Back at the beginning of this century, the Fed (and Ben Bernanke in particular) became worried about deflation. When the tech bubble popped they were so worried about the potential for deflation a la the Great Depression that they overdid it and caused a housing bubble. But why does the Fed fear deflation? That fear is rooted in a misunderstading of the Great Depression. This article explains the difference between good deflation and bad deflation.

In short, deflation caused by an increase in productivity is good and deflation caused by money supply contraction is bad. In an economy with a constant money supply and rising productivity, prices should fall. In fact, that is the basis of capitalism. What we are experiencing today is a deflation caused by a fall in the money supply via credit contraction.

So how do we transition to good deflation? We should allow the price of gold to fall to around $500/oz and then stabilize the price through open market operations by the Fed. After it is stabilized, the price should be controlled based on productivity. If productivity is rising at 2%, the Fed should allow the price of gold to fall by 2%. If producitivity is falling at a rate of 2%, the Fed should allow the price of gold to rise by a similar amount. This would produce an economy where the cost of living falls as long as productivity is rising. That is exactly what we should want for our citizens. Become more productive (by acquiring new skills, etc.) and you are rewarded with lower prices and more purchasing power. That is how real wealth is created through a capitalist system.

A system such as this would align the interests of politicians and their constituents. Create an education system that actually performs and productivity will rise. Raise taxes too high and productivity will fall. Run large deficits and the Fed will have to sell bonds to keep the price of gold down. That would reduce growth and productivity. Run a budget surplus and the Fed will have to buy bonds to keep the price of gold from falling too much. That will increase growth and productivity.

A monetary system based on gold is not perfect, but it is a hell of a lot better than what we are doing now. The key to growth is productivity, savings and investment. For as long as I’ve been alive, government has enacted policies that attempt to manipulate consumer spending. That hasn’t worked out too well. It’s time to go back to something that has worked for centuries.

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