It has become quite obvious in the last months that the US government is doing its utmost to prevent any prolonged deflation in the economy. Deflation is nearly unanimously declared as evil to be avoided at all costs.
The immediate question is to ask why deflation is so completely unacceptable? Lower prices mean that more people can afford goods and services that were previously out of their price range (e.g. houses). So where is the problem? Well, an often repeated argument against deflation goes like that: in deflation people always hold off on purchasing goods and services in anticipation of an even lower price in the future. People stop buying anything and the economy goes into a tailspin.
This reasoning is utter nonsense. Except for that part about the economy going into a tailspin...
Economic calamity will indeed happen in a prolonged deflation but not for the reason that was stated in the intro.
The reason for deflation being an economic catastrophe is quite different and a little bit more complicated. In order to understand the root of the problem we need to understand what deflation is. Deflation is not a drop in prices around us. The price drops are only the effect of a deflation. Deflation is essentially a contraction of the money supply. Nowadays, most of the money is not at all created by the mint or the government's printing press. Instead most is created in the form of credit.
The way that modern money is created is through the process of lending initiated by private banks. Banks do not lend money that they collect in deposits but rater create it out of "thin air" according to certain limits to which they are bound by the government and the Federal Reserve. This is how virtually all of money in existence is created. And therein lies the problem.
See, when banks loan you money they expect certain interest on the loans they make. That means they expect to get more money in than what they loaned out. Since virtually all money created is created through loans, it is arithmetically impossible for everyone to always repay their loans. Not unless someone else somewhere else goes into more debt making the debt problem bigger and thus growing the global supply of money. Notice that in this scheme there is never a point where money created from new debt can cover all existing debt. It's like a snake getting fat from eating its own tail.
This is arithmetically impossible which means that by definition some of the players in this game will have to drop out. There simply isn't enough money in existence nor is there a way to create it to ever settle all debts. Instead debt has to exponentially grow forever or the balloon has to pop with a huge bang (this is well illustrated in an animated film called "Money as Debt.")
This is exactly what happened to us recently and here is why:
When some of the money in the form of loans is defaulted on banks do not collect it and their bad loans have to be written off thus contracting the global pool of money. This only exacerbates the problem on a global scale as the defaulted on money reduces the pool of cash from which the still performing loans can be repaid. As more of those loans fail the global supply of money contracts further and the whole thing becomes a self perpetuating downward spiral. Less money in existence by necessity generates more bad loans which in turn contract the money supply which causes more loans to go bad and so on.
Thus a monetary system based on money produced by debt has only two modes of operation. The bubble mode when the money supply keeps expanding exponentially and the burst mode which causes a deflationary contraction of the money supply. While things generally work well during the bubble cycle (save for the nagging feeling of always drowning in more debt no matter what one does or how well he/she manages her finances), during the burst phase contractions are extremely painful and very hard to reverse. Just ask president Obama.
Now, there has been a lot of noise in the blogosphere about the so called Austrian Economics and their ideas about returning to the "gold standard" that is to a currency based on precious metals or other commodities with fairly well understood total reserves. While this would stave off inflation and eliminate the balloon effect of a fiat currency system it would essentially guarantee that most folks would never in their life obtain a loan. When money itself becomes that valuable it is hoarded mercilessly. Under such a system we would be back to the medieval model of banking where borrowing money was an act of the last resort and usually confined one (as well as his family) to a life of servitude. The direct consequence of that is feudalism. Another issue with gold based money is that it invites forgery, coin shaving and other physical manipulation aimed at gaming the system. Another is that it is just not practical in the modern world of "speed pass" tags and smart cards. Gold based money is not the solution we need. But the final nail in the coffin of the Austrian solution however, is not that it advocated the gold standard but that it advocates private banking.
Instead what I advocate is quite the opposite. We should focus on nationalizing not just the process of making physical currency but also the virtual kind. That is nationalizing the process of lending money. Of course this means killing off the so called 'financial industry' in America (and the rest of the world) but this is going to be far less painful than you might imagine. For a start, the financial "products" are not really anything of value. They are simply numbers in spreadsheets that get changed and adjusted according to certain rules. Nothing is produced, no clothes are manufactured and no food is grown by making more of those "products". The only function of the financial industry is to supply the means of exchange for those who actually make real stuff. However, when this duty rests in private hands it is only logical that it will become a for-profit activity. Moreover when the supplier of this unique "product" (i.e. money) has a great incentive to keep as much of its "product" for itself, pathological behaviors quickly develop. First of all it creates financial behemoths that are 'too big to fail'. This is only natural as large banks can quickly snowball by swallowing the little once thus growing their capital base which allows them to create more money to swallow more small banks and so on. Hence the 'too big to fail' scenario.
The second problem with private banking is that when your entire economy wholly depends on those "products" you have no option but to keep propping up those pathological entities. Why? Because your entire money supply is controlled by unelected entities whose priorities may or may not align with that of your country. Who's to say that it is more profitable for Mr. Megabanker to have your economy prosper rather than let it take a nosedive and grab all those foreclosed properties and repossessed tractors in the aftermath? After all Mr. Megabanker's bad bets will have to be written off by the government desperate to keep the money supply ever expanding and the game of musical chairs going. Hecen the quantitative easing that Obama, Bernanke and Geithner are so ferociously engaging in. Meanwhile the crisis has only one predictable outcome: real wealth (houses, cars, companies) is transferred to Mr Banker while some those who were forced to play his monetary balloon game lose their shirts.
The only way out of this quagmire is with a monetary system that is nationalized, transparent and run by elected officials. Anything else is bound to produce a pathology of one kind or another.