The Deflation Phenomenon

deflation

In my last post, The Riddle of Scarce Abundance: A Redux, I made the claim that technology has a naturally inflationary bias, rather than a deflationary one. I want to explore that thought in more detail.

Let’s consider the idea of technology lowering the costs of goods which is, by definition, price deflationary. If I purchase a smartphone that replaces any number of individual products, it stands to reason that helps me keep more money in my pocket. This will most likely have an inflationary effect, related to the concept of “more money chasing fewer goods.” It’s apparent that technology has allowed the price of many goods to drop. In an environment where more money is available, then it stands to reason that prices will increase in other areas for producers or rentiers to capture more of it.

But if deflation is “less money chasing more goods,” inflation’s opposite, then what would it look like to have an environment of “more money chasing more goods”? That’s pretty much where we are right now so let’s examine it:

If I have $100 and purchase five items with that total amount, each item will have an average cost of $20. However, if a technology-driven drop in prices allows me to purchase the same five items plus five more for the same $100, then the average cost per item is $10. You could posit that technology has caused price deflation.

So technology drops the prices and a greater global market increases demand; instead of selling a $100 item to a thousand people, you can now sell a $10 item to a million people.

From this point, you are looking at two possible scenarios:

  1. Expanding global markets indicate that price increases should happen at some point somewhere at the top of the global supply chain because demand has increased in aggregate, which should cause commensurate price inflation;
  2. Competition has greatly increased at the top of the global supply chain so that prices for raw materials, commodities, and other essential resources continue to drop with demand, forcing price deflation.

Considering the tanking of commodity prices, my guess is that competition at the apex of the global supply chain has increased substantially. In other words, there are far more companies providing raw materials, commodities, and resources at the apex of the global supply chain. This likely happened when countries chased growth by significantly lowering the costs of borrowing money in the wake of the global recession.

To clarify, our current deflationary situation could be the result of too much competition at the top of the global supply chain. It’s also possible that major technological advances at the top of the global supply chain have greatly lowered the marginal costs of making essential resources available, though I think this is less widespread than people think. However, it is unlikely that efficiencies created by technology farther down the global supply chain are producing a glut of resources because far greater global demand should be offsetting that condition.

So, if I’m correct, it stands to reason that increasing the cost of borrowing will force consolidations that will lower competition and increase prices at the apex of the global supply chain which will trickle down, increasing price inflation.

But this creates its own problems, particularly the prospect of runaway price inflation. On top of that, raising interest rates hasn’t actually worked; every central bank which has attempted it has been forced to reverse course because of increasing disinflation/deflation.

So what’s happening? My guess is that central banks can’t raise rates high enough to quickly kill competition at the top to force consolidations. Come to think of it, let me rephrase that: central banks are scared to create runaway price inflation by increasing interest rates too high, too quickly. Another problem is growth; higher interest rates will negatively impact the anemic growth most countries are already experiencing.

So, if I had to guess, it seems like the central banks are worried about accelerating inflation too quickly, which will slow down economic growth by harming consumers, and allowing continuing disinflation/deflation, which will also slow down growth by harming debtors. Central banks are stuck between a rock and a hard place, with recession looming no matter what course is taken.

The world seems to have decided that it’s going to bank on (pun intended) the Federal Reserve of the U.S. to solve the problem. As banks move to negative interest rates to put more money into the real economy to battle disinflation, the Federal Reserve is slowly stepping up its interest rates in the hopes of making borrowing more expensive without letting the inflation beast out of the dungeon. It looks like its going to be a delicate dance.

If my speculation is correct, then the problem is that money became too cheap and abundant in the wake of the Great Recession. Companies that would normally go out of business in such a competitive atmosphere can prop themselves up indefinitely because of easy cash, either through lending or through markets. The problem is that even with the spigot turned off, the level of money in the system makes runaway inflation a serious threat.

Which brings me back to cryptocurrency, particularly having a good one. With it in place, people would have a completely liquid safe haven against inflation. However, I think I understand why some people may think Bitcoin is suited to this particular financial atmosphere; its artificial scarcity allows it to better retain value in such deflationary conditions, something that would be more difficult for an expansionary cryptocurrency. In the event of serious inflation or hyperinflation, any cryptocurrency, provided it had widespread acceptance, would, in theory, provide a safe haven. I’m not sure Bitcoin is at a level of acceptance and maturity that it can provide an effective buffer in the event of a major financial shock though. No doubt some are willing to bet that it can.

So where does that put me with my original hypothesis as presented in my post, An Alternative Theory of Deflation? I’m still pretty certain that the demand for interest is a significant deflationary force, though I’m not sure how much. I’m also still certain that the extraction and holding of profit is also significantly deflationary, particularly when it is parked in banks and not reinvested. The move by banks to negative interest rates seems to support this. At the very least, these factors are contributing to an environment in which technology and competition is driving down prices while the money supply in the real economy dries up.

So, is technology actually “deflationary”? In a properly functioning economy, it shouldn’t be, at least not ultimately. The increase in dollars it produces as well as the increase in demand should be offset by an increase in the prices of related essential resources, such as commodities. With the exception of oil and natural gas (and probably a few others), I doubt that technology has improved the marginal costs of extracting or processing essential resources significantly enough to create the apparent “overabundance” that we are now experiencing. I’m more inclined to think that easy credit has facilitated unwise expansion and increased competition at the apex of the global supply chain. The common wisdom is that China, with its surging economic growth, motivated this expansion, which makes sense, and the global glut is a result of its cooling economy. In any case, reigning it in without creating massive inflation is going to be a challenge.

How would all of this be handled in the world of The Currency Paradox? Simple. Neither inflation nor deflation would have to exist. The true price of every physical item can be known based simply on the aggregate amount of time it took to create it. Easy modifications can be implemented for certain situations; for instance, ears of corn can be priced by the amount of time they took to grow and be harvested divided by the number of ears harvested. Almost all items, even virtual ones, can be priced in relation to time/effort.

But that’s a post for another day.

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One thought on “The Deflation Phenomenon

  1. Pingback: The Fed and Neo-Fisherism | The Currency Paradox

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