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Inflation and Deflation -- A Reader's Perspective   (Gary G., December 10, 2007)


Regarding your paragraph below in your 12/7/07 posting, Muddling Through Malaise:

3. The foundation of the inflation/deflation question is supply and demand. In terms of the dollar, or any currency, if there's no demand for the buck the price drops. If there is more demand than supply, the value rises.

The basic argument runs thusly: the U.S. Treasury, Fed and U.S. money-center banks can create stupendous sums of new dollars which then overwhelm demand. This is what has caused the dollar's decline against other currencies and against gold--a massive imbalance between supply of dollars (ever-growing) and demand (weakening as holders get tired of declining value).
The bolded statement isnít exactly true.

For clarity, money = credit in todayís world of fiat currency. This is true because there is no legal currency that is redeemable for a fixed amount of any indestructible, tangible asset of value. All money, whether electronic or paper, is created and destroyed through the expansion and contraction of credit.

When there is more money (from credit expansion) spread over the relatively same amount of goods and services, the prices of things go up with no change in economic well-being. This is inflation.

When the amount of money decreases due to a contraction of credit, the prices of the relatively same amount of goods and services fall as money available to pay for them shrinks. This is deflation, or stated another way, an increase in the value of money.

When more goods and services are produced and sold with the same amount of resources, this is economic expansion, even though prices may fall if credit/money does not expand.

When fewer good and services are produced and sold with the same amount of resources, this is economic contraction, even though prices may increase if credit/money does not contract.

Note: Economic expansion and contraction can also occur through changes in population, though that alone has no bearing on the standard of living. It just means there is more or less economic activity overall.

A key to understanding inflation and deflation is understanding how and why credit expands and contracts. The why part is probably most important, and the why of it all directly relates to mass psychology. In order for credit/money to expand and inflation to occur, there has to be both willing lenders and borrowers. When either the lender or the borrower is less willing than the other, it is unlikely there will be dramatic credit expansion or contraction. And when neither lenders nor borrowers are willing to lend and borrow, you have credit contraction.

The US Government is a net borrower, but a special borrower with the power to tax to pay back its debts and a seeming endless willingness to borrow. So government can arguably tilt the playing field towards credit expansion when it convinces willing lenders to lend, but only so much. The government cannot compel unwilling lenders to lend Ė though they can provide an incentive by compelling taxpayers to pay interest to those who do lend. Other borrowers, in contrast, can have much greater difficulty in convincing people to lend, since those borrowers typically rely on continued economic or credit expansion to pay lenders back.

The Fed is a lender, but also a market maker. As a lender against government collateral (govít debt), it can feed a willingness to borrow, but it cannot make people borrow. As a market maker, the Fed attempts to stabilize the credit markets in the short term, but only at a profit. There are limits to how much the Fed can run counter to the herd without getting burned. So Fed policy really only works in an expansionary environment when there are willing borrowers.

If and when mass psychology turns from expansive to contractive, deflationary forces will take hold. Both the government, as a net borrower facing more skeptical lenders, and the Fed, with no ability to force non-governmental borrowing, will be at a loss to counter those forces.


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