I'd like to expand upon my previous post, which is already too long.
A period of steady, predictably deflation wouldn't be too terribly damaging. The people and the economy would adapt, and life would go on.
Take lending as an example. Current inflation is something on the order of 3% to 5%.
Under current conditions, if a bank loaned money at the exact rate of inflation (3% or 5% or whatever) then they would just break even. If the loaned at a rate less than inflation (say 0% or 1% or so) they would lose money, and if they loaned at a rate higher than inflation (say 10%) they would make a profit.
Banking would work the same way in a deflationary period, it's just the numbers that would be different. Let's say deflation is something like 10% (or in other words inflation is -10%; currency become 10% more valuable each year). For the bank to break even on a loan, it still has to lend money at the exact rate of inflation (-10%; that means that on a one year loan, they would only expect you to pay back to 90% of what you borrowed). To make a profit, the bank has to loan at a rate higher than inflation (-5%, or 0%, or something like that). If they goof up and loan at a rate lower than inflation (say -15%), then the bank would lose its shirt.
The system of lending works the same regardless of the actual rate of inflation/deflation (lend at a rate higher than inflation to turn a profit; lend at a rate lower than inflation and you take a loss), but the numbers are different. It would take some getting used to. A 5% mortgage rate looks pretty darned good right now, but in a deflationary period (inflation=-10%) it would be a terrible deal: you would be paying back 15% more value than you borrowed each and every year.
Anyway, we could live with a system of constant, predictable deflation. We'd just have to get used to the new ways the numbers worked out.
What we couldn't adapt to is a system where the rate of inflation or deflation is constantly changing. A banker can make a reasonable estimate of what interest rate to loan money at if he knows what inflation/deflation is going to be in the future. He simply sets the rate of the loan a few percentage points over the rate of inflation regardless of what inflation happens to be. But if he doesn't know what the inflation rate will be going forward, then he can't make any loan without taking on a significant risk. If he sets his interest rates too low, then he might end up losing money and being ruined by the loans he made. If he sets sets his interest rates too high, then nobody will borrow from him and he'll still be ruined. The best course for all concerned is to avoid lending or borrowing money.
Economic stagnation is the eventual result of unpredictable inflation and deflation.
I guess my point in all of this is that it's predictability that matters most of all. This is where the gold standard fails and the Fed Reserve system shines.
Under the gold standard, the only way to increase the money base is to dig more gold out of the ground. If some miner strikes a mother lode, then suddenly the money base has increased tremendously. Supply and demand: the supply of gold/currency increased, therefore the demand decreased. This means inflation.
If the population grows suddenly, then so will the demand for currency. Demand goes up, supply goes down, and you get deflation.
If an entrepreneur or an inventor suddelny manages to increased the productivity of the nation's workforce (the invention of the assembly line would be a good example - suddenly laborers were able to produce tenfold more than they were before). Again, the demand for currency goes up, supply goes down, and you get deflation.
Under the gold standard, what you find is that a never ending sequence of unpredictable events (gold production, population changes, productivity changes, economic growth, etc) is constantly causing sharp spikes of inflation and deflation. The rate of inflation becomes upredictable, and it becomes very difficult and very risky for people to make sound investments. So people simply stop investing.
But thankfully we have the Federal Reserve system. Under our existing system, a smart guru in Washington is able to wave his magic wand and make the money base bigger or smaller whenever it's necessary.
Population boom? Bad news if you're on the gold standard, you get deflation. No problem if you're on the Fed Reserve standard. The fed can simply create more currency. Supply rises to meet rising demand, thus no change in inflation/deflation. Predictability is maintained.
Alaskan gold rush? Bad news if you're on the gold standard, you get inflation. No problem if you're on the Fed Reserve standard, because the supply/demand ratio for money isn't based upon gold. Predictability is maintained.
Henry Ford or Ma Bell or Bill Gates making your workforce dramatically more productive? Bad news if your on the gold standard, you won't have enough additional currency to cover the increase in productivity and worker output, you get deflation. No problem if you're on the Fed Reserve system, the Fed Chairman will simp;y increase the nation's money supply to match the increase in economic output. There'll be no change inthe rate of inflation/deflation, predictability is maintained.
You get the idea.
Obviously the Fed Reserve system can be abused or mismanaged. If the Fed Chairman increases the money supply at the wrong rate or at the wrong time, he'll actually end up causing inflation or deflation instead of controlling it. So the increased flexibility of the Fed Reserve system doesn't come free of risk. But it's a cost that's worth paying, the advantages outweigh the risks. I's like any other government power. Beneficial to the people if it's wielded properly, dangerous if it's not. Ultimately it is the responsibility of the electorate to make sure that our government does the right thing with our money supply.
Sorry for being extremely long-winded.
