, and will be reflected in lower prices once supply and demand are in balance. Yet today, wages are not following, and won't as long as the recession ends and employment stays within a normal range. As the business cycle progresses the economy should cure itself, and there is no reason to think a depression is going to happen as long as banks shed bad assets and bounce back (for the record, that is what did NOT happen in Japan).
What's happened in the last year is that bank credit dried up very quickly. Bank lending is one component of the money supply, but an important one. This is worthy of another article, but bank lending does this by accepting deposits and lending them out, while maintaining reserves that are only a fraction of deposits, say 20%. So the depositor with 100k in a mattress deposits it. The depositor thinks they have 100k 'in the bank', but they don't. They have a promise from the bank to repay 100k, and the borrower has 80k in borrowed cash, with 20k left in the bank as a reserve.
However, in practice most borrowers don't stuff the cash into a mattress- they deposit it, which goes into another bank, which keeps 20% (16k) in reserves and lends the rest, etc., etc. As this process plays out, the banking system converts cash that was sitting in one person's mattress into multiple deposits. In the end, most of the money ends up in reserves, but because of widespread lending, there are many more deposits than you'd think for only 100k going in in the first place. This is OK in terms of keeping money in circulation, but it creates systemic risk when something goes wrong... and it did. In our case, the last deposits to be lent out were loaned against some overvalued real stock, commodities, and real estate, and because banks have limited reserves (20% in this example), a bunch that did poor underwriting ran out of cash.
The government decided to solve this problem by borrowing more money and spending it (fiscal policy) and by the fed both lowering rates and literally printing money (monetary policy). Yes, the fed really did start printing money - they started using dollars to buy longer term treasury bonds and mortgage backed securities in an effort to push mortgage rates down, accomplished by 'expanding the fed's balance sheet' as explained by Bernanke. 'Expanding the balance sheet' is just a polite way of saying 'printing money'.
The problem for the economy is that the amount of loosening by the fed is enormous, even in light of the problem. That's because most lending done by banks is simply the refinancing or extension of existing credit... the amount of actual new credit required each year is small. So the bank failures and concurrent tightening stopped new lending, and some borrowers with notes due could not refinance and defaulted, but most loans remained outstanding... The greatest damage was done instead by higher rates, which cause a negative wealth effect for those with variable rates. But the fed and treasury did a good job of squashing that through a variety of measures. So now, the major problem remains really low rates that are inflationary, and way too much money supply. This is the problem the government needs to solve, and soon.
The asset bubble that occurred after the fed loosening in 2000 is an example of what happens when money is too cheap. And economists are worried that action needs to be taken now if inflation is to be avoided.
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