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November 15, 2010

Kind of Misleading Video About Quantitative Easing That Everyone's Linking

Someone sent me this last week. I skipped linking it, because I thought it was sort of simplistic. And wrong.

The wrong part of it is the suggestion that it's somehow a good thing if the dollar's buying power increases -- that is, if we have deflation.

If I'm wrong about this, let me know, but I thought that economists agree (including conservative ones) that the following list of inflation states, from most preferable to least preferable, is correct:

1. Very low inflation, around 1-2% per year

2. Low inflation, like 2-4% a year

3. High inflation, like 4-8% a year

4. Very high inflation, like 8-12% a year

5. Deflation

6. Hyperinflation, 12+% per year and likely higher than that

Am I right or wrong about that? I think I'm right that that's the general consensus. Deflation is among the worst situations to be in, because if it becomes a positive investment strategy to just bury your money in the backyard, many will do that, and that means billions will not be used to provide loans to new (and existing) businesses, which means that those billions will not be used to produce further billions, etc.

Deflation is essentially a hurdle to investment, to putting money to work. If deflation means that money increases its value by 1% per year with no risk at all (and you can insure it, I guess, against the risk of theft or destruction), that means that any investment will have to pretty much guarantee a 2.5% return at minimum before being worth any investing at all. (Like, subtract the 1% from that you'd make by not investing, include another cut for taxes, include another cut for no guarantees, etc.)

This video is kinda dumb in that it suggests deflation is something we should all be happy about. Increased buying power, yay! Yeah, at the expense of dramatically decreased investment and business start-ups and etc.

Maybe they don't mean that... but they seem to.

One part of it is more accurate -- the part about there being almost no signs of this supposed coming deflation at all.

Policymakers would like to inflate the dollar. Doing so seems to them like the path of least resistance. (Certainly it's seemed that way in the past for governments in budget trouble.)

We have to always bear in mind the third-most powerful psychological drive there is: Rationalization. (According to Jeff Goldblum in the Big Chill, it's actually the most powerful one; as he says, you've gone plenty of days without sex, but how many days have you gone without one juicy rationalization?)

Rationalization is the process by which we convince ourselves that the easy thing to do, the thing we want to do, is actually the right thing to do. And humans are damnably good at it. Find a cheating husband, put him on the lie detector, and you'll probably find that he believes his rationalization, Well my wife didn't want to have sex anyway; this is really sort of for her benefit, my relieving her of the pressure to have sex by seeking it from my mistress... I mean, in a way, I'm practically a hero, aren't I? Well maybe not a hero, but a good samaritan, certainly.

The video is right in that regard-- a lot of people have decided that the budget is in such bad shape our only hope is to inflate the hell out of the dollar (oh, right, all the times that's worked, eh?) and so are convincing themselves that a dramatic burst of deflation is right on the horizon that we must protect ourselves against.

But is it? Prices seem to be rising at rather normal-ish sort of levels, don't they? Where exactly are these pre-earthquake tremors of coming deflation?

The idea, I guess, is to discourage hoarding-- many companies and banks, they say, are sitting on money now, because they're worried about instability and would rather just not risk their money in such adverse conditions. So I guess the idea is Punish them for hoarding by making it a bad deal to just sit on money (as inflation impounds value from it).

But I don't know at all about that. Seems to me that if people are worried about instability and uncertainty, the correct thing to do is cure those worries by action that actually addresses them, not punish them by making their best available strategy also a bad strategy. I see doing the latter as increasing uncertainty -- who knows what the hell is going to happen?

And if that's what people think, they won't invest their cash. They'll buy gold.

List of Inflation States Changed: A.G. says that 1% is "ideal" inflation so I changed it to reflect his input.


Comment: Tantor writes:

Deflation is bad because the whole business world runs on borrowed money. It's great to borrow money in inflationary times because you're borrowing a buck now and paying it back in a devalued buck that may be worth only 95 cents or even way less. However, if money is deflating, that means you're paying back that buck with deflated money that may be worth $1.05 or more, plus interest.

That's how a lot of farmers lost their farms back in the 1930s, when money was based on gold. Farmers took out loans to buy their seed corn and paid it off when the harvest came in. However, if gold spiked up, that meant they'd have to pay their seed loans off in dollars which were worth a lot more than the ones they borrowed. Such loans ruined them. That's why the gold standard was bad.

Every business borrows money to buy its inventory. When deflation screws up those loans and makes it impossible to make a profit on borrowed money to do business, the economy tanks.

Which isn't to say that deflation is happening now. But this Ron Paul-ish idea that deflation is a good thing is kinda crank.

Disagreement: Vic says that deflation had nothing to do with the wipeout of farmers in the 30s. That the bottom fell out of the market and they couldn't sell their crops for as much as it cost to grow them... but... that sort of sounds like a deflationary effect to me.

Another Take: Contemplationist:

Its more accurate to say that there are two kinds of deflations - a secular deflationary trend produced by better technology and innovation in service and product delivery etc, and a rapid deflation produced by increased demand by the public to hold cash.

Economists would agree that the first kind of deflation is not bad though they might not prefer to accommodate it as public policy due to some other extant circumstance (political reasons). But all except Austrian economists would say that the second type is a bad type of deflation, and can be fought by accommodating the public's increased demand to hold cash - by producing more cash.

Thats standard monetary macro 101.

I can't link them all but a lot of commenters are offering the Von Mises/Ron Paul view, which I don't buy.



digg this
posted by Ace at 03:53 PM

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