News

Alice in ‘Flation Land

alice

‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’ ‘The question is,’ said Humpty Dumpty, ‘which is to be master, that’s all.’

After Alice left Numberland, she found herself in ‘Flation Land, where she encountered Humpty Dumpty, so robust in good times, now perched precariously on his Wall. Alice solemnly pondered Humpty’s fall. All the King’s horses and all the King’s men had put the many pieces of this delicate egg back together (with the help of scotch tape and a little tarp), but which “flation” would be master, Alice wondered. Would it be Deflation? Stagflation? Inflation? Perhaps even the dreaded Hyperinflation?

Alice knew: Inflation would be master. The magical trillions conjured out of thin air in Numberland had convinced her of that much. It was just a question of when. Inflation, the rise in prices caused by an increase in money supply, is inevitable when so many dollars are pumped into the system. Once the stimulus works its magic, there will likely be a rush for scarce goods and services. Warren Buffett predicts that, thanks to the government’s costly economic rescue efforts, inflation could eventually exceed the highs of the 1970s.

But, it has also been suggested that inflation offers a convenient means of reducing the cost of our ever-expanding debt. As the dollar’s purchasing power is eroded by price hikes, any amount owed is worth less. Say you owe $1,000 and prices double. The value of that debt is effectively halved because, post-inflation, that $1,000 buys half as much. Not bad if you’re a debtor. A nightmare if you’re a lender. The money you lent has become less valuable, and the interest charged was too low, resulting in a loss. Any subsequent loans will be at exorbitant rates, to compensate for inflation.

Rising prices also hurt anyone on a fixed wage, as hard earned bucks get less bang. Unfortunately, most salaries are not inflation-adjusted, making us vulnerable to price increases. Ultimately, inflation takes a toll on economic growth by squelching borrowing, discouraging investment and savings and inducing product shortages and hoarding.

But before inflation takes hold, Alice thought, we will experience deflation— falling prices and tight credit. And sure enough, with consumers cutting back amid mounting job losses, the CPI (Consumer Price Index) released on April 15 showed prices down 0.4% from a year ago. That, coupled with the 1.1% decline in March retail sales indicates disquieting deflationary pressures. Nevertheless, deflation is only bad if it is prolonged, as in the case of Japan. In such a scenario, interest rates are zero, and prices, demand and wages drop precipitously. This causes the value of debt to increase, a crushing blow to any debt-ridden society. Fed Chairman Ben Bernanke once famously remarked that he would drop dollars from helicopters to prevent a deflationary drop in demand from setting in.

What about stagflation, that lethal combination of economic stagnation and inflation? Last seen in this country in the 1970s (a period of high prices, high unemployment, high interest rates and low/no growth), rampant inflation was finally tamed by the Fed aggressively reining in money supply. A deep recession ensued.

Finally, Alice considered the worst “flation” of them all: Hyperinflation. Could we be entering an era of out of control inflation caused by excessive money supply and unsupported by economic growth, resulting in an utter loss of confidence in the dollar? Anything seemed possible.

And with that, Alice returned to the price stability of Wonderland.

Tags: Alice in Wonderland, deflation, economy, hyperflation, inflation, stagflation