Tuesday, December 2, 2008

Inflation/Deflation vs The Free Market Pricing Mechanism

There are many factors that economists and pundits bring up in describing inflation and deflation. Unfortunately most of these factors are symptoms rather than causes. Recently in the news headlines decry the threat of deflation.

The so called "pundits" are confused. Deflation and its opposite inflation are ultimately and always a function of the money supply. If too much money is injected into an economy--defined as the money supply increasing more than the supply of goods and services available--inflation is the end result. Conversely if the money supply does not keep pace with the supply of goods and services deflation occurs.

Government's responsibility is to keep a stable currency. That can be accomplished by tying the money supply to something like gold (the U.S. used to be on the gold standard) or increasing the money supply by the amount of growth in the gross domestic product of the country (not as good as the gold standard, but better than what we have now).

When the money supply is controlled by government, inflation or deflation is the sole product of its meddling. Even if those in government act with the very best of intentions, injecting too much money into the system leads to inflation; not keeping enough money in the system leads to deflation. Government meddling over a period of many years can destroy a currency. That is why the U.S. dollar's purchasing power today is only a fraction of what it was in the 1940s. Extreme actions by government can trash a currency in a very short period of time. Many examples of this abound (humanity doesn't seem capable of learning from others mistakes), but one of the best known examples is the Weimar Republic in 1923.

In our day, the rush by the U.S. government to "bail out" the financial industry and possibly other industries by injecting billions of dollars into the system can only lead to inflation. Let us hope it will not be hyperinflation.

The free market pricing mechanism is simply everybody reacting to market forces of supply and demand. If too much money is being supplied then prices go up, the opposite happens if there is not enough money in circulation.

The most important point about pricing in a free market is that prices still fluctuate even with a stable supply of money. If a particular product is not able to be supplied in amounts to meet demand the product's price will rise. If demand for a product declines and the supply becomes too great then the product's price will decline. The market is constantly adjusting prices.

This phenomenon is merely the natural functioning of a free market and has nothing to do with inflation or deflation provided the money supply is not being overly manipulated by government.

Sadly the U.S. government has injected billions of dollars into the economy and has intentions of injecting much more.

How can housing prices be in a tailspin if the government is injecting too much money into the economy and fueling inflation? The government has been pumping too much money into the economy for most of the 2000s and keeping interest rates artificially low. These two factors created an overblown demand for housing over the last many years pushing prices higher and higher. Now with the change in economic conditions the demand for housing has declined; many speculative markets have almost completely dried up. Demand is off and prices are adjusting accordingly.

Four other perspectives: Robert Higgs , Rich Karlgaard , D.W. MacKenzie , Steve Hanke, and WalterWilliams

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