For a theory to be valid, it must produce results consistent with reality. Neither the deflationist arguments in Wiemar Germany in the 1920s, nor those made in 2008 in the United States could meet this most basic of all criteria. The contemporary U.S. deflationists are claiming that an era of lower prices is upon us even though consumer prices are continuing to rise and the rise seems to be accelerating. Both groups of deflationists redefined inflation to be something else, or in other words, they changed reality to match their theory instead of the other way around. In neither case was any relationship demonstrated by them between their definition of inflation and changes in consumer prices.
The deflationists claim that inflation is an increase in money supply plus bank credit. While everyone could agree that bank credit in the United States was falling in 2008, the same could not be said for money supply. Their are many definitions of money supply and M3, a broad category that would include the Federal Reserves newly created money pumping operations such as the TAF, TSLF and PDCF was expanding rapidly. Since the deflationist argument would fall apart using their own criteria if M3 figures were used, they chose to look at much narrower definitions of money supply such as M2 to try to support their theory. Even then, M2 was experiencing robust growth of over 6% until the second quarter of 2008, when it slowed to around 1%. This was hardly the dire collapse that the deflationists claimed to be happening.
Logically, the deflationist definition is inherently defective because it considers inflation to be a local rather than a global phenomenon. In an era with worldwide commodity trading, prices are set globally for key components of consumer inflation such as energy and food products, not based on what's happening in a single country. Under such circumstances, currency fluctuations then determine the different rates of inflation between countries.
The deflationists argument is also too limited in that it considers money supply and credit, but not assets. In a rich developed country, people can spend their wealth (liquid and tangible assets) as well and they will if they need to do so to buy necessities. This is exactly what happened in Wiemar Germany, where the middle and even upper classes sold their family's prized possessions in order to eat.
The U.S. deflationists also try to bolster their case with comparisons to what is happening in the United States now and what happened in the deflationary periods of the 1930s U.S and the 1990s Japan. Only the most superficial comparison shows any similarities between the U.S. in 2008 and these earlier time periods. Under closer examination the deflationist comparisons completely fall apart.
NEXT: The Inflation Versus Deflation Argument - Part 4
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