Deflation versus inflation

I'd like to write on deflation versus inflation a bit more today. I think this topic is a critical one for anyone with money or anyone who hopes to have money someday, but more to the point I find the topic interesting because it involves trying to make sense out of a complicated situation.

Even more to the point, I find that a lot of people are unconvinced that a slowdown in the economy and a decrease in the supply of goods and services will likely propagate deflationary pressures. I for one won't argue against being unconvinced of this (for we should resist being convinced of much of anything in economics), but I will argue against people who are convinced of the opposite, that a slowdown will propagate inflationary pressures.

But the inflationists have such a simple and “bulletproof” argument, it does invite a welcoming certainty. Their argument goes something like the following.

A decrease in the supply of goods and services will cause consumer demand to outstrip that supply and thus for prices of goods and services to increase.

(Note: this may smell like a straw man fallacy in that I'm supposing a broad group as making a specific argument. I assure you that it is not my position to say that the inflationists are wrong; instead, it is my position to say that we should be skeptical of this particular reasoning of the inflationists, which happens to be common if not outright assumed.)

It's hard to argue against the time-tested law of supply and demand, and so the inflationist rests comfortably secure, knowing that any challenge to his prediction of inflation will be thwarted with a gentle flick of the wrist, a casual turn of the head away from the challenger, and a mention of the Law.

But let's think about what an inflationist is actually arguing. If he's arguing that prices will increase as the availability of goods and services decreases then it seems that he would also be forced to argue the symmetrical opposite, that prices would decrease as the availability of goods and services increases. After all (*gently flicks wrist and turns head away*), it's the law of supply and demand.

I smell something fishy here. And so I present to you, JEC readers, the following transcript of a dialog that really actually did take place back in the year 1860. Maybe, just maybe, it will reveal something to us.

Adam: Greetings, Bob. Who do you think will win the presidential election this year?

Bob: Lincoln.

Adam: Really? One can only imagine what will happen to the Union if he's elected.

Bob: Well, Adam, it's not that hard to figure out what would happen.

Adam: You don't say.

Bob: I do say. In fact, it's pretty clear to me that this country will torn asunder as the southern states oppose the new party's policies. A years-long and bloody civil war will ensue. The southern states will fight fiercely and bravely, but ultimately the northern states will win owing to their superior navy and superior industrial base, and the nation, then brought back together and made free of slavery once and for all, will industrialize with even greater rapidity.

Adam: That's a bold prediction, Bob.

Bob: I'm just getting started! The industrialization process will be unparalleled, both in scope and in achievement, to anything mankind has yet accomplished. Factories will be constructed by the thousands and countless new technologies will spring forth in a sweeping tide of progress. There will develop a mass migration from farm to city, and it will fuel the fires of the growing economy. The nation will obtain levels of wealth and prosperity never before realized or even dreamed.

Adam: No kidding?

Bob: No kidding. Indeed, we will find myriad ways to harvest the energy in the oil deposits recently discovered in Pennsylvania and, as we will later discover, many other areas of the world! With such boundless energy I foresee a wealth of technological possibilities that makes advancements such as the steam locomotive and telegraph primitive by comparison.

Adam: What kind of possibilities?

Bob: Personalized automotive transport. Machines that fly. Mechanical agriculture. An analytical engine on every desk. Telegraphs that transmit sound signals and can fit within one's pocket. A vast, global communication network to make information freely available. Landing a man on the moon and returning him safely to earth. Really, I could go on and on, but I think you catch my point.

Adam: These next few millennia surely will be exciting!

Bob: But that's the amazing thing. All these marvels will come about within the next mere 150 years. Even then there will be entire years and decades of stagnation. Indeed, I can foresee the entire world being plunged into a vast war twice during that time and yet emerging riper for progress than ever before.

Adam: I'll grant you that there's a slim possibility that you're right. And suppose for the moment that I assume you're right. What then?

Bob: Well, isn't it obvious? With such an increase in the availability of goods and services owing to our technological progress, consumptive demand will not and cannot keep pace. It is obvious beyond any doubt that, by the law of supply and demand, goods' and services' prices will decrease.

Adam: Yes, I suppose it is an obvious conclusion assuming such a speedup in the economy. That loaf of bread that costs a dime and those dozen eggs that cost me two and that dress shirt that costs me a dollar—these and more would all be reduced in price to mere fractions of pennies.

Bob: Yes, there's no denying the time-tested law of supply and demand.

Okay, I admit that the whole dialog is made up. But consider the point: the last 150 years have been, on the average, ones of great economic expansion and yet prices have, on the average, increased rather than decreased. This should, at the least, hint to us that if we were to face, on the average, an economic retraction then there's more than meets the eye than a simple supply-and-demand relationship between goods/services and prices.

We know, with our 150 years of hindsight, that even though the availability of goods and services increased terrifically during those years, it has been outmatched by a supply in the availability of money. In other words, banks have loaned money into existence faster than actual, real wealth has been created. Demand is not the product solely of human desire and want; it's necessitated by money. (I may desire chips and salsa at the moment, but if I'm unwilling to pay anything for them then my demand for chips and salsa, economically, is zero.) The law of supply and demand being what it is, if the money supply increases faster than the supply of goods and services, then the prices of goods and services will, all else held constant, increase. And this is what we've seen during the industrial age.

Hopefully you are at least considering the role of the money supply when thinking about inflation and deflation and that increases and decreases in the money supply have the ability to trump increases and decreases in the supply of goods and services. If the money supply were to shrink fast enough then we would have deflation, no matter what happens to the supply of goods and services. As to what will actually happen over the next 150 years, it's anyone's guess. Where's Bob when you need him?