Should we be worried about future deflation or inflation?

There is a lot of worry these days about weather we are in deflation, slipping into deflation or about to enter into an inflationary environment. It obviously makes a big difference in future planning and how investments are allocated. As you can imagine, there are very different views among the different economic philosophies.

Before I get philosophic differences however, I need to provide a simple definition of inflation and deflation. Very simply, inflation means an increase or inflation of the money supply (more money units) and deflation means a contraction in the money supply. In the case of inflation, an increase in money units means that each unit is worth less or one’s purchasing power is diminished. Therefore prices increase. Inflation, the way the word is used today means an increase in prices. Therefore, the cause of inflation is usually misdiagnosed. I’ll talk more about this in other posts. So lets look at the different viewpoints.

Keynesian/Demand-Side View
The big government economists (Keynesians and demand-side economists) are worried that the money spent to date (the stimulus and fiscal and monetary policy) is not enough to fill the spending gap left when consumers and businesses reduced spending.

Influential economists like Paul Krugman, have said all along that the stimulus packages have not been large enough to fill the gap in spending and that now we need a much bigger stimulus package in the neighborhood of $1 trillion more dollars if we are going to turn this economy around. If we do not get that kind of spending, we will slip into a deflationary death spiral that is very difficult to get out of. Therefore, we could end up like Japan in the 1990’s with 10 years or more of almost no growth.

Their definition of deflation is falling prices (due to lack of demand) and they see falling prices everywhere (housing prices, food prices, car prices, etc.) He doesn’t see falling computer prices over the years as detrimental or deflation however. He also does not mention how we are going to repay the loans.

Keynesian/Supply-Side ViewThe opposite position is taken by the less government economists (Keynesians and supply-side economists) who see a marginal improvement in GDP growth, which they have extrapolated into a V shaped recovery. They are worried about the coming inflation because of artificially low interest rates and high debt levels.

They see inflation (a rising consumer price index or CPI) everywhere. They think that unless the Fed raises interest rates very soon and begins to take money out of the system, we will get severe inflation within the next year to eighteen months. Interest rates should be raised to one percent higher then the nominal growth rate of GDP (growth rate before inflation.) So if the economy is growing at 3-4% as they expect, interest rates should be at 4-5% not zero.

Their definition of inflation is a rising CPI index (which is the symptom of inflation, not the cause.) The CPI index as you know is a basket of goods and services the government uses to measure price changes.

Capitalist ViewThe almost no government economists (Capitalists, Austrians, Objectivists) have a much different definition of deflation and inflation. They see deflation and inflation as it was originally defined: expansion or contraction of the money supply. Their view is that the government has been and continues to pump money into the economy (print money), which will be inflationary. However, consumers are currently over-leveraged (too much credit vs. disposable income) and must reduce spending and increase savings in order to b ring their financial lives into balance. This slowdown in spending looks like deflation (prices are being reduced by almost every store advertising.)

Therefore we are currently in a period of de-leveraging, not deflation and until the consumer starts spending again (by using or reducing his savings or expanding his credit) we will not enter an inflationary phase. But based on the money that has been added and expected to be added to the economy, we could be in for serious inflation.

Conclusion

Therefore, your current position should be focused on a de-levering economy, which will take considerable time and considerable pain. However, if the government pumps too much money into the economy (a debatable number) or credit becomes too easy again, too soon, it will be time to reposition yourself for inflation.