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Monday, October 19, 2009

Economic and Monetary Inflation and Deflation

Continuing from my monetary post series starting with "What is Money" and "Creating Money and Credit"

Before May 1st, 1933, Inflation and Deflation was viewed in terms of economy AND currency valuation as both tied together. However, since the world moved to Fiat currencies, it is a mistake to continue to link an Economic deflation with currency valuation. In general, there is pressure that still exists on currency valuation with the economy, as well as interest rates.

But without currencies tied to valuation of a "limited resource" such as gold, the ability to create money at will has seperated economic valuation from monetary. With that said, lets focus on the definition of Economic Inflation and Deflation.

Economic Inflation (Expansion)
I am starting with inflation, since most people have an easier time grasping the concept of Economic inflation. When an economic system is expanding at such a rate that it creates rising resource costs as businesses and consumers "complete" to buy the resources. For example, in India you could say that the extraordinary economic growth the country has experienced since the late 90's was an "economic expansion". But some resources exploded with higher costs as that country competed for key resources for the business and economic growth. Salaries rose dramatically for skilled workers in key fields, such as software development. Prices rose, at times perhaps too quickly, for real estate in growth cities. Credit is over-extended. Credit maybe cheap or expensive, depending on monetary inflation, and the sources of the economic expansion.

Sometimes Economic inflation may be based upon artificial supply and demand, such as the USA. With loose monetary policies, the USA pulled itself out of a recession in 2002 with a growing economy, where real estate costs exploded, as well as compensation for financial corporations. During this time, the US dollar also lost value, but costs for basic resources did not rise substantially. However this I consider "Monetary Inflation", described in section below. The money supply increased driving artificial valuations from loose monetary practices. Economic and monetary changes are linked, however in this case the government made money very cheap, in effect watering down US dollars to artificially create economic expansion. During times of economic inflation, you may see companies become over-valued.

Typically with rising asset prices, and wages, people put money into higher risk investments, this usually leads to monetary inflation and currency valuations going lower.

When economies over-expand, or do so through fraud, then economic deflation follows.

Economic Deflation (Contraction)
When an economic system, say the USA, sees it's economy contract, assets become cheaper, and labor experiences pressures to have lower wages and benefits. Typically credit also is reigned in, with lenders being more careful who they lend to.

Economic contractions are CRITICAL to ensuring a robust economy. A correction is required when the economy gets ahead of itself, and a "cleansing" of over-extended companies must occur to provide fertile conditions for a sustained return to an economic expansion.

Typically with falling asset prices, and wages, people put money into lower risk investments, this usually leads to monetary deflation and currency valuations going higher.

Monetary Inflation (expanding money supply)
Money is a resource, just like food, gold, real estate, etc. If money is too easy to acquire, then the value of the currency goes lower compared to "harder to get" currencies. For example, for 100's of years the British pound had a very strong valuation, due to numerous factors. One critical factor (except last 10+ years) was Britain maintained monetary policies that ensured the pound was "harder to get" than other currencies. This could have been through higher interest rates, or bank lending/credit creation as compared with other nations.

Monetary Deflation (contraction money supply)
If money is hard to acquire, then the value of the currency goes higher compared to "easier to get" currencies. For example, since about 2001, America has pursued aggressively artificially low interest rates and easy to get credit/money. At the height of the real estate market, anyone could get 600,000 dollar loan with NO JOB. All that was required was for you to lie on the application, the lender did not even ask for proof of what you wrote.

Ability for such easy acquisition of money devalued the US dollar (inflation). Since 2008, American financial institutions are pulling back on credit, like demanding proof of a job before lending money. As money supply contracts, compared to other currencies, the currency becomes more valuable.

In essence, when money is a scare resource, it can buy more goods/services, for lower prices.

Economic VS Monetary Inflation/Deflation
The reason I separated the definition Economic vs Monetary Inflation/Deflation is that when you listen to an "inflationist" or "deflationist", each focuses on different aspects of financial pressures to define "inflation" or "deflation".

Most Inflationists focus on currency valuations, and not the economy. Their primary focus is the value of the dollar, and where they should invest money to ensure they can retain purchasing power.

Most deflationists focus on the economy, and the overall pressures of the marketplace. They tend to see that monetary deflation is "locked" with the economy, where most inflationists do not.

Mish(Video), Robert Precter, and blogger Karl I view as Economic Deflationists, typically tying currency valuations more closely to the economic activity.

Mark Faber(Video), Peter Schiff (Video), Daniel R. Amerman, and Jim Rogers I view as Monetary Inflationists, where they are less concerned about the economy, and more concerned over US dollar valuations.

Harry Dent is a cross between both. To me he is an economic deflationist based upon demographics, but an inflationists based upon monetary policy. Mr. Dent believes the economic deflation should overcome the monetary inflation cycles over a longer period of time compared to other deflationists I have read about.

Both inflationists and deflationists may like purchasing resources, such as gold, as a hedge against currency fluctuation.

Summary of terms according to MY definition
  1. Monetary Inflation / Deflation refer to valuation of currencies compared to each other and natural resources
  2. Economic Inflation / Deflation refer to the expansion and contraction of the economy, and valuation of assets in the economy (wages, prices for services, employment, etc)
  3. Gold or other natural resources may be favored by either camp for currency hedging to secure wealth.
Next up is Misrepresenting Economic and Financial Data.

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