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Understanding the Basics - Inflation,
Deflation and Federal Reserve Policy

Eccles BuildingJuly 15, 2014 | by Steve McCurdy

To fully understand today’s debate about deficits, zero interest rates, quantitative easing, a cheap dollar, deflation, hyperinflation and currency manipulation, it might be helpful to know some of the history of economic cycles and how and why the Federal Reserve System was originally established.  

                                                                                The Money Supply 


In this country we measure our money supply by two gauges called M1 and M2. M1 includes all cash, currency, and checking accounts, and M2 adds Certificates of Deposit, Savings Accounts, and money market funds to M1. Ideally, the money supply would be pegged to maintain stable prices while at the same time keeping pace with population increases and expansions of the economy. In reality, of course, those goals present moving targets, and so the money supply is never exactly spot-on. When it rises too rapidly we have inflation, and when it rises too slowly or declines we have deflation. A theoretical inflation rate of zero would indicate a perfect money supply, but in the real world that never happens.

The Federal Reserve

Until 1913 we relied on a gold standard and the forces of supply and demand operating in free markets to correct for inflation or deflation and keep the money supply basically on track. However, in 1913 it was decided that we needed a federal agency to help regulate the money supply by intervening in the markets whenever necessary. The result was the Federal Reserve System, and the Federal Reserve Bank (“the Fed”) was given the power to regulate the money supply by arbitrarily manipulating interest rates.

$100,000 Gold Certificate 
A $100,000 Gold Certicate Dated 1934

Both inflation and deflation benefit certain individuals and institutions and harm certain others. Inflation is good for borrowers but bad for lenders, and deflation is the exact opposite. During periods of inflation the value of money declines, and during deflation it rises. When either inflation or deflation become too extreme or persist for too long, the results are recessions or depressions. We refer to them as “Inflationary/ Deflationary Recessions/Depressions” depending upon their respective causes.

The most devastating and longest lasting depression was the Great Depression, which began in the US in 1929 and spread around the world, lasting in some countries until the mid-1940s. The Great Depression was a deflationary depression, and the Federal Reserve played a controversial role.

Free Coffee and DonutsPrior to the formation of the Fed, the US did not have “Fractional Reserve” banking, meaning that banks could not "create" new money by loaning more than the amount of their deposits.

In the early days of the Great Depression there was an enormous contraction of credit due to bank failures, bankruptcies, and unemployment, all of which created a huge demand for liquidity and dramatic need to increase the money supply. Instead of using its mandate to accommodate the demand, however, the Fed fell back on its Real Bills Doctrine and declined to create new money, resulting in what some economists believe was an additional 30% contraction in the money supply, prolonging and deepening the Depression.

When one considers that part of the rationale for forming the Federal Reserve System in the first place had been precisely to preclude a disaster like the Great Depression, then today’s Fed policies of quantitative easing and monetizing debt become easier to understand.

Deflation today is the worst nightmare of governments and central banks not only because of these Great Depression mistakes, but also for other, equally compelling reasons, the most important of which follow:

• Taxpayers experience standard-of-living gains from deflation, but the government cannot tax these gains because they result from lower prices instead of higher wages,

• Deflation increases the real value of government debt,

• Deflation slows GDP growth while nominal debt continues to rise, thereby increasing the debt to GDP ratio,

• Deflation increases the real value of private debt as well as government debt, resulting in private defaults, bankruptcies, and unemployment, and,

• Deflation is almost impossible for the Fed to control because it feeds on itself. Its defining feature is that it makes money more valuable, causing people to hoard cash instead of spending it.

In his 1966 Essay "Gold and Economic Freedom," former Fed Chairman Alan Greenspan wrote:

"In the absence of the gold standard, there is no way to protect savings from confiscation through inflation.There is no safe store of value."

Government’s fear of and bad experiences with deflation have obviously created a strong Fed bias for inflation. The effects of this bias are clearly seen in the following price increases since 1971, when President Nixon ended the gold standard: average home prices are up by 1,180%, gasoline prices are up by 1,042%, The Dow Jones Index has risen by 1,856%, and a dozen eggs cost 389% more than they did in 1971.

In the wake of the Great Depression experience, the Federal Reserve has always over-corrected on the side of inflation, and there is no reason to think it won’t continue to do so. For this reason, most economists believe that the end game for our present world-wide financial crisis will be a hyperinflationary currency collapse rather than a deflationary depression. But make no mistake about it. However it turns out, this coming disaster will have resulted from decades of bad political decisions, economic mismanagement, and the absence of sound paper currencies.    

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