The current discussion of inflation and deflation is focused narrowly on money supply, which is important but only a small part of the equation. Gold bugs worry that printing money will lead to massive inflation. Deflation proponents argue that the government is not adding to the money supply because the new money simply replacing demand that has been lost to the deleveraging process. These oversimplied views of inflation miss the point: inflation is as much a function of the supply of goods and services as it is a function of money supply.


Once you factor in the supply of goods, and services you will see a struggle between inflationary and deflationary forces that will play out in this country on an uneven basis across the economy. Inflation will affect industries differently based on capacity, profit margins, productivity and exposure to a falling dollar. Secondly, you have to consider on what the government spends money rather than how much money is printed. Some industries will experience inflationary pressures sooner than others, while some industries are going to be stuck in a deflationary cycle for a long time.


For the near term, inflation in aggregate is unlikely. Today, the economy has massive over capacity, resulting from a decade long build-out to support consumer demand that was fueled by debt. That debt pulled consumption forward from the current recession into the boom years. So our industrial capacity exceeds consumption demand, and will for a long time. That demand is gone, but the capacity is here, and it will be here fighting inflation until it is worked off over a longer period of time. Basically it is very difficult to pass along higher prices when you have 10 competitors who are willing to hold the line on prices.

The discussion also misses the question: how is the money going to be spent? Not all government spending is equal. It is possible that, and has on rare occasions, government deficit spending leads to disinflation. For example, the money that the government spent on building out the Internet, has had significant deflationary affects by promoting productivity and competition. The inflationary impact of government spending is really a question of ROI. Wisely spent money isn’t inflationary, where as poorly spent money is.

As you consider what the government is spending the money on, you should worry more about inflation. The bulk of the money has gone into the financial system where it creates no supply of goods or services. The vast majority of the new money enables the Fed to hold troubled assets. This new money serves only to protect the foolish from the consequences of their action. Only the silliest of bureaucrats talk about making money on these investments. We are making pennies on the Goldman Sachs and State Streets while losing dollars in AIG, Citibank, and the rest of the portfolio.

Worse, the government is altering consumer demand in order to fight deflation where it is needed, at the expense of creating it where it is not needed. Housing in this country is overpriced. Cars in this country are overpriced. Yet, the government encourages us to buy houses, cars, and energy efficient products. When a buyer takes these incentives, it is at the expense of other parts of the economy. In my specific case, I am replacing a perfectly good air conditioner which is an energy efficient one solely because the government will pay me to do something stupid. Given the size of that expense, I am not painting my house which actually needs to be done. While this is my individual decision, it is clear from the statistics on car sales and retail sales that there is a transfer of consumption from retail to autos that is in part caused by cash for clunkers program.

The net effect of this is going to be terrible for the long-term economy, which leads me to believe that inflation wins out in this struggle over time. The government thinks that it is smarter than the market. In my case, the air conditioner company wins, while the painters and my neighbors lose. Whatever economic activity that is created by the winners will be more than offset by the economic loss created by the losers. People who need to be farmers, or painters, or waiters will continue to live on the government’s dime working in banking, and auto production, and whatever other business the government decides is good for the economy. At which point, money supply is somewhat beside the point.