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The “D” word

No, not that one. Deflation.

My old quartet baritone writes:

Pardon my economic ignorance, but how can we have deflation when all of the prices are going up? And if deflation was really a concern, then the Fed certainly would have dropped rates recently instead of leaving them alone, wouldn’t they? The word I’ve been hearing more is that goofy word stagflation, a combination of inflation and a stagnant or shrinking economy.

Fair question. Allow me to take a stab, bearing in mind that I hold only a B.S. in Economics. Which is, on the other hand, somehow appropriate.

First, it takes a while for changes in the economy to cycle down to the consumer level. For example, the cost of steel sheet, plate, and structural shapes has more than doubled since January, but we haven’t seen anything like that kind of increase in the prices of cars, washing machines, or rents in new office buildings.

This works both ways. Gasoline and food prices have skyrocketed over the last couple of years, driven by unregulated speculation and a flood of U.S. dollars from the U.S. Treasury. However, the credit crunch that’s still unwinding through the global financial markets has already started the pendulum swinging in the other direction.

Second, Ben Bernanke doesn’t really have that much room to maneuver. When the real rate of inflation is considered, somewhere around 7.5% when figured with Clinton-era methodology (and perhaps closer to a real rate of about 12%), the Fed’s 2% interest rate to banks is already a net negative number!

Experts across the Western world are now openly talking about deflation, a bad sign. Ambrose Evans-Pritchard explains:

The money supply data from the US, Britain, and now Europe, has begun to flash warning signals of a potential crunch. Monetarists are increasingly worried that the entire economic system of the North Atlantic could tip into debt deflation over the next two years if the authorities misjudge the risk.

The key measures of US cash, checking accounts, and time deposits – M1 and M2 – have been contracting in real terms for several months. A dramatic slowdown in Britain’s broader M4 aggregates is setting off alarm bells here.

Money data – a leading indicator – is telling a very different story from the daily headlines on inflation, now 4.1pc in the US, 3.7pc in Europe, and 3.3pc in Britain.

Paul Kasriel, chief economist at Northern Trust, says lending by US commercial banks contracted at an annual rate of 9.14pc in the 13 weeks to June 18, the most violent reversal since the data series began in 1973. M2 money fell at a rate of 0.37pc.

The situation is complex, there’s no question. But the bottom line, simplest answer is this: a contraction in the money supply, spurred by the credit crisis, will have the opposite effect as the Fed’s overheated printing presses over the last few years. Fewer dollars in circulation will mean that each individual dollar is worth more relative to goods and services.

As a result, prices will drop — helped along by the sad reality that a lot of us will be out of work and buying less stuff than normal. Thus, deflation.

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