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Thursday, December 18, 2008
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More Media Crisis

A couple weeks ago I had a pair of posts talking about how the media is really fueling much of this crisis.  Today, the Journal Editorial board is doing it again.  Except instead of going after fuel costs or housing prices, now the problem is slight deflation:

Ben Bernanke keeps hitting the gas, but the economy remains stalled. Now, the Federal Reserve chairman is pulling out jumper cables: The Fed's announcement Tuesday that it would cut its target interest rate to near 0% is an unprecedented jolt to an economy falling deeper into recession.

It's the correct approach. And it illustrates just how worried the government has become about this stubborn downturn. The Fed's action has its risks, no doubt, but the government must act to combat the fear that has washed over the economy in the last few months.

Businesses, banks and individuals have hunkered down and are hoarding cash. Consumers have awakened from a credit-bender to find themselves with a nasty hangover. Hoping to spur borrowing, the Fed is flooding the economy with money. Normally, such an action would be inflationary, but these aren’t normal times. The government said Tuesday that consumer prices dropped 3% from just three months earlier — the steepest decline since the depths of the Great Depression.

The Fed is worried about deflation, which marked the darkest days of the 1930s, when falling prices fed production cuts which left more workers out of a job. In addition to setting historically low benchmarks for interest rates, the central bank said it would try to juice the system through direct purchase of government bonds and other assets from banks.

Lets look over some of the premises presented in those paragraphs.  Consumers (and businesses) are "awakening from a credit-bender"... in other words, they've over extended their borrowing.  The solution?  Spur more borrowing of course!  That's like saying the ideal cure for someone who almost drank themselves to death is give them an IV of vodka.  We've been hearing for months how easy credit, and people over extending themselves beyond their limits was one of the primary causes of this crisis.  Now that people are trying to correct that, that's somehow also a problem.  But the editorial foolishness gets worse.

Now we have to worry about deflation!  Deflation, according to the popular logic, is bad.  But we can't be so overzealous in our solutions that we cause inflation, because that too is bad.  Are you confused yet?  You should be.  Once again, in an attempt to sell newspapers, the Journal is taking whatever the current state of the economy is, and selling the worst aspects of it.  They're finding whoever is the loser in the current situation, and shining a spotlight on them.  We need to help the loser... until they're the winner, at which time they are the cause of all the problems for the next loser.

The problem is, both inflation and deflation each have winners and losers.  During inflationary times, sellers tend to win out.  You dollar has more value today compared to tomorrow, so there is more incentive to buy now, and prices are going up so sellers make more money.  At the same time, credit is cheaper because the inflation tends to offset interest.  This however is offset by the ever increasing costs of raw materials needed to make certain products, so manufacturing can suffer, while the service industry tends to do better.

During deflationary times, your dollar has more value tomorrow than today, so people tend to save more.  This causes a separate problem in that your past debt is now more expensive than it was before, making it harder to pay off.  Of course, none of this means that people never spend their money, but rather it means they put off certain purchasing decisions for a future time.  In other words, they're more careful with their dollar.  But when people do choose to buy things during deflationary periods, their dollar goes further and they get more for their money... certainly a win for consumers.  Of course, even manufacturers can win during deflation because the raw materials used to build finished products is cheaper for them too.

So it would seem that both inflation and deflation are both good and bad.  The ideal obviously, would then be an equilibrium state.  But how do we get there?  The answer is to do nothing... at least from a government standpoint.  When the government acts in order to fight inflation, or deflation, they are artificially picking who should be the winner and who should be the loser, often times exacerbating any problems.  Because of the influence of companies on government over consumer influence, the government generally chooses policies that favor inflation.

Now as I said before, some inflation, for some period of time is not bad.  However, having extended periods of either inflation or deflation can have negative effects as one group is favored for too long.  In the case of inflation, it tends to breed inefficiency in companies because ever increasing prices can offset poor management, poor manufacturing processes, etc. (like in the American auto industry).  This is why recessions (and some deflation) can be beneficial.  Companies that are having problems are exposed, and either have to become more efficient in order to survive, or they go under, allowing the money that had been put into those failing companies to be better spent in other areas of the economy.  The worse thing we can do is directly bail out these types of companies, since it can actually turn recessions into depressions, or prolong recessions.  This is what happened in Japan during the 1990's.

So while equilibrium is the ideal state, we will never get there.  Instead, we have to understand that instead of equilibrium, the natural state of the economy is to vacillate between growth and recession, inflation and deflation.  The ideal is to have equal times of both, which on average works out to be an equilibrium.  Buyers and sellers, manufactures and consumers push and pull against each other, always fighting towards equilibrium.  When one gets to big at the expense of the other, then their habits will change to offset the loss, which begins to pull things in the other direction.

To think that government can insert itself into the process is foolish.  As soon as it picks one group over another, the losing group will try to compensate for their losses, usually in ways not expected.  The winning group also tries to take advantage of its status, and will engage in risky behavior that it normally would not have.  This is what causes things to go down hill.  That is what should be avoided at all cost.

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