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While a long term inflation believer myself, there are definite deflationary forces in the economy today.  Battling these tough forces is the Federal government, pulling out every stop possible to fight this war.  My question that I’m posing today is: are these forces really a deflationary disaster that must be avoided at all costs or is it merely the economy being restructured based on market forces?  How you answer that question determines much.

Deflation is typically marked by decreasing demand across the board.  Consumer demand contracts which causes retailers to drop prices in an attempt to create demand and liquidate excess inventory.  This impacts on manufacturers.  This contraction leads to lay offs which makes demand go even lower.  The downward spiral continues until…. ?

1. The Keynesian folks will tell you this spiral will continue indefinitely until an external force (government) breaks the cycle by stepping in and “creating” the demand.  The problem here is that by creating artificial demand, you are sustaining businesses that perhaps should not be sustained.  You are allocating capital to areas that should go away potentially.
2. The capitalist purists will say that eventually when all excesses are removed from the economy, leverage is brought back down to a better level and people rebuild their savings (maybe), then the economy is fully restructured and ready to grow again.  The problem here is that there can potentially be a great deal of pain involved (i.e. unemployment, foreclosures, etc.).  Politicians will never “not act” which makes this solution pretty much never a real possibility.

I tend to embrace solution #2 because by embracing solution #1 we continue to keep companies alive that should not be.  This restricts future growth by not allowing capital to flow to other, prospering areas and businesses.  We want our capital to go to the most economically productive areas.  Zombie banks are not economically productive.  By repeating this Keynesian intervention during every single recession or downturn, our ill-structured economy becomes more and more ill-structured where eventually we end up with an economy propped up only by government and insane levels of debt.  This economy becomes more immune to the stimulus drug.  Over time, each dosage must be increased to provide the same level of effectiveness.  Meanwhile, the idea of “restructuring” becomes more and more painful as the withdrawals of a 20 year addict are most likely much worse than those of a 2 year addict.

Solution #1 works until… well, it doesn’t work anymore.  As we close 2009, how many times have we thrown around the word “trillion”?  The effectiveness of these shots of heroin can definitely be debated as we continue to hover around 10% unemployment.  Is it possible to up the dosage further?

Solution #2 can be put off until… it can’t be put off anymore.  When will it not be able to be put off anymore?  When the market forces overwhelm even the greatest & largest economy/government the world has ever seen.  Eventually, this WILL happen.  It might be brought upon by China refusing to lend more money or perhaps by a currency collapse.  So, solution #2 will eventually be the solution.  It’s a matter of when and a matter of whether we choose solution #2 or if the market chooses solution #2.

Pain now, or pain later?