Why does the Fed fear deflation?

The U.S. Consumer Price Index fell by 1.5% in August, marking the sixth consecutive monthly decline, writes economist Frank Shostak. Most experts believe that falling prices signals problems for the economy because consumers will postpone buying goods, expecting prices to fall even lower.

Many economists define deflation as a fall in prices, rather than a fall in the money supply. Deflation, therefore, becomes the enemy against which an inflationary monetary policy is directed. With a sufficient increase in the supply of money, prices will rise and people will be more inclined to buy now rather than later when prices will be even higher.

But is this reasoning realistic? Why should falling prices discourage consumption? People must support their lives in the present and so will buy in the present. Even in our inflationary world some prices have fallen deeply while consumers have been buying. As Shostak notes:

From December 1997 to August 2009, the prices of personal computers have fallen by 93%. Did this fall in prices cause people to postpone buying personal computers? On the contrary, since December 1997 consumer outlays on personal computers have increased massively. These outlays stood at $83.2 billion in August 2009 as compared to $3.4 billion in December 1997.

Furthermore, most experts claim an inflation rate of around 2% is good for economic growth, while these same experts would say a rate of 10% is bad. What is the logic here? The higher the rate of inflation, the more pressure consumers will feel to buy now rather than later. So why would 10% be worse than 2%?

Shostak suggests the problem lies in the understanding of inflation and deflation. Inflation is an increase in the money supply, not a rise in prices, while deflation is a decrease in the money supply, not a fall in prices. Generally, though, an increase in the supply of money will produce a rise in prices, while a fall in its supply will lower prices.

New money in today's world is created by the banking system out of thin air. It allows users of the new money to take from the pool of available wealth without contributing anything in return. This exchange of nothing for something impoverishes wealth generators "and weakens the process of wealth-formation."

From January 2001 to June 2004 the Fed's cheap credit encouraged the creation of nonproductive activities. When the Fed tightened monetary policy from June 2004 to September 2007, these activities could not be finished and had to be shut down, and workers employed in these projects lost their jobs. Prices for the goods and services produced by these activities are falling.

Nevertheless, the money supply has been growing, and as long as this is the case we have inflation regardless of what prices are doing. If the CPI were adjusted to include the prices of stocks and commodities there would be more evidence we currently have inflation, not deflation. And if we look more closely at the CPI, some components are indeed rising in price, such as medical care and education.

With all the money the Fed has created the economy is poised to reflect a strong increase in prices, perhaps by the second half of next year.

The best way to create a foundation for sustainable growth is to allow wealth-generators to rebuild wealth. But the Fed and government policies are directed at supporting wealth-generators to fund nonproductive activities, claiming this will keep prices from falling. But this only weakens the ability of the economy to generate real wealth. Addressing the symptoms - falling prices - only makes matters worse.

As long as there are enough wealth-generators funding nonproductive activities, we will see an illusion of success. The illusion will evaporate when the percentage of wealth-generating activities drops sharply due to a lack of real funding. We will then find ourselves in a prolonged recession. And the more the Fed and government try to fix the symptoms the worse it will get.

How do we achieve a real recovery? Allow nonproductive activities to fail and stop increasing the money supply. With the expansion of real wealth and a constant stock of money, we can expect prices to fall.

Whether prices fall on account of the liquidation of nonproductive activities or on account of real-wealth expansion, it is always good news. In the first case, it indicates that more funding is now available for wealth generation, while in the second case, it indicates that more wealth is actually being generated.