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Inflation or Deflation: What is good for the economy and citizens?

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Inflation or Deflation: What is good for the economy and citizens?

Inflation

Inflation and deflation do occur with any monetary system even with currencies backed by 100% gold. What is inflation? At any given time, the unit of money, for example, a unit of gold, can buy a certain amount of a given product or service. This is the result of subtle perceived balance between the economic sides of supply and demand. At any given time, there is a total of (1) a certain amount of printed money, the right of accessing money (debt-credit), and financial and non-financial assets on the demand side of the balance and (2) the products and services available on the supply side.

Let's assume that a 100 percent gold back monetary system is in place in a small isolated island country, without any connection and trade with its neighboring countries. We also assume that the island produces gold but also all other products and services the Islanders need. Let's suppose now that by a miracle, the community of gold producers discovers an easy gold mine, which requires little labor and resources to produce the units of gold.

Under these circumstances, the gold miners would obviously can and want to produce a lot of gold in a record time. This would result in substantial increase in the amount of gold on the island. Consequently, the demand side grows. However, on the supply side of the equation, people who do not belong to the community of gold producers, would further have to invest the same amount of labor and resources to produce the unit of their products and services. With the increased amount of buying pressure due to the increased amount of gold, people who possess gold are now wealthier and compete among themselves for purchasing the same amount of goods and services. Furthermore, the producers of goods and services are forced to ask higher prices to sustain their customary lifestyle. This process automatically devalues the purchasing power of gold or, in other words, causes higher prices. The process of raising prices is commonly called inflation. Inflation is not the cause of higher prices but the effect of increased or inflated demand. The rising price of goods and services is the consequence of stronger demand. The root cause of inflation or raising prices is discovery of the easy gold mine, which makes it easier and cheaper to produce gold and, therefore, raises the level of demand.

Inflation is caused by either increased level of demand, decreased level of supply, or both.

In today's societies, the root cause of inflation is generally the central banker’s policy of supporting the demand side of economy by printing fiat currencies.

In conclusion, anytime the subtle balance between the demand and supply sides of economic equation shifts in favor of demand side, inflation is generated. Printing of fresh money by Central Bankers, political decisions to ease access to money by artificially lowering the interest rate, lowering the bank’s capital requirements, and increasing the volume of debt and credit cause inflation. Manipulation of financial markets by central bankers leads ultimately to artificially created asset bubbles that would have to pop up later on.

Inflation is Exogenous. This means that in order to generate inflation, external factors must artificially intervene and manipulate the established monetary and economic systems. Therefore, aggressive interventions and manipulations by central bankers are a prerequisite to (1) first compensate for the continuous endogenous rate of deflation and (2) artificially create a positive inflation. In contrast, deflation is endogenous. This means that if left alone, any economy would automatically be deflationary and with falling prices because technological innovations make it ever-increasingly easier to produce goods and services at lower costs.

Countries which suffer from destruction of war, the amount of available goods and services shrinks drastically in a record time. However, the amount of money in circulation remains the same or may even increase. The decreased level of supply side of equation hence also generates inflation or sometimes even hyperinflation.

Deflation

In contrast, now let's assume that in the same island country, a revolutionary technological innovation such as deployment of robots in the processes of production of goods and services makes it much cheaper and easier to produce the unit of goods and services. Let's also assume that the community of gold miners cannot use the same technology for various reasons and therefore, still need the same amount of labor and resources as before, to produce the unit of gold. In this example, now the supply side can produce much more than before and therefore, producers of good and services must compete against each other to attract the same amount of gold. They offer more of their products and services for the same amount of gold, or ask less gold for the same amount of goods and services. At the same time, the gold miners are forced to ask more for their unit of gold to sustain their customary lifestyle. Consequently, the price of goods and services falls.

The process of falling prices is called deflation. Again, falling prices are the effect, not the cause of deflation. The root cause of deflation is the deployment of robots, which makes it easier and cheaper to produce goods and services and therefore, increases the supply side of the economy. In conclusion, even in stable monetary systems where each issued certificate (bank note) is 100 percent backed by gold, inflation and deflation do occur. Each time the subtle balance between the demand and supply sides of economy shifts in favor of supply side, deflation occurs.

Deflation is endogenous. This means that if left alone, any economy would naturally be deflationary and with falling prices. The cause of this phenomenon is technological innovations which make it ever-increasingly easier to produce goods and services with less effort and fewer resources.

Technological innovation and their deployment in the systems of production of goods and services is one of leading causes of shifts in this subtle balance between supply and demand sides of economy.

Under normal circumstances with a monetary system backed by gold and without politicians and central banker's manipulation, technological innovations tend to affect both sides of this equation. Therefore, the rate of inflation and deflation would naturally remain contained and limited.

Likewise, a financial crash such as the one of 2008 led to substantial loss of wealth with falling prices of financial assets, commodities, and real estates. This was the result of reduced amount of available wealth on the demand side. The falling valuation of financial asset was deflationary. Deflation was the effect and symptom. The root cause was vanishing of some $60 trillion of wealth due to losses in the stock, derivative, real estate, and bond markets.

A monetary system of certificates (bank notes) backed by 100 percent deposits of physical gold remains relatively stable in terms of inflation and deflation. This is because the amount of produced gold is the only means that increases the demand side of the economy.

The levels of inflation and deflation are usually measured by price of commodities. The price of oil plummeted in 2008 as a consequence of market crash, depression, and deflation.

Fiat monetary systems permit the politicians and central bankers total freedom to manipulate the demand side of economic balance. Such manipulations are actually the root cause of subsequent aggravated financial bubbles and economic deflation and depressions.

                    Figure 13.0 Chart courtesy of the TC2000.com

Figure 13.0 shows a monthly chart of CRY0 (commodity) for the period from 1992 to October 4, 2017. It shows the deflationary period from 1996 to 1999, the deflationary period of 2001, the inflationary period from 2001 to mid-2008, the brutal deflationary period of 2008, the inflationary period from 2009 to 2011, and finally, the deflationary period from 2011 to October 2017.

The chart shows the price of a basket of commodities in US dollar. The price of commodities is closely linked to US dollar index and interest rate. Inflation usually fluctuates in line with price of commodities. Raising inflation rate and higher price of commodities are both the effects and symptom, but not the cause. When the US dollar is stronger against a basket of other currencies, prices of imported products tend to fall and vice versa. This is because when the US dollar is strong, other currencies are weak. Therefore, price of all commodities, fixed in other currencies, becomes cheaper, when bought in US dollar. This has the effect of importing deflation in to the US.

Here, it is worthwhile asking a question: Although the Fed has printed trillion of US dollar notes, lowered the interest rates to nearly 0 percent, and increased the debt-credit market to a new historical high, why the economy remains deflationary, in particular after 2011? There are several reasons for that.

The freshly printed money remained within the speculative financial assets. It has not found its way to the real economy. The cheap money has mainly been lent to major property speculators and public companies. The first group has been speculating with the borrowed money and bought real estates for speculative future profits and the second group, bought back their own stocks. Both of those markets have become major bubbles again. However, the inflation associated with those two markets has seemingly not contributed to any increase in price of commodities. Furthermore, it implies that the fresh money was not evenly lent across the board. Medium and small businesses, as well as individual consumers, have obtained relatively little access to loans. Consequently, the freshly printed money has mainly stayed within the financial markets and not actually made its way to the real economy. This is why the CRY0 has been deflationary since 2011.

Despite historical debasement of US dollar, it has remained quite firm against other currencies, in particular, china’s Renminbi (Yuan). Cheaply produced Chinese products have been massively imported. This contributes to falling prices of goods and therefore, is deflationary. Based on chart of figure 13.0, we have to assume that the fractional portion of inflation due to the Fed’s monetary stimulus has been largely offset by deflated prices of imported Chinese products.

In conclusion, the Fed’s easy money policy has well created huge inflation in the stock and housing markets. They both have become bubbles, subject to bursting soon. The other even larger bubble is the debt-credit (bond) market.

What is Good for the Economy And Citizens, Inflation or Deflation?

In a monetary system where money is 100 percent backed by gold, the free-market’s driving forces would naturally regulate the level of inflation or deflation. Such monetary system is deflationary in nature because deflation is endogenous. The amount of money in circulation would increase proportionally with increased productivity of gold. On the other side, the same technological innovations that contribute to increased productivity of gold, contributes to increased productivity of goods and services too. This way, the associated rate of inflation or deflation remains relatively stable. In any society, the level of inflation or deflation would then be commensurate with the deployment of technologies on the demand and supply sides of the equation, and on the established monetary system.

As already said, the driving forces of free markets adjust naturally the level of inflation and deflation in a monetary system that is 100 percent backed by gold. It would naturally be deflationary. However, the central bankers may intervene to provide more liquidity, meaning printing more gold certificates relative to actual amount of available physical gold, to temporarily support the economic expansion. The prerequisite for success of such policy is however, that central banks courageously remove from circulation the excess amount of certificates, in times of normal economic growth. Sadly, the history shows that central bankers and politicians tend to think first of their own interests before the ones of their citizens. Once the central bankers and politicians have printed excess certificates, spent the money, and artificially created inflation, they tend to resist the removal of excess certificates vigorously. Now the money is theirs! It looks like that once the politicians and central bankers are given a temporary and exceptional possibility of a certain right, for example, in times of crises or war, they tend to make it a permanent right in the future for their own benefits. Therefore, the best monetary system would be the one that is 100 percent backed by gold and prohibits in the constitution any right for central bankers and politicians to manipulate the amount of money in circulation. Again, President Hoover once said, “We have gold because we cannot trust governments.”

A sound economy requires a stable monetary system with a currency backed by gold. This limits the level of political manipulation of economy and finances drastically. The supply side of economy produces goods and services that are freely offered on the market. With gains of traded product and services, companies partly invest to improve the productivity, pay their employees, and cover their own costs of living, as well as paying taxes to the smallest possible governments for a restrictive list of services (not for the bureaucracy). The lift-over is then placed in a yield bringing bank account. The role of banks would then be to ensure the safety of savers' capital and pay interests for deposited funds. Furthermore, the banks would have to give loans against interests, for sound projects that again, would improve productivity of communities and countries. Banks would provide full transparency to their customers and be forbidden by law to take speculative positions and gambling with saver's money for the purpose of higher bonuses for the board of directors. The country would then be saving and making funds available to improve the society's productivity. Moreover, the level of debt-credit remains commensurate with the rate of economic growth. With endogenous deflation, saving becomes attractive with the advantage of ever-increasing funds available for sound projects. Due to build-up of inefficiencies, crises would still happen in such systems but with milder consequences only. The Kings are the citizens, and the governments would be there to serve their citizen, not to enslave or exploit them. One of main government duties would then consist of ensuring that the citizen's obsolete jobs, a s a result of ever-increasing technological innovation, are replaced by jobs of the future. The governments would spend the allocated money to offer training opportunity for unemployed citizens rather than paying unemployment benefits alone, or keeping unsustainable and inefficient jobs for the sake of political games of displaying lower unemployment rates.

Such economic system would be in the opposite of many countries that currently promote the idea of creating debt for consumption.

The propaganda saying that low or high levels of inflation are good for the economy is a fallacy. The main reason for this aggressive propaganda lies in the truth that by the systematical creation of artificial inflation, the governments legally transfer the buying power of saving citizens towards central banks and governments.

Three fundamental laws of economy contradict this propaganda.
  1. Deflation is Endogenous and inflation, exogenous. Under normal conditions, the price of goods and services should consistently fall over time. Consequently, the citizens should be living in a world of continuous deflation, where the buying power of their savings continuously increases. Why doesn't happen? Because governments and Central banks artificially create inflation through (stealth) printing of paper money. The US government gave up unilaterally the gold backing of US dollar in 1971, so over four decades ago. Then, they established a fiat monetary system. Why did they do it? This is because under the fiat monetary system, central banks and governments are allowed to print an unlimited amount of money (bank notes) without constraints. With a gold backed system, they would have to deposit proportional amount of physical gold in the central bank’s reserves. Consequently, artificially created inflation is good only for governments and central banks because it let them transfer the buying power of saving citizens toward themselves. Inflation is not good for citizens and savers, nor for the economy.
  2. Another law of economics stipulates that lower prices of goods and services generate new demands. This is because people who could not afford to purchase goods and services at higher prices, could do it at lower prices. Based on this law, lower prices generate demand, not higher prices. Creation of inflation and future higher prices can neither create immediate demand nor prevent its postponement. This is because the huge majority of citizens spend already all money they earn to support their everyday lifestyle and pay their regular bills. Those expenses are compulsory for their daily life and therefore, cannot be postponed irrespective of inflation or deflation.
  3. Finally, the governments seem to ignore the time value of products and services, another law of economics. Wealthy people, who can afford, are simply willing to pay more for something they can enjoy sooner, rather than later. Just look at the Apple’s new gadgets. Their entire marketing policy is based on this simple economic law. People are willing to pay substantial amounts of money for such products. A few are even prepared to sleep several nights in front of the shops just to be among the first ones to get the product. Others are willing to buy it even in black markets and pay an additional premium. The Harry Potter books also witnessed a similar phenomenon. People know that the price of electronic gadgets decreases drastically over time. Why don't they wait to purchase the products cheaper in a few months or years? This is because this law of economics is in action. We see here that neither higher, nor lower future prices modify the level of demand significantly. The argument that inflation creates immediate demand could potentially apply only to those who have a certain level of available cash at hand. However, these people do not want to delay the joy of getting things earlier, if they can afford them right away.
Based on these analyzes, three fundamental laws of economy contradict the government’s arguments of pretending that inflation is beneficial for the demand, employment, and economy. If the government’s arguments are wrong, why they persist so aggressively in using it as propaganda? They have good reasons. Let's assume a yearly inflation of 2 percent as is the policy target of the Federal Reserve and the European Central Bank (ECB) in 2015. What do they gain from such level of artificially created inflation?
  1. This propaganda lets them print an amount of paper money to compensate not only for the real endogenous portion of deflation but also to artificially create an additional inflation of 2 percent.
  2. Taxation law is based on the nominal economic growth, not on real growth. Therefore, with a 2 percent nominal growth, they can tax their citizen at least 2 percent more, even when the citizen real buying power decreases.
  3. The governments have currently accumulated huge amounts of debts. By creating inflation, they make their debt less costly over time.
  4. Inflation also incites the credit-debt market to grow. It gives a sense of (false) GDP growth to the government, industry, and citizens. This helps politicians to report positive news to voters.
In contrast, governments and central bankers hate deflation. This is because the price of products and services falls over time. Falling prices generate new demand, and people tend to consume more. However, the overall nominal amount of government tax income decreases. Moreover, the real value of government’s debt increases over time.

What are the ultimate benefits for politicians and Central Bankers to enforce inflationary policies? There are two main reasons:
  1. They want to build ever bigger and ever stronger governments with ever-increasing power. They can do this by managing ever-increasing larger government’s budgets. The government budgets usually grow through a collection of taxes during expanding economic periods.
  2. During economic recessions, such as market crash of 2008, the government's tax income shrinks drastically. Governments could then increase taxes and reduce expenditure, including cutting certain social benefits. However, this would be a courageous policy, because unpopular with the voters. Printing of fiat money is therefore, a much easier way of taxing the citizens than taking sound and courageous decisions of increasing taxes or decreasing spending.
For citizens, however, what is important is not the amount of dollar they may own but rather the units of products and services they can buy with.
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