Opinion: Deflating the Hype About Deflation

"Inflation is taxation without legislation."
-- Milton Friedman

Since everyone today is fearful of deflation and falling prices for everything from commodities to stocks to housing, this is a good time to consider what causes deflation and its opposite, inflation.

Deflation is caused by a reduction in the supply of money available in an economy, relative to the goods and services available. This usually happens because of a combination of wealth destruction, credit contraction and excess production.

The most classic example of this is in Japan, which has experienced mostly deflation for nearly two decades despite, enormous efforts to combat it from the government. Many people believe that the U.S. is headed for a similar fate because of our housing and stock market collapse combined with the credit crisis.

Here is why that is not very likely to happen.

First, the Japanese government was very slow to respond to its deflation problem with zero interest rates, quantitative easing and massive government spending. By the time it did get around to implementing these policies, the psychology of deflation had already taken hold among the Japanese people and businesses.

In contrast, the U.S. government has moved forward with these anti-deflationary policies in short order. Although significant damage has been done to consumer and business confidence, the problem has not been going on for years as it was in Japan.

The Fed has already come out and effectively said that it is going to target and basically guarantee a certain level of inflation. If the Fed has credibility about anything, it should have it with respect to printing enough money to create inflation, if that is what it wants to do.