Inflation vs Deflation: Why You Should Care

Building self-sufficiency isn’t just about living off the grid or growing your own food. It’s also about protecting your hard earned dollars from forces beyond your control. Two of these forces often discussed yet seldom understood are inflation and deflation. Most people don’t give these two ideas a single thought in their daily lives, but you should.

Inflation

Most people think of inflation as meaning rising prices. This is the #1 misconception concerning this topic. Inflation is actually an expansion in the amount of money in circulation. One of the most immediate side effects of this is rising prices because when you have more money floating around, there are more dollars competing for the same amount of goods and services. Picture a room full of people who are all trying to buy the same thing. If you were to suddenly give all of them an extra $100, you can be absolutely certain the price of what they all want to buy will go up. If people have more disposable money, sellers can safely raise prices and not lose business.

Another way of looking at this same topic is that if you have a pool of money, and you suddenly increase how much money is in the pool, each individual dollar’s value gets diluted. This means that when you have inflation, you have a currency that is worth less than it was before. If the amount of “stuff” in the world available to buy stays the same and there’s just more money around, then all that happens is that the price of all that “stuff” goes up. Nobody gets richer, but whatever money you already had becomes less valuable.

Shadowstats.com Alternative CPI ChartSo how is inflation measured? Well if you trust the government, you can look at the consumer price index (CPI), which tracks the price of goods over time. However, as is often the case with statistics, the method by which they are calculated is often manipulated to achieve a desired result. For example, the US government has altered its formula for calculating CPI repeatedly since the 1980’s, probably because social security benefits are linked to CPI, so lower CPI means less payouts to retirees. John Williams, an economist and founder of ShawdowStats.com, routinely puts out charts tracking inflation using the old 1980’s and 1990’s formulas. The red line (current method) clearly understates actual inflation, which if you were to use the old calculation would be closer to 10% year-to-year! Suffice it to say: don’t trust the government. Trust your own finances. If you’re finding it’s harder and harder to save the same amount of money each year, you can rest assured there’s inflation.

Deflation

Deflation is more difficult for people to understand than inflation. As you might expect, it’s the exact opposite of inflation: it is a reduction in the amount of money in circulation. To use the example of the room full of people again, if you’ve got a room of people all wanting to buy something and you were to take away $100 from each and every one of them, you can be certain the price of whatever’s being sold will go down. Essentially, you have less dollars all competing for the same goods and services so sellers are forced to reduce prices. Because the pool of money has shrunk, each individual dollar goes up in value! Yippy! You can buy the same stuff with less money.

Now where this topic begins to get confusing is the mechanism by which deflation occurs. The banking system currently used is called fractional reserve banking, meaning banks only have to keep on hand a fraction of what their customers hold in their accounts. The rest is loaned out. When banks make new loans, they are introducing more money into circulation. To use an example, let’s say John goes to Bank of America and deposits $100. Bank of America then takes $95 of John’s money and lends it out to Jane. Although Jane has agreed to someday pay back Bank of America, she nonetheless has $95 to spend and John still has his $100. With the push of a button $95 was created from thin air and voila! We have inflation. Eventually, one of two things happens: either Jane pays back the $95, or she spends everything she had and goes broke. In either case, $95 vanishes from the system. If she pays it back, she no longer has the $95 to spend. If she goes bankrupt, the $95 also disappears except that Bank of America also takes a loss because they’ll never get it back. In either case, the amount of money floating around that can be spent has shrunk and voila! We have deflation.

Which is Better?

This is a heated debate among economists, but I’ll give you my take. Let’s summarize real quickly:

Inflation = More Money = Higher Prices = Less Purchasing Power
Deflation = Less Money = Lower Prices = More Purchasing Power

In accounting there are always two sides to an equation that must balance, so this means that which is better depends on who you are. If you are a saver, like most people, inflation is bad. All those hard earned dollars you’ve stashed away lose purchasing power the longer they sit there. Conversely, if you’re a saver then deflation is great because everything you buy suddenly costs less!

Why then do all the experts on TV say deflation is terrible, that we must have inflation? Why do all the central banks of the world have “inflation targets” and are doing everything in their power to force inflation. Why do they fear deflation so much when it’s so clearly a good thing for savers. The answer is because the primary beneficiaries of inflation are (wait for it…) banks and government. Remember, in a fractional reserve banking system the banks only keep a very low percentage of people’s savings on hand in the vault. In a deflationary environment, where people are paying down debt, they must first withdraw money from the bank to pay the debt. However, banks only have enough money on hand to cover at most 10% of their customers’ accounts. The only way they survive is by constantly loaning new money into existence and charging interest. Otherwise, they’re forced to give people back their savings and they end up going bankrupt because they don’t have enough on hand to do so. Decreasing the money supply is like taking oxygen away from the banks.

Governments also love inflation because they are not savers. They have more debt than actual savings, so they prefer the value of money to go down because they can pay down old debts using cheaper and more abundant dollars. This is why they work with central banks to drive down interest rates, print money, and force inflation.

Why Should You Care?

Ever since the 2008 financial crisis, the US government has been printing money and injecting it into the system in order to drive up inflation in order to 1) keep the banking system from imploding, and 2) to continue to pay down debt with cheaper dollars. However, the money they’ve injected into the system hasn’t made its way to the John Doe’s of the world. It’s gone straight to the banks and financial industry. That’s why the stock market has soared to such grand new heights. It’s not because the economy is doing well, it’s because of inflation. However, the real economy’s natural tendency is towards deflation and every time they even hint at stopping the printing presses, the markets either flatten out or start to drop. The reason natural forces want deflation is because there is so much debt built up in the system. The system tried to reset itself in 2008 but the government used massive bailouts and money-printing to stop the reset, and in the process they added insane amounts of debt onto the already unsustainable pile, essentially kicking the can down the road towards an even bigger reset. By trying to force inflation, they’re trying to swim upstream, and there are only two possible outcomes:

Inflation Wins

If the government is successful in forcing inflation, financial markets will continue to rise higher, making the rich richer. The purchasing power of each dollar will also continue to get weaker, making the poor poorer. If gone unchecked, inflation can lead to hyperinflation, which is a scenario under which the currency has lost so much value that people completely lose confidence in it and it’s value rapidly plummets towards zero.

Deflation Wins

If the government is unsuccessful in combating deflation, banks and even some governments will be forced to declare bankruptcy. This will cause runs on banks and since we know there isn’t enough real money in the system to cover everybody’s deposits, most people will lose their savings. And if you think FDIC insurance will help you, think again. There isn’t enough money in the FDIC program to cover all the eligible deposits in the US. Personally I think deflation is the more likely scenario, and there’s a good chance it’ll be on par with the Great Depression or worse. The reason is because there is way too much debt built up in the system: there’s $17 trillion in the the US alone, over $1 trillion in student debt, and an overwhelming number of Americans are either buried in credit card debt or wouldn’t survive more than a few weeks without work. When debt gets paid down or written off, money vanishes and you get deflation, so I just don’t see it not happening. What’s worse is that it’s not localized to one country. For the first time in human history, every major country is sitting in the same perilous situation.

Evidence would support that we are already heading into a deflationary event. Coal, steal, oil, and copper have all dropped in price, which is usually a clear sign that economic activity is slowing down. Corporate earnings are expected to decrease in 2015 and the stock market is showing signs of possibly topping out now that money-printing has slowed down.

Banks with Highest Derivatives ExposureRock and a Hard Place?

Both of those two options clearly suck. However, like deciding to live off the grid you can do things to insulate yourself from the ravages of inflation and deflation.

  • Don’t keep all your money at one bank, and definitely don’t keep your money in a high risk bank like the ones listed at the right. Typically, smaller local banks tend to be safer than the big boys that have 30 times more debt than assets.
  • Instead of keeping your savings in US dollars, consider buying some physical gold or silver if you can. Most financial advisors suggest keeping 10% of your net worth in gold, perhaps more given today’s environment.
  • Keep some physical cash on hand, under the mattress so to speak. Many suggest having enough cash on hand to last you 1-3 months in case of emergency. This also keeps you from spending it.
  • Rather than sitting on cash, invest in your home by increasing energy efficiencies. This will save you money over the long term.
  • Stay away from overly-inflated asset classes such as stocks. It may seem like a party right now, but it could crash and burn at any moment’s notice. A 25-50% stock market crash wouldn’t surprise me the least if and when deflation takes over.
  • Pay down debt, especially if deflation is the more likely scenario. The less you owe somebody else the safer you’ll be if you ever lose your job or if people get desperate for their money back.
  • Cut down your living expenses. It’s so much easier to cut costs out of your budget than it is to go find more money, and most of us have indulgences that we could probably do without.
  • Have emergency food and water supplies at home in case there’s an interruption in the supply chain resulting from a financial crash, same as you’d want if a hurricane barreled through your home town.

Where There’s Risk There’s Opportunity

Wealth is like energy: it can’t be created or destroyed, it can only be transferred. There were more millionaires created during the Great Depression than any other moment in history because a select few dared to see the writing on the walls. If 90% of people are losing, you can be sure the other 10% is making out big time. Don’t let yourself be in the 90% that lose because you didn’t take adequate precautions against what many would call the unthinkable. Crises always come when nobody thinks it’s possible, so best be prepared.

Further Resources

Here are a few videos I recommend on some of the topics discussed in this article.

How Inflation Statistics are Manipulated

How Money is Created from Thin Air

How the System is a Ponzi Scheme Rigged to Fail

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One thought on “Inflation vs Deflation: Why You Should Care

  1. Pingback: Financial Precipice à la 1929? | Clan Against the Grain

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