There is a lot of talk these days about deflation, which is a general decline in prices. We worry about persistent declines in prices because they encourage consumers and businesses to delay purchasing goods, services and capital since the price tomorrow will be lower that the price today. This, of course leads to increased unemployment, decreased corporate profits, and downward pressures on the nation’s gross domestic product. While we have experienced deflation in most commodities of late (the producer price index, ppi), be certain that it won’t be persistent, nor will it result in deflation in terms of consumer prices (the CPI).
The current crisis has forced (or encouraged) our government to add trillions of dollars to our current national debt, which just passed the $10 trillion mark much faster than expected. This year the U.S. budget deficit is expected to top $800 billion. Coupled with possible tax cuts in the short-term future, increases in government spending on public works, and promises of an additional stimulus package, a potential disaster, in terms of inflation, looms in the future. A former chief auditor of the federal government said it best—the first thing you need to realize about the government is that they have no money.
You can’t lower taxes while piling on debt, increasing government spending, and adding another stimulus package without expecting someone to pay for it in the future. Two government actions in the future will surely dampen the prosperity of X and Y-ers as they age in the work force.
There are only three paths available:
1) To pay for its future obligations, the government can print more and more money which depreciates our currency (the $ will be worth less in real terms) making foreign goods more expensive in the U.S. Accordingly to the quantity theory of money, MV = PQ where M is the money supply; V is velocity of the money supply or how fast the money turns over; P is the price level; and Q is the level of goods and services or output. Thus, if velocity is fairly stable over time-which it is- and output increases at a pace of 3 percent to 5 percent, prices will make up the difference. Thus if the money supply grows by 10 percent, prices will increase by 5 percent to 7 percent. Not only is this not deflationary, it is inflation at a pace well beyond the level that is acceptable. http://en.wikipedia.org/wiki/Quantity_theory_of_money
2) Taxes will be raised in future years to pay off the debt and interest on the debt.
3) Interest rates will rise as the government issues more debt to pay interest costs and to retire the old debt.
Thus, any signal of deflation in prices now is a façade; expect higher prices in the future (maybe double digit inflation for some time) and a dollar that will be more useful in starting fires than buying a loaf of bread (nothing like a little hyperbole to bring the point home). When will this occur? Not until 2010 when U.S. Treasury Paulson is lounging on a beach in Hawaii sipping on a Margarita.
Aaron Konen and Ernie Goss