Sorry About that Inventory, Prices Must Come Down

As George Reisman notes in a recent column, falling prices are not the cause of deflation, they are the solution to it.

Reisman defines deflation as the lowering of DEMAND for goods - this lower demand drives prices lower so that equilibrium is reached.

The losers in a deflationary environment are asset holders. People with fixed assets (like houses) and even liquid assets (like stock market investments which are held long term), as well as companies with large finished goods inventory; all have seen a large decline in the value of these assets over the course of 2008.

Reisman rightly implies that holding off on clearing the market is not the solution. This is what happened during the 30's in America, and Japan in the 90's. In the former case money tightened thus driving prices higher, not lower as they needed to go to clear the market. In Japan, the money supply was opened wide, but institutional restrictions held prices artificially high.

In our current situation, the Fed has opened the money supply widely putting short term interest rates close to zero. By pumping lots of liquidity into the market they hope to stimulate demand. As well, prices are falling in the housing market, and no restraints on falling prices have yet arrived (e.g. beware price controls, remember them from the Nixon era?).

The market must be allowed to clear to get the economy moving again, however the looseness the Fed is now encouraging and enforcing through it's various powers, will most likely result in rampant inflation sometime around late 2009 - 2010 so beware.