When Deflation Isn’t Deflation

By: Joshua_Burnett

The most common argument I run into when I tell people that hyperinflation is looming on the horizon revolves around the current “deflationary” period.  People have a hard time seeing the U.S. turning into the next Zimbabwe when we’re supposedly not experiencing any inflation at all, let alone hyperinflation.  The problem lies not in the fact that we’re actually experiencing deflation and that we’ll face a fundamental, 180 degree reversal in direction in the next few years; the issue is actually found in an institutional misunderstanding of macro economics and the role it plays in defining deflation.

Our understanding of deflation is composed of two things: a definition and a commonly utilized method of measure.  When these two coincide (as they almost invariably have) we not only understand what deflation is but we can quantifiably measure it.  When the two separate we must reexamine our position.  The secret lies in macroeconomic fundamentals, for only through a solid grasp of these may we understand the microeconomic realities we deal with on a daily basis.  A martial arts mentor once told me: “Advanced techniques are simply the basics mastered.”  In honor of that spirit, let us return to the basics.

The definition of deflation is a contraction of credit and available money.

The contemporary measure is a fall in the general price level as measured by the Consumer Price Index, or CPI.  In layman’s terms: things get cheaper as each dollar buys more.

This measure has proven to be consistently accurate because it does for purchasing power what the gold standard did for the fractional reserve system: it ties abstracts to concretes.  One loaf of bread is worth exactly one loaf of bread; it has the same nutritional value now as it did a hundred years ago, which is the same nutritional value it will have in another hundred years (assuming a constant recipe, of course).  Whether that loaf of bread costs 25 cents, $1.50, or $100 gives us the ability to measure the purchasing power of the dollar.

This system has been reliable because it doesn’t simply rely on a loaf of bread, which can vary according to the individual pressures the wheat farmers, yeast merchants, and bakers face, but rather on an entire basket of products and services that have been constructed to provide an overall view of the market as a whole.  This diversification is what has historically allowed us to rely on the Consumer Price Index as a dependable measure.

But what happens when the macroeconomic realities change the entire basket simultaneously?  The measure is structured to interpret any possible move of the entire basket in only one way: as either inflationary or deflationary.  But what if a stimulus was to occur that wasn’t due to inflation or deflation?  As any good engineer will tell you when the gauge is measuring something other than what it’s designed for, you’re getting a false reading.

Current CPI indicators tell us that we’re experiencing monthly deflation rates in the range of 1.3%.  Again, we’re using the measure of deflation; but what happens when we compare the definition of deflation to current events?  Is “a contraction of credit and available money” really occurring?  The Fed has increased M1 by 16.1% from May 2008 to May 20091.  We’re looking at a $1.85 trillion budget deficit this year alone.  The Congressional Budget Office has predicted deficits of a total of $9.3 trillion over the next decade (without, incidentally, compensating for any type of universal healthcare system… yet).

All of this will be covered by printing more dollars.  Chinese students openly laughed at Secretary Geithner when he told them the dollar was a safe place to store their value.  Is what we’re seeing really the dollar becoming more valuable?  Logically, no.  Judging by the definition of deflation, no.  So why are we getting deflationary readings from our primary instrument?

The answer once again lies in macroeconomic fundamentals.  Last year consumers in the United States were buying the most expensive oil (in real dollars) they ever had with prices peaking at $147.30 per barrel in July of 2008.  This event occurred at a unique time in history; we’re more reliant on oil for transportation of people, goods and just-in-time delivery than we’ve ever been before.  If one adjusts for inflation it becomes instantly obvious that these aren’t actually the highest prices we’ve ever paid for oil (we actually paid more for oil in the 1860s, 1870s, and 1970s); they’re just the highest we’ve paid when we’re this reliant on oil.  This price spike and dissipation was also an aberration in the concentrated time period it occurred in; although we were similarly reliant on oil in the Oil Crisis of the 1970s that event occurred over the span of years, not months. 

As a result literally everything became more expensive.  From groceries to entertainment to repairs; we saw the advent of “fuel charges,” implied or specified, being tacked on to almost every good and service.  In other words, the basket of goods composing the Consumer Price Index saw a drastic increase in cost, an increase which had very little to do with an expansion of the money supply.

The accompanying 78% drop in the price of oil over the next six months was similarly remarkable.  Goods became cheaper to transport than they had in years but the accompanying price bleed off was accomplished more slowly as businesses were leery of dropping prices down to pre-oil spike levels.  As time passed prices were slowly decreased from the top down; eventually these discounts reached the consumer. 

So what fruit did this yield?  The CPI has decreased 1.3% over the course of the last year which was the largest decrease since April of 1950.  This was neither a lessening of the true cost of goods themselves nor an increasing value of the dollar; even though one could technically argue that the purchasing power of the dollar increased over this period that statement would be an inaccurate representation of what was actually occurring; the reality was that prices were returning to where they should have been.

What this means is that we’ve received a false deflation reading.  The CPI measure of deflation is designed in such a way that pressures and problems faced by individual commodities and services are averaged out against the presence of many others so that such false readings are generally avoided.  Rarely has our dependence on a single aspect of the economy been as starkly demonstrated as it was last summer where the price of a single commodity affected the entire economy.  Economists can now rest assured that they’re not going batty; the facts do bear out the hyperinflation we’ve all been seeing in the mix; one simply must dig a bit deeper to find it.  Don’t rest too long though; we’ve got the Dollar’s self-destruction to prepare for.

1 Federal Reserve Statistical Release, 25 June 2009

By Joshua Burnett,

© 2009 Copyright JOSHUA S. BURNETT, - All Rights Reserved
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