Preventing Deflation Won't Stop the Depression

The world's monetary authorities are, at present, desperately trying to stop "deflation." Deflation is a complex and controversial topic, but suffice it to say deflation is the perception of falling prices. The theory behind central bank actions is that when prices are perceived to be falling, one becomes reluctant to invest or even spend on consumables, when just waiting will get one a better deal.

Obviously, stock and commodity prices have fallen dramatically in the last few months. Most real estate has been falling for a couple years now. Consumer prices are beginning to fall as well. Can this process be stopped? Actually, yes. Central banks can ensure that the money supply rises fast enough to devalue the money in one's pocket, making assets, goods and services again an attractive use of that money.

Can arresting deflation stop the 2008 Depression? No, it cannot. Depressions are a self-reinforcing process of declining income. Wages have been falling in purchasing power for decades. Households responded at first by sending more of the population into the workforce to support the household. Families with a single 'breadwinner' are now quite rare. Lately, workers have taken to eliminating savings, borrowing against the value of their homes, as well as taking on increasing amounts of consumer credit in an attempt to fund their spending. This is, of course, not sustainable. In fact, defaulting consumer debt will be a serious drag on the world economy for quite some time. A further drag is rising unemployment, and over all personal income in decline.

At this point, the economy will not recover until several things happen: the losses from bad investments are recognised; failing undertakings have been liquidated; savings rates return to healthy levels; employment and the purchasing power of wages begins to rise. Current government policies are not promoting any of these conditions. If anything, the policies are working against the first two conditions.

It is possible that we are witnessing an effort to 're-inflate the bubble.' Perhaps if the public sees that their houses and investments have stopped falling in value, they will pull out their metaphorical charge cards and dig themselves even deeper into debt. Leaving that central banker fantasy aside, we believe that conventional economic theory is incorrect. The current decline in prices is a symptom of economic contraction, a destruction of purchasing power. Alleviating the symptom will not cure the disease. Denominating prices in a debased currency will do nothing to help the current situation, and even risks igniting an economy-destroying hyperinflation.