Deflation or Inflation: Take Your Pick

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Deflation or Inflation: Take Your Pick

By: Rick Kahler, CFP®

The Federal Reserve recently announced they will again start inflating the money supply in hopes of staving off a sustained deflation. Deflation is when available money is reduced or prices decline.

Why are government officials so afraid of deflation? Deflation is economic stagnation and reversing it is difficult. What government officials know how to deal with is inflation. Actually, inflation is the political savior of an overspending country that finds itself deep in debt, as the U.S. is today.

Unpalatable Tools to Retire Debt

A country has four tools to retire its debt: raise taxes, cut spending, declare bankruptcy or debase the currency through inflation.

Of these options, bankruptcy is the most unpalatable. It would most likely result in a gut-wrenching depression and the country being unable to borrow for the foreseeable future.

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Spending cuts are almost as undesirable. Taking away something the electorate views as an “entitlement” is akin to ending your political career.

Raising taxes is somewhat more appealing, especially if the increases apply primarily to those the electorate perceives as “the rich.” Increasing taxes too much, however, reduces the incentive to work and could lead to an economic crash and falling tax revenues. This actually increases the country’s debt problem, as the government must increase borrowing to avoid spending cuts.

Inflation: The Politically Palatable Option

A slow, chronic inflation is the most inconspicuous and politically desirable way of reducing the debt.

With inflation, the losers are the people and institutions that own the debt, because the currency shrinks in value. For example, say you loan the government money by buying a $1,000 U.S. government bond that matures in ten years. At the time, that same $1,000 could buy a laptop or a round trip ticket to London.

Suppose the United States inflates its currency at a 7 percent rate for the next ten years, which would be about twice the “normal” inflation rate of 3.3 percent for the past 80 years. At the end of that time, the bond matures and you get your $1,000 back. You go to buy a laptop; they now sell for $2,000. That trip to London costs $2,000, too.

You might conclude the prices of laptops and airline tickets have gone up. Actually, in real dollars (which are dollars adjusted for inflation), the cost of these items hasn’t gone up a dime. It’s the value of the dollar that’s gone down, in this case, by 50 percent over ten years.

The big winner here is the U.S. government. Its debt has been chopped in half (again in real dollar terms) in ten short years, without raising taxes or cutting spending. This is intoxicatingly appealing to politicians.

If the country slides into chronic deflation, government revenues will fall while the real value of its massive debt will grow, further stagnating future growth. It becomes a vicious cycle, which politicians have few, if any tools, to combat.

That is why gradual inflation is the preferred medicine. When it’s done well, citizens become like the proverbial frog that is cooked slowly in a pan of water where the temperature is gradually increased, rather than being frozen to death by deflation. In the end, of course, neither outcome is good for the frog.

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Rick Kahler is a Certified Financial Planner™ professional licensed with a registered investment adviser that provides personal financial advice online for a flat fee. He is an author of four books on financial psychology and recognized by BusinessWeek magazine as one of the 15 most experienced financial planners in the nation. Contact Rick for help with virtually any financial need.

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