[Many readers have pointed out that our long-running discussion of deflation has tended to overlook the impact of price increases, or at least price stability, on essential goods and services. In the essay below, Robert Moore, a frequent contributor to the Rick’s Picks forum, explains how both type of “flations” can co-exist. That he has done so without using the words “inflation” or “deflation” is not merely clever, but persuasive. Read on to sharpen your understanding of how supply and demand interact in an economy where some debtors are being liquidated while others continue to pay their bills and debts. We will mention up-front that although Robert is no “deflationist,” the economic outcome he predicts is exactly what we have long predicted – i.e., a drawn-out drop in the standard of living until all debts have been paid – either by creditors, or debtors. RA]

Ok, I’m going to try to make it through this entire essay only uttering the words “inflation” and “deflation” in just this one sentence. Why, you ask? Because these terms are just too ambiguous for a productive economic discussion. Each word has two unique, and distinct (some might say polar opposite) definitions when used in the context of money supply versus the context of general price levels. This degree of ambiguity makes both terms completely worthless in an analysis of cause and effect. There must, by necessity, be a dedicated term to describe the cause, and another term to describe the effect; otherwise you find yourself drawn into an analogous discussion where explosions are causing explosions, and the end effect is simultaneously identified as the root cause — a rational impossibility.

So, before we go much further, let’s settle in on some fundamental ideologies that I hope we can all agree on:

1) As demand for an item increases in a limited supply scenario, the price for that item (the amount of alternative wealth it would take to procure that item in trade) would rise.

2) As supply for an item increases in a limited demand environment, the price for that item (again, in terms of transferable wealth) would decline.

3) Market supply of durable goods is formed from two sources: a) allocation of capital (time labor, raw material) to yield new production and inventory; and b) re-introduction of existing stock (via resale, recycling, or dishoarding).

4) Market Supply in non-durable goods is formed only by new production, and results only from the capital (time, raw material) required to yield this production.

Many people claim that money follows the same basic supply premise described in number 3 above. I contend that money is different. Money fails to consistently abide by these basic supply-demand arguments (may Ludwig Von Mises have mercy on my soul for making that statement). Debt makes money act differently. In a sound economy, people aspire to accumulate wealth, and to enjoy it. Demand for money is really only a demand for the opportunity to do more work in exchange for greater wealth and a higher standard of living. Only in an unhealthy economy is overall demand for money driven by debt levels, and by the need to stay ahead of rising prices. The more debt that gets introduced into the system, the more money that must, by necessity, circulate through the system in order to maintain this debt.

As Debt Increases…

In a closed system where the money supply is constant, as total debt increases over time, less and less money is left to purchase essential goods and services after whatever increasing amount is necessarily allocated toward servicing the increasing debt. The net effect of this is: a) declining prices in all consumer categories, as more and more of the money has to move toward servicing the debt, leaving less money available to purchase goods and services (both essential and non-essential). The net effect becomes a generally decreasing standard of living for all debtors; and/or b) decreased economic productivity as debtors feel the increasing desperation that they may never conquer their increasing debt, until debt defaults eventually begin releasing money from the service of debt, allowing it to once again purchase essential goods and services.

I believe this is what we saw in the early 1930’s, as the debt level peaked at the end of the Roaring 20s and tipped over into the long deleveraging. In a system where the money supply can be increased at will, increasing debt can be maintained right alongside rising prices, as the remainder money after debt servicing never feels the constraint of the increasing debt service obligations. I believe that is what we witnessed during the later Greenspan/early Bernanke years — increasing debt, offset by increasing money supplies, leading to economic distortion as rising prices provided no warning that there was anything to be worried about with total debt levels.  It was like the Roaring 20s on steroids.

The Friedman Argument

So, the argument that rising prices can only result from too much money in the system (the Friedman argument) only operates unequivocally if the system is devoid of (or maintains very little) total debt. So long as credit is easy to come by, prices can rise without there being sufficient money to offset this debt. The question we face today is: Is this really the economic equivalent of the perpetual motion machine? Can continued debt issuance stimulate continued demand for real goods and services in perpetuity?

Alternatively, as the system becomes too heavily burdened with debt, the willful reduction of total money (or credit) available to consumers has two affects:

1) reduction in demand for “non-essentials” as the available money must be used first to service existing debt and to purchase required essentials.

a. As demand for non-essentials declines, so too must prices for these items

b. prices on essentials will fluctuate based on the available remainder money after debt service, but will ultimately remain relative to demand for these essentials (which increases organically with population over time); and/or:

2) increasing debt defaults so that the money that would be used to service or pay down debt can be freed up to purchase essential goods and services.

a. As available money is de-allocated from debt service and allocated toward purchasing essential goods and services, prices in those items must surely rise.

Today’s Conditions

Both of these appear to be what is occurring to varying degrees today. People fortunate enough to have a job and a positive cash flow are prone to fall into category 1, while more desperate people (unemployed, more debt, lower cash flow) probably fall into category 2. Either way, so long as the unemployment and/or debt default rates keep rising, the number of people in both categories will also continue to rise, along with rising prices in consumer essentials; while demand and prices on consumer financed non-essentials can only continue to decline (as there is less and less money to service any new debt, particularly debt of a frivolous nature).

Also interestingly, what we are seeing today is a scenario where decreasing the consumer debt in the system is not necessarily resulting in reduced total debt, as governments have been more than willing to step up to the borrowing window on our behalf.  So the slowly declining consumer debt is allowing the increasing remainder money to stimulate rising price levels in essential goods and services (just as we would expect). This could explain the conundrum of rising prices of consumer essentials during what is clearly a debt clearing/deleveraging period, and it might also serve to explain the viewpoints of the few policymaker types who think that raising taxes would be an effective means of fighting rising prices in consumer essentials (damn the standard of living man, this is economic war!)

‘Essentials’ Will Prevail

If total money supply in the system (and therefore total debt in the system, since all fiat currency is simply denominated debt) keeps increasing as the consumer portion of that debt keeps decreasing, then the resultant price increases in essentials could become much more pronounced, until eventually the priorities themselves ultimately trade places, and the available money first finds its way into the procurement of essential goods and services, while whatever remainder money then gets allocated to the service of existing debt.

This is the only inevitability I can see for us, as either path highlighted above (paying down our debt or defaulting outright) will ultimately lead us to the same place, and that place is a lower standard of living for a very broad segment of the productive population. The only alternative is to eliminate debt-based money and replace it with money of inherent, intrinsic value — i.e., money that once again accurately serves as the amount of alternative wealth it would take to procure a given item in trade — a proposition that is not likely to go anywhere since it eradicates the ability of non-productive elitists to manipulate the total money/debt supply in the system at will (a topic for another day, I suppose).

So, I’ve managed to remain true to my promise, and I did not use any “flations” at all in this essay. Let’s see how many of you can challenge my viewpoints, or support your own opposing viewpoints, using similarly unambiguous, cause and effect style language, rather than leaning on whatever flavor of “flation” you prefer to use as your verbal crutch of choice.

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