Commercial Break

This past week I was prompted by Mickey Axlebender Thirdson to pontificate on deflation, since people were talking about it but did not seem to know what it meant. Of course, if one is speaking of pneumatic tires, deflation causes a "flat", and if one is talking about a bore (as in, politician who won't shut up) the term has no meaning since the bore is a boor and cannot be embarrassed sufficiently to become deflated. However, when one is speaking about economics, then the common sentiment is that deflation is when prices go down.

It is a bit more complicated than that, though. Perhaps we need to look first at "inflation", which everyone thinks they understand. We will need a place to stand on if we are going to move the Earth, saith Archimedes, and that place in economics will be a standard medium of exchange. Gold comes to mind quickly, as does the cost of a loaf of bread. The USBuck has been taken to be the standard for the past half century (yes, Virginia, there was a time when other currencies were considered the standard -- see "pieces of eight", for example) and the rise of the Euro notwithstanding, foreign investors have rallied back to the dollar recently because, relative to what is happening in the rest of the world, and in spite of US economic woes, the USBuck is still the most confidence-inspiring piece of paper afloat.

Inflation is generally seen to be a process whereby prices are rising. There is a need to understand why prices rise. In a rational economic world, prices rise due to a rise in demand relative to a decline in supply. In other words, people are bidding for something, and the competition drives up the price. There are multiple intertwining factors in action, however. One factor is the item being purchased, and another is the perceived value of the currency used. In other words, the USBuck is a commodity in trade. In general, the more USBucks there are in circulation, the less valuable they become, and the more of them are required to barter for the item being purchased. When the government creates more USBucks, to the buyer, the USBuck has become less valuable, and to the seller, the item being sold has become more valuable. Inflation in the price of the commodity being sold, where the demand for the commodity has not increased, is actually caused by deflation of the value of the currency used in trade.

So, we flashback to Jimmy Stewart in "It's A Wonderful Life", and we see him instructing Momma Dollar and Poppa Dollar to hide in the safe and create lots of little dollars. Unwittingly, Frank Capra was commenting on the reason why FDR was unable to solve the problem of the Great Depression with all of his programs. They all tended to create little dollars.

Entrepreneurial buzz is full of the concept of "creating wealth". Wealth is "created" when a product, for which there is a demand, is produced. Too much of the "wealth creation" that has taken place has simply been fabricated through artificial accounting constructs. One popular method has been to provide seller financing of a piece of real estate. The seller needs money and is looking for a buyer, and the buyer has no money and wants the property, so the seller "creates" the money by allowing the buyer to make payments over the life of the contract. There is risk involved, and the seller compensates for the risk and charges interest (the time value of the money) to make up for the fact that he cannot use all of the sales price right away (opportunity cost has to be compensated for). The money used to make the payments (USBucks printed by the Federal Reserve) was originally intended to be used in direct exchange for goods and services without any adjustment for lost opportunity costs. Because the terms of the contract are now competing directly with the interests of the private banking system (the Federal Reserve), feedback in the economy forces the Federal Reserve to print additional USBucks to protect its own position. Money has been "created". This does not necessarily lead to a decline in the value of the USBuck IF there has been a corresponding increase in the total goods and services being traded and in the number of buyers of those things. Unfortunately, as has been pointed out in prior posts, there is a huge oversupply of housing (the most common wealth creation venue under the above scenario) and the net effect of the increase in USBucks has been to lower their value in trade.

Deflation is commonly taken to be the situation when prices are falling. Why do prices fall? Prices fall either because there is too much "stuff" for sale -- no demand for the "stuff" -- or because the number of USBucks available has declined. If there are fewer USBucks, then the demand for USBucks rises, and the buyer is entitled to get more "stuff" for fewer USBucks because of the relative value. To look at the backside of it, deflation caused by a reduction of the number of USBucks in circulation is actually inflation in the buying power of the USBuck. My opinion -- William Jennings Bryan, with his "Cross of Gold" speech, was a blithering populist idiot who did not seem to realize that the alternative to crucifying the farmer with the gold standard was to suffocate the rest of the country with worthless paper.

Sad to say, it appears that just now the deflation in the worth of the dollar is coinciding with a deflation in the worth of the goods and services in some sectors of the economy. There are too many houses; about 10% of the total housing stock should be bulldozed and returned to cropland or some other productive use. There are too many cars (particularly cheaply made, breakdown-prone, high-priced, gas-guzzling ones) -- a fact easily illustrated by the lack of car sales having very little impact on whether or not Americans are still getting to wherever they want to go. There are too many mortgages that were made at below-market teaser rates and which will default as the rates reset to market and the borrowers can no longer afford to pay.

The government response has been fantastically stupid. Instead of listening to economists, the Congress and Senate chose to listen to every plaintiff whose ox had been gored, especially the Federal Reserve bankers. In the blink of an eye, the Federal Reserve was allowed to create $700,000,000,000 of new BailoutBucks, a move which cheapened the money in everyone's pocket overnight. Prices should have shot upwards, but one other factor was at work -- the machinations of the Infernal Revenue Service.

I have several very bitter disagreements with the tax thieves. One has to do with their desire to strangle the taxpayer. The term "mark to market" is now getting some attention, but it is an old IRS tactic that was adopted by the people who invent accounting rules. According to the IRS, if the market interest rate is 5%, and I loan you money at 1%, you must pay income tax on the 4% I did not charge you. The accountants were forced by this tactic to come up with a definition of "fair value" that relies on the current market price, even for assets which a taxpayer does not intend to sell. If I buy stock at $1/share on December 30, 2008, and it goes to $2/share on December 31, 2008, and back down to $1/share on January 2, 2009, I have a gain of $1/share for the 2008 tax year, even if it was not realized. For a cash basis taxpayer, there is no effect, but for an accrual basis taxpayer, there is an imaginary taxable gain of 100%. This is the result of "marking the value of the asset at current market price". The tax must be paid in 2009, and you can take a write-off for the imaginary January 2 loss in 2010. IRS will use your money, interest free, in the meantime.

When "mark to market" is applied to assets that are being held for income generating purposes, the decline in the market price of those assets can cause catastrophic effects in the credit ratings of companies. That is why so many lenders and insurance companies are now in a credit crisis. That is why throwing money at the problem will not help. The rules have to change. I advocate that "mark to market" be used only for assets actually traded, and "value in use" be given more emphasis where accrual accounting is utilized. IRS will not be happy with such a concept. It is not an accident that a recent Federal tax court decision (10/30/2008) ended in a ruling that disallowed a value for the cost of a historic facade restoration in New Orleans. IRS argued that only sales comparison should be used, and that cost and lost income should not be considered. "Judge James S. Halpern ruled that the court would not supplant its responsibility to assess an expert appraiser's reliability by accepting USPAP as the defining standard of reliability, stating that federal rules of evidence only require that expert testimony be based on reliable principles and methods." (Appraiser News Online, November 19, 2008, Vol. 9, No. 21/22). In short, the IRS can ignore Congress and make things up as it goes along.

Deflation? The horse is out of the barn, but it's a mule. There are too many USBucks running around out there. The politicians are planning to print more in an attempt to "stimulate" the economy. There is too much "stuff" for sale, and the only way out of the rabbit hole is to either reduce the amount of "stuff", or reduce the number of USBucks. Meanwhile, back at the ranch, prices will continue to go down, and the country will suffocate in excess USBucks.

Too simplistic? If I have to cut my throat, I would rather do it with Occam's Razor.