There are mounting fears that deflation has snuck up on us in the dark and is setting a trap. Or at least, that's what the media seems to be suggesting. We'll look at whether deflation is something to fear and whether it has ever actually happened or is likely ever to happen.

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What Is Deflation?
In recent articles describing the coming deflationary apocalypse, no two definitions are alike. One even mentioned good deflation as a general increase in the supply of goods leading to lower prices, which seems a lot like the law of supply and demand - a related, but separate economic force. Another pointed out that deflation leads to falling prices; except this was presented in a negative light. The truth be told, consumers would be expected to undergo the horrors of paying less for goods and services in an economic deflation.

The concept of deflation would have to be unfamiliar for anyone under the age of 80, because we've seen nothing but inflation, brief periods of disinflation and the slightest whiffs of disinflation from the great depression forward. It's telling that inflation has hit double digits several times in the last century and been a single digit presence most of the other years, while deflation has only ever touched double digits once in history and is often visible only in retrospect as a slight retraction in the relentless climb of inflation. (To learn more, see our Inflation Tutorial.)

The Currency Dealers
The Great Depression is the fallback for anyone who can't explain why paying less for goods is a bad thing. The problem with using a great depression-style deflation is that the "deflation" of the great depression was not an increase in the purchasing power of each dollar, but the throttling of the money supply.

During the Great Depression, the Fed saw gold reserves grow and money supply shrink, something that should have been impossible under a gold standard with a reasonable Fed. By reducing the money in circulation, the Federal Reserve essentially destroyed the ability of supply and demand to balance.

Producers of all types were dropping prices, which should have eventually hit a point at which people would buy, but there was no money with which to buy. This led to more than just lower prices. It touched off failure after failure as the lack of money - a medium of exchange - shut down the normal processes of the economy.

It is no coincidence that much of the businesses and work that did go on in the U.S. during the depression was of the barter/direct trade variety. The great depression gives deflation a bad rap because it was the scapegoat for poor monetary policy. Oddly enough, the same is not true for inflation even though the stagflation of the '70s was nearly as damaging in terms of the destruction of real wealth. (To learn more, see The Great Inflation Of The 1970s.)

Deflation AND Deficit Spending?
We no longer have a government that is shy to buy up assets to backstop the economy. As TARP proved, we'll even buy up car companies, let alone injecting capital into banks. So where is this deflation to come from? At best, we may get lucky and have a period of disinflation - a slowing of the inflation that usually ticks on like clockwork. Still, even this is unlikely because - and there's no way to dress this up - the U.S. is running an extremely fat deficit. Deficits have to be paid, and an old favorite for payment short-cut is, you guessed it, to crank up inflation. (For more, check out Top 6 U.S. Government Financial Bailouts.)

Why One and Not the Other?
It's worth asking why inflation is such a non-issue and deflation is something to be feared. After all, you and I see our savings eaten away by every percent of inflation and our purchasing power decrease at the same time. If inflation favors debtors, then surely deflation favors savers. This is correct. By any of the myriad definitions of deflation, a dollar increases in actual value. This means that the dollar value of debts will also increase for those who have them, whereas the purchasing power of savings will increase for those who have some.

The U.S. government, however, is one of the largest debtors in the world, via bonds and outright loans. Similarly, banks and the entire financial system are debt-financed for the most part, again with bonds and loans. So, you can understand why deflation would be a nightmare for them. This is why deflation has never happened in the real sense other than through monetary bungling.

The Bottom Line
When people talk about the fact that computers are cheaper today than ten years ago, they are talking about increased production (and efficiency) pushing up supply and lowering demand - this is supply and demand at work, not monetary policy. Deflation and inflation are controlled by the supply of money.

Since we moved to a fiat currency, it has been inflation more or less non-stop. Periods of disinflation are rare, and true deflation is the Loch Ness monster of economics – known only through tall tales meant to spread awe and terror. We've learned to deal with inflation and its steady tax upon our wealth, surely we could adjust to a dollar going further and prices dropping. In truth, a hard money policy would be the best solution, but given the choice between being bled by inflation or helped by deflation, why not give deflation a try for once? (To learn more, see Deflation: A Two-Sided Coin.)

Catch up on your financial news; read Water Cooler Finance: The Unrelenting Claw Of Bernie Madoff.

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