Well, the title being “Deflation is the Government’s Worst Enemy” is debatable, of course, but did make for a catchy subject line. And even though there might be worse things that could happen to a government, deflation certainly is up there among the most threatening.

Maybe a more appropriate threat would be not being reelected to their positions in upcoming terms, but that is for a whole other discussion. Jim Rickards, in his book, “The Death of Money,” acknowledges that deflation is “the Federal Reserve’s worst nightmare.”

The problem with deflation is that it causes the Federal Reserve –which is a “separate entity” married to the government — to do things that will have catastrophic impacts to national debt, government revenue, and the banking system.

The real problem with deflation is tax revenue drops substantially and the government has a way of spending substantially beyond what it takes in from the taxpayers, and falling prices perpetuates this. A simple example would be a bicycle at the store that costs $100 and the government collects $9 off of the sales tax on it. If the cost of the bike goes down to $80, now the government is only collecting $7.20. So a good way for the government to stay in business is for prices to steadily rise, because without having to actually raise taxes on everyone, they can collect more off of the percentages of higher-cost goods.

When prices fall, a number of things happen that cause this downward cycle to worsen. If companies have to lower their prices, this will likely mean they will make less money and therefore have to cut labor expenses. When people get their hours cut or are even laid off, they don’t spend money and the cycle spirals, which all leads to lower revenues for the government and higher national debt – essentially all boiling down to taxes. The other problem with deflation is that it causes buyers to wait to purchase things because they are anticipating potentially lower future prices and again, this puts a strain on economic growth and tax revenue.

Even though deflation and recessions can be unpleasant, they are necessary and fundamental to a healthy economy. Prices can’t go up forever, and corrections in the market allow for the economy to reset. Aside from that, I tend to like deflation, especially when I am looking to buy something. I always enjoy purchasing something that I was already planning on spending more on, but am now getting it for a discounted price.

The reality is that periodically, economies do need to go through this recessionary process, but the Fed fights this cycle tooth and nail.

Here is How They Do It…

Deflation is fought in one of two ways. One of these is by printing more money, essentially diluting everyone’s purchasing power and causing everyone’s money to devalue while trying to counterbalance the effects of deflation in the economy. When the money supply increases, the cost of goods go up since there is a larger amount of dollars in the system chasing the same amount of goods. The other thing they do is keep interest rates at close to zero,which is another tactic that has been ongoing during the years leading up to the financial crisis of 2008. Since 2008, interest rates have been kept low to counter the struggling economy we’ve dealt with since. Low interest rates are an incentive for people not to save money, but rather spend it in the economy. This creates a demand for goods, which pushes prices higher. This, too, helps to counter deflation in any economy.

The reality is that there is so much firepower that the Fed has that it can’t keep interest rates low for an indefinite period of time. In theory they could, however, eventually something is going to have to give. The truth is people still really aren’t borrowing to a large degree, and they really aren’t spending to a large degree, and lower interest rates have not substantially helped this. The threat of deflation is upon us because prices do want to start coming back down, and things have gotten expensive around the world.

Look at oil, for instance, which was over $100 and is now down at around $50, not in a hurry to snap back upwards. This is very much an example of deflation, and an industry that has been beatenup in the process. I’m very interested to see what will happen as real estate slows and the major indices start to decline, wondering how our next recession is going to play out.

It’s actually ironic, but deflation will actually ultimately lead to inflation and continue to put further strains on the overall economy. If only we could allow the free market to take its course…