Price vs. Value in the Inflation/Deflation Debate

Aug 26, 2008 – A friend recently wrote to me saying that value is what you are offered when you want to sell something. I disagree. What is offered is a price, which may be above, below or at fair value of the item being sold.

For example, we all know that stocks sell at a price that at any time can overvalue, undervalue or fairly value that stock. The same thing can happen with houses.

In the United States, and indeed much of the world, house prices rose in recent years during a period of easy credit in which mortgages and other loans were plentiful. The availability of easy credit always leads to bad investments and money being spent unwisely. Proof of this point is self-evident from the bankruptcy of lenders like IndyMac Bank and the collapse of Fannie Mae and Freddie Mac and other institutions that extended housing loans imprudently.

We are now seeing the inevitable shake-out from a period of easy credit, and housing prices are declining as a result. For example, the widely watched Case-Shiller home price index released today by Standard & Poor’s indicates that the decline in U.S. home prices is accelerating. Prices dropped a record -15.9% in the past year.

This decline in the price of homes is wealth destruction. But wealth destruction is not deflation. Many people confuse this point.

Deflation is the opposite of inflation. Both are monetary phenomena. Inflation is an increase in the quantity of money, with the consequence that each unit of money purchases less and less over time as the inflation proceeds. Deflation is a contraction in the quantity of money, with the result that each unit of money purchases more and more over time as the deflation proceeds.

Right now, M3 (the total quantity of dollars in circulation) is growing by over 15% per annum. This rate of growth is highly inflationary, so the dollar is being inflated. This inflation is incurring even though there is much wealth destruction as a result of declining house prices.