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The Inflation/Deflation Conundrum

By Paul Nathan      Printer Friendly Version Bookmark and Share
Dec 15 2010 2:08PM

Back in the 70's everyone defined inflation as "an increase in prices."   Milton Friedman, and others, convinced the public and the pundits, that we needed to focus on the cause of inflation, which Friedman defined as "an excessive increase in the supply of money."

Today, everyone cites the Friedman definition.  But they have lost sight of the whole definition i.e., inflation is "an excessive increase in the supply of money that leads to an across the board increase in prices."  This definition contains both cause and effect. (The Austrian School of monetary theory disagrees with this definition.  It holds it is the hoarding and dis-hoarding of money that leads to inflation and deflation, and may or may not coincide with a rise in prices.  I agree, and I think that theory is being proved today, as the money supply has increased and the general price level has remained low.  But, it is the Monetarist definition that is most widely accepted, so we will use it here. For a further discussion of this subject see "Why Prices Are Not Skyrocketing", in the archives.) 

A statement uttered so often today, is that "we have both inflation and deflation going on at the same time."  Do we?  The answer is obviously "no" -- not if you define your terms. By definition it is impossible to have both an increase and decrease in the nation’s money supply, at the same time.  And it is impossible to have an across the board increase and across the board decrease in prices, at the same time.  That's the short answer.  The long answer is a little more interesting.  Let's put the Monetarist theories and the Austrian classical theories aside for a moment.  Let's do what economist's tell laymen never to do.  Let's look at the meaning of the question in the vernacular.

We live in a world where prices of some things are noticeably rising and others are falling.  This is where we get the vernacular expressions of "commodity inflation", and "real estate deflation", and "energy inflation", and "technology deflation", and "food inflation", etc.  But we are not experiencing an across the board progressive increase in prices.  We have not experienced a significant across the board increase in inflation in thirty years.  The CPI has in fact fallen from rates of 14% to under 1% in that period.  We have had what might be called a progressive dis-inflation.

Some argue that the indexes that measure inflation are wrong.  I have news for these folks. They are always wrong -- no matter which index you use, it must be wrong by its nature.  There cannot be an index that properly measures all prices and their cross relationships at a single moment of time.  We subjectively choose a method of measurement and that is our yardstick -- and there are many of them with many different types of goods, weightings, and compensations.  Soon there will be a "Google CPI."  It will comprise all of the retail prices within the Google universe, priced on a minute by minute basis.  It will also be wrong.  Here's the problem:

If you are in the home industry as a contractor, a builder, a construction worker, a real estate agent, appraiser, or mortgage lender, you live in a world of deflation, where the price of what you sell has been going down, together with the income you have been receiving.  All have been falling for about three years. 

If you are a miner, or selling or buying commodities, or in the farming or agriculture business, you live in an inflationary world.  If you export anything now-a-days, you live in an inflationary booming world where price increases are routine and dramatic, and unemployment has been running only in the 3 to 4% range.  So, where you live, and which part of the economy you work in, determines whether you are experiencing "inflation" or "deflation".  That is what is meant by those who say we are experiencing inflation and deflation at the same time. Thus, inflation becomes an acutely personal matter. 

The job of an economist, however, is to determine what is going on with the economy as a whole.  Terminology such as the above only serves to confuse things. If monetary policy is stable, when prices go up in one area, they must fall in another area.  We can not have "gasoline inflation" without having less money to spend somewhere else.  We can not have "food inflation" without it costing us more and having less to spend on other things.  In an evenly rotating economy we always will have some prices rising and others falling. 

So, there is nothing unusual about the statement.  Increasing and decreasing prices in a market economy is the norm.  And that is just what we have had for the last thirty years.  It is only when we have excessive amounts of money being printed that we can have the phenomenon known as inflation -- a progressive across the board increase in prices.

Now, there is a secondary argument made that is important to look at.  That is the statement that it is only the things we need or really want that are going up, not the things that are less important.  Gold and silver are perfect examples.  They are precious metals.  At 1400 dollar gold, people have to pay a lot more for their precious ounce of gold than when it was 35 dollars an ounce in the 1970's.  And that silver dollar you had in your pocket in 1967 will buy about 30 dollars worth of goods today.  What changed?

Well, money supply increased dramatically throughout the 20th century --that is for sure.  But, something else has changed recently that has led to an unusual run-up of some commodity prices in particular, many to all time highs.  Because some governments continuously practice protectionism, dollars have piled up in their treasuries and are not being allowed to flow back.  These governments prevent their citizens from freely importing other nation's goods.  This has caused huge imbalances.

Under the automatic rules of the gold standard, money was free to flow from nation to nation, and did so for centuries.  As money flowed into a nation its money supply would increase and prices would rise.  The exact opposite occurred in the nation where money flowed out -- prices would fall.

As this occurred those who saw cheaper goods become available abroad would begin buying those goods instead of domestic goods and the entire process would reverse itself.  It was like a teeter-totter. The result was a world in constant movement toward equilibrium.  No government intervention was required.  Balance was constantly being restored automatically due to free markets and free trade.

That is not the case today.  Today, we have Sovereign Wealth Funds, as an arm of governments who wish to get rid of their surpluses.  They are going after commodities -- and strategic commodities at that.  Oil is being stockpiled along with things like copper, gold, cotton, sugar, and anything that is of importance to that particular government and nation.  It is a government led demand, not a consumer led demand. 

This has added to the price imbalances and distortions as dollars have been concentrated and focused on particular commodities that governments want.  It is one thing for dollars to come back from China seeking an array of consumer products that individuals want.  It is quite another thing for a fund set up by a government to go around the world buying up scarce resources.  If the American government were to do this, all hell would break lose!  In this country, the American government is not the major purchaser; the consumer is.

Add to this government created demand, ETF's which track and/or accumulate commodities, and you add another source of demand by investors throughout the world. Finally, this is trickling down to the "man on the street."  He is recognizing that if there is something he really needs or wants, he better get it now before it is entirely out of reach or its availability disappears completely.  Is this inflation?  No.  It's called "hoarding."

The end game as they say, is a run on particular goods which are scarce and/or necessary to live.  Food, energy, and strategic metals, are among the goods being sought.  Gold and silver are being accumulated as the ultimate medium of exchange to trade for precious goods.  Prices of collectibles, antique, exotic cars, certain wines, rare works of art, are all going through the roof.

So, it is fair to say we are experiencing a surge in prices of those things we really need or want.  But, as long as the money supply increases remain stable, we pay for these things at the expense of other things forcing those prices downThis is the cause of the inflation/deflation conundrum.  This is the world we are living in, and will be living in for some time to come.  It is a world of protectionism, unending trade surpluses, and price imbalances and distortions -- all leading to hoarding.

The solution is free trade, free markets, and eventually a universal monetary system based on confidence; a monetary system based on stability and predictability; a system based on the free flow of money among citizens throughout the world.  This kind of system requires a lot more freedom, a lot less government, and objective rules that are adhered to by governments.  It is a system that is attainable.  It is a system that lasted and served mankind well for centuries.  It was the gold standard.  And it rested on the two pillars of free market capitalism and free trade.

For more information on the gold standard, the evolving events in today's world, and my weekly market update and trading strategy, I invite you to

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Paul Nathan
December, 2010



Paul Nathan has specialized in gold and gold stocks and has written extensively on monetary and economic matters since 1968.

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