What’s worse, deflation or inflation?

Inflation is the general rise in prices. We get less stuff for the same amount of money. When you look at it in that way, inflation is obviously bad. Our money is worth less since we can’t buy as much with it. Any money we have, or will get in the future isn’t worth as much. This is what leads to the inevitable reminisces of “I could buy a zillion pounds of x for 10 cents!”  when talking about our childhood.

All of us have lived with inflation over the years, mostly of the incremental variety although there was a time in the 70’s when it was a little more aggressive. This was accomplished by manipulations of the federal reserve. You see, causing inflation is pretty easy, all you have to do is create more money and things get more expensive. Why would they do that? A lot of it has to do with fear and political pressure.

It’s like this, as long as there is a moderate amount of inflation, all costs, including the cost of labor go up. People are fooled into thinking that they are actually making more money, that they can actually buy more, at least over the short term. Eventually, they catch on and demand more money, and then a little inflation kicks in and they are happy. There is an irrational fear of deflation, any movement downwards in the amount in the paycheck make people freak out.

That’s what deflation might bring, but what does it mean? When there is deflation, money increases in value. Things drop in price, so we can buy more with any given amount of money. The trick is that wages are just more things, and they will drop if there is general deflation. Never mind that everything else is dropping in price too. Somehow wages rising in order to keep up with inflation doesn’t cause any consternation at all whereas wages dropping to keep track with deflation will cause riots. Never mind that inflation kills value, never mind that inflation kills savings.

And that’s the real crux of the issue. Americans do not, in general save. If we were a nation of savers, we would welcome deflation with open arms. Deflation would make our savings worth that much more. Instead, we are a nation of debtors. As deflation sets in, debts are more difficult to pay back, all debts. That includes mortgages, credit cards, and T bills.

No, inflation suits us much better. The more inflation there is, the easier it is to pay off debts. Inflationary pressure is built into the very foundation of the banking and financial sector. It encourages people to incur debts, hell, it encourages governments to incur debt. It simultaneously makes it more difficult to save. In addition to have to get paid enough in order to forgo spending the money right away (i.e. interest) we also need to make enough to cover the devaluation of our savings (i.e. inflation).

Imagine a world in which currency continued to increase in value over time. We would be regaled with stories of how our grandparents were paid with $100 bills whereas we now count our micropennies with care. Imagine a world where depositing 10% of your paycheck in the bank would accrue value just sitting there, where the fifty dollars you made last year can now actually buy you more now than then. Imagine how important it would be to save instead of spend…

That’s fantasy of course, there are some real complications of a constantly deflating currency but I mention it just to point out how fully we have incorporated expectations of inflation. Our inclination is to spend and go in debt first. We have seen the results of too much debt when the economy doesn’t do so well. As someone that doesn’t hold any debt and has a small amount of money set aside, I wouldn’t mind some deflation at all. Instead, I am sure that the Fed will do anything it can to prevent it, and therefore overshoot and cause larger inflation that is necessary. Hold on to your hats folks, it could get a little wild…

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