Jan. 5 (Bloomberg) — Sometime soon the U.S. Senate is expected to confirm Federal Reserve Chairman Ben Bernanke for a second term. Soon the Senate will also vote on legislation to overhaul the financial industry.

Neither action directly determines the U.S. monetary outlook. Yet a monetary assumption underlies all of Washington's finance- or banking-related activity these days. The shared belief is that the potential for deflation or credit-and-deflation-related spirals deserve our near-exclusive attention.

One task for the Financial Services Oversight Council that would be created by the House reform bill, for example, is to sort out which are the too-big-to-fail institutions and prevent future Lehmans. In other words, we need to further systematize the dumping of cash into companies and the economy or face apocalypse.

Our leaders treat an inflation crisis as the lesser threat, a remote possibility that warrants lip service, at most. Thus over the weekend Bernanke mentioned the possibility of having to increase interest rates at some later point — but it was really just a passing reference.

Depressions, in the general line of thinking, come from deflation. Linking deflation and depression has become second nature. It almost seems an alliterative link, as though the two go together because both start with the same letters.

In their recent Man of the Year portrait of Bernanke, for example, Time magazine editors seem to use the word depression as a synonym for deflation. "The first thing any Depression scholar comes to understand is that nothing — not hyperinflation, megadeficits or irked Chinese creditors — is as bad as a full-on Depression," it said.

Effects of Deflation

Deflation, as we hear so often now, hurts good people, strivers who over-borrow.

What's the reality about deflation and inflation? Deflation can cause depressions, as the U.S. saw in the early 1930s, the period Bernanke has studied so intensely. In the Great Depression, there wasn't enough money around — literally. Lacking cash, banks collapsed, and good people did lose homes or farms. More banks collapsed.

Deflation doesn't always spell apocalypse. It can coexist with prosperity — or even perpetuate it. There was deflation in the 1920s. Prices fell in 1923, and 1925 through 1928. The money shortage hit one sector, farming, hard. Overall, the economy grew. Unemployment stayed low. Vigilance on inflation kept prices stable. Stable prices made life easier.

Steady Tuition

As Harvard University's alumni magazine reported recently, in wonderment, Harvard's tuition stood at the same level, $150, between 1870 and the beginning of World War II. Such consistency is something tuition-juggling families would trade a lot of financial-aid dollars for today.

What about inflation? Many economists treat inflation as an acceptable evil. Over the weekend Bernanke spoke of concerns about a "possible unwelcome decline in inflation."

The trouble is that mild inflation can become significant inflation faster than central banks can act. And significant inflation can match deflation blow for blow. In the 1970s, inflation coexisted with slow growth or outright shrinkage of the economy. Those who don't think about inflation also didn't think about the first half of 1980, when West Coast mortgage rates rose to 17.5 percent. That meant people could afford less house than today. The U.S. homeownership rate dropped below 65 percent and did not come back until 1996.

Wheelbarrows of Cash

The German hyperinflation of the early 1920s lives in memory as a black-and-white visual of men with caps pushing around wheelbarrows of cash. This cartoon obscures bitter reality. Hyperinflation isn't the opposite of depression. It's a kind of depression. The effects of Germany's hyperinflation were worse than the effect of our Great Depression.

Like a deflation, the German hyperinflation ruined the lives of good people, many of whom were not rich. How? By making fixed incomes — pensions, government salaries — worthless.

In the same years that deflation ruined the farmer in Minnesota, inflation was ruining the bureaucrat in Germany: "A man who had been saving for 40 years and who, furthermore, has patriotically invested his all in war bonds, became a beggar," said the author Stefan Zweig, according to "Culture and Inflation in Weimar Germany" by historian Bernd Widdig.

The creepy thing about hyperinflation is that it also ruins businesses, as well as charitable and educational institutions. None can plan. As Widdig notes in his book, "The Department of Canonical Law at the University of Munich had a budget of 2,000 marks in 1922. Yet the subscription price for a single scholarly journal was already 10,000 marks."

Inflation Misery

Hyperinflation has a capacity to mock virtue that deflation lacks. Even that symptom that we tend to assume is unique to the Great Depression, raging unemployment, came eventually. In 1924, unemployment among German union workers was 24 percent. Hyperinflation helped make Hitler possible. Much more recently, in Zimbabwe, hyperinflation helped keep President Robert Mugabe in power. Serious inflation has dogged Latin America for a century, causing, overall, magnitudes more misery than even the storied deflation of Japan.

It is monetary narcissism on the part of the U.S. to assume that just because serious inflation hasn't occurred here lately, it can't materialize in 2011, 2012 or 2015.

Two centuries ago, the Prussian military expert Carl von Clausewitz warned that generals who fight the last war confront defeat in the next. Clausewitz's rule holds true for 21st century monetary policy makers as well. There is nothing about deflation that is more modern than inflation.

Optimal Fed

The optimal Fed fights for stable money alone, not employment as well. The optimal financial governance reform replaces discretion with a rules-based system that treats inflation and deflation like twins.

The current legislative proposals won't yield either an optimal Fed or an optimal financial reform. So it's all up to Chairman Ben. That means not only making statements about future bubbles, but using his moral authority to push through reforms that make it easier for our system to prevent inflation as well as deflation. Herr Bernanke, meet Herr Clausewitz.

(Amity Shlaes, senior fellow in economic history at the Council on Foreign Relations, is a Bloomberg News columnist. The opinions expressed are her own.)

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