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Deflation Explained
By Donald L. Luskin - LuskinReport.com
Issue Date: Aug 17 2001

What is this thing called deflation? We're in the middle of it, and we answer some of your biggest questions about it.


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Comments and questions continue to flood in about deflation. After months of writing about it, following the pioneering work on deflation over the last four years by Jude Wanniski of Polyconomics, and by MetaMarkets Think Tank member David Gitlitz of Kudlow & Co., the subject is finally getting real traction. You read about it in the mainstream financial press and hear about it on CNBC almost every day now.

So let's get to some of the questions that have been pouring in by email; you've already seen my responses to the questions posted here on the discussion boards.

Is this article similar in description to "stagflation"?

"Stagflation" is the combination of inflation and stagnation - it puts together two categories of analysis that are best kept separate, but are often confused. The first category of analysis is monetary - is the unit of account (the currency, i.e., the dollar) appreciating or depreciating versus goods, services and assets? If it is appreciating, then prices of all things are falling, and that's deflation. If it is depreciating, then the prices of all things are rising, and that's inflation. The second category is macroeconomic -- is the nation's economy expanding or contracting, and how fast? This can be measured any number of ways, such as gross domestic product, national income, retail sales, employment, and so on.

Just as you can have inflation at the same time as you have stagnation -- as in the United States in the 1970s - you can also have any other combination of monetary and macroeconomic states. For example, you could have "depansion," which is the combination of deflation and expansion. Or you could have "intraction," which the combination of inflation and contraction. It's a myth that inflation produces growth (or is caused by growth), and it's a myth that deflation is the same thing as contraction (though the words are often sloppily used interchangeably). The only truth is that, over the long term, the goal of sustainable growth is best achieved with neither inflation or deflation - both tend to induce costs and inefficiencies that retard growth.

Do you think that Greenspan Co. are as smart as you are - do they recognize the problem as you see it? Also, assuming they do, are they willing and able to take the appropriate action?

Gee, that's a flattering question. And I'm just arrogant enough to take the bait: no, I don't think that Greenspan & Co. see the threat of deflation as I do. And I think I am right and they are wrong. Greenspan - and just about everyone else, for that matter - has been conditioned from birth to think in terms of inflation only. Inflation is bad. It is to be feared. And if inflation is bad, then its opposite - deflation - must be good, or at least unimportant. That's why Greenspan & Co. go nuts at the first imagined whiff of inflation - and launch "preemptive" attacks against it, even at the cost of killing the greatest bull market in history. But even when advanced signs of deflation are all around them, they don't even notice.

What does all this mean to the individual consumer/investor? If we do, in fact, enter a "deflation crisis," it would seem that the wisest course of action for the individual would be to get very liquid and thereby preserve his purchasing power.

All else equal, in a deflation crisis cash is king. The very definition of deflation is that cash appreciates versus goods, services, and assets. So you certainly don't have to worry about purchasing power. Quite the contrary. Just sit on cash or bonds, and watch your purchasing power get greater and greater. That's what people have been doing in Japan for 10 years, and why zero interest rates don't help.

OK, let us say the Fed prints more money and buys government bonds; now government has the printed money. How does it get into the consumer's pockets to stimulate buying? Will govt drastically reduce income taxes or capital gains? Then it is possible. The boom was technology-driven and so was the bust. As technology becomes affordable, reliable, businesses will invest again in technology and a new cycle will start. My thinking is that it is two years away. A lot of people have lost a lot of money believing in the instant tech promise that failed to materialize. They will not buy just because they have money in pockets. They will be cautious for a couple of years until their losses are recouped.

When the Fed buys bonds, it is not buying them from the government - it is buying them from banks. This puts banks in the position of holding non-interest-bearing instruments which they will be eager to lend out. But the model works even if the Fed buys bonds directly from the Treasury. Normally, the Treasury sells bonds to ordinary people in exchange for their cash - this no money is created or destroyed when the government borrows. But if the Fed prints fresh money to buy the bonds, then the government will spend that money in the economy and it will get into people's hands - without taking it away from them at the same time by making them buy the bonds. As to the second part of the comment, I totally agree. The purpose of quantitative easing is to cure deflation, to repair an assault against the integrity of the unit of account, and to restore economic actors to the parity of relationships that existed before the deflation played hob with all their long term contracts and commitments. This will not in and of itself electrify consumer demand and make everyone go out and buy three Cisco routers whether they need them or not. But it will alleviate the burden of excessive illiquidity that comes from the natural preference to hoard cash when cash is king.