Much press currently circulates on the ravages of inflation.  When most people think of inflation, they think of rising prices.  Inflation, as I define it, is an increase in the supply of money and credit.  Rising prices can bethe result of inflation, though there are other causes as well.  Blame assignment for current rising prices focuses on the government’s deficit spending and Federal Reserve balance sheet expansion.  News flash — such spending and expansion has occurred for well over a decade.

 

“Money doesn't talk, it swears.”

-Bob Dylan

This article focuses on the opposite of inflation, which is deflation.  I’ll use the better understood term of inflation to assist with understanding deflation. 

Misunderstood Topic

Deflation is a difficult topic to understand.  Inflation, on the other hand, evokes phrases like, “a dollar does not go as far as it used to” or “cost of living allowance.”  We never hear “the dollar goes farther than before.” The administration of President Gerald Ford popularized the fight against inflation with the slogan “WIN” or “Whip Inflation Now.” Ever see a slogan saying, “Whip Deflation Now?”

Deflations are associated with economic depressions.  The Great Depression ushered in the most recent period of sustained deflation in the United States.  Prices of many assets fell.  Monetary Wizards fear the “D” word. One of the last words you will hear out of government or central banks is “depression” or “deflation.”

Inflation alters an important economic statistic, GDP, or the total value of all goods and services in the economy.  While GDP is increasing, the economy feels better even if it is on the back of debt.  Debt is less of a problem during inflation since the debtor will have more dollars in the future with which to pay off loans.  The same applies to governments.  Inflation helps their debts too.  Deflation does the opposite to debt.  Debt is harder to repay. 

Deflation is a monetary and psychological phenomenon.  Inflation means confidence and belief.  Deflation means the opposite.  The monetary component is the reduction of outstanding credit.  The psychological component is the expectation of lower prices.  During a deflation, people hold out for lower prices.  Why buy now when prices will be lower in the future?  During an inflationary episode, the opposite occurs — people buy now in expectation of higher future prices.  

What Is Deflation?

Deflation is the reduction of money and credit outstanding.  The public experiences inflation and deflation as rising and falling prices respectively.  Rising prices can result from the increase in money sloshing through the economy chasing things like homes, cars, private schools etc.  Money increases as loans or lines of credit increase.  Falling prices can result from a reduction in money or credit.  When there is less money chasing homes, cars, and private schools, prices fall to meet demand. 

Prices can fall for other reasons.  If you were the first person to buy the latest electronic gadget, you know what I mean.  When your friends bought the same gadget a few months later, they paid less.   Your friends paid less since there was more supply due to greater production or an improved manufacturing process that reduced the price of the gadget. 

In another case, we might have a bumper crop of an agricultural commodity that greatly exceeds demand.  Prices will soften accordingly.  In either case, the supply of money and credit could remain constant and the economy experiences price decreases for these two items.  What we are discussing in this article is monetary deflation. 

Think of deflation in the following manner.  During inflation, the public recognizes that the purchasing power of their money is constantly falling.  The public needs more credit to combat their money’s decreased purchasing power.  The house you were looking at that was $150,000 is now $200,000.  Unless you inherited $50,000, you will need to borrow an extra $50,000.   If credit is abundant, your lender is willing to extend an additional $50,000.  If by chance you weren’t a great credit risk, your lender still had a product for you, a sub-prime loan.  During a credit boom, lenders expand the number of people qualifying for loans.   More credit in the economy means higher prices for those goods and services the credit chases. 

During a deflation the opposite occurs.  Banks tighten credit.  You would not qualify for that extra $50,000 and perhaps any type of loan.  If far enough in the deflationary process, the $150,000 house might sell for $125,000, which would be good if you could get a loan.  If the price fell to $75,000, you might think it a bargain, if you could get a loan.  If you had $75,000 in cash, you have instant purchasing power that someone waiting on credit does not.  In a deflation, the purchasing power of money increases.  Cash is king! 

Feeding The Credit Monster

The inflationary credit system relies on continuous amounts of credit creation to feed itself.  With deflation, since lenders reduce credit, the effect on the system is severe.  When an economy experiences a reduction of credit, existing credit experiences stress due to refinancing needs.  Banks are not as eager to roll over loans or grant new financing.  During times of credit expansion, existing credit is rolled into new credit.  Deflation also stresses those in debt who may be unable to cope with interest payments.  This leads to my second Economic Law, 

“Deflation is a lack of confidence.”

Deflation is a lack of confidence since lenders are less willing to lend and borrowers are less willing to borrow.  By contrast my first Economic Law says,

“Credit = confidence.”

Credit means to believe.  During a deflation, that belief weakens.    

Another condition for deflation is the inflation that preceded it.  Without the increase in the amount of credit, there is nothing to deflate.  This leads to my third Economic Law, which postulates,

                        “Inflation precedes deflation.”

During a deflation, the amount of outstanding credit shrinks, and debts are still payable, forcing debtors to find other sources of funds.  That source can be assets.  Asset liquidation raises funds necessary to service previous debt.  Liquidation forces down the price of assets.  Furthermore, deflation encourages cash retention on the part of the public for two reasons: 

  1. a) The psychological expectation of lower prices.
  2. b) The psychological expectation of less credit in the future.

If credit were tightened enough, it would encourage the use of cash for transactions where credit is used currently. 

Deflation Triggers

If lenders are willing to lend and borrowers willing to borrow, credit can continue to expand.  Of course, another prerequisite of credit expansion is the ability of borrowers to pay back or at least roll over their loans. 

The catalyst for deflation may be any number of events.  It could be a bank failure caused by a run on a bank or investments that soured.  It could be the failure of a municipal or corporate bond.  It could be the failure caused by home foreclosures. It might be large numbers of poor credit risks unable to pay their bills.  It could be sheer saturation of credit strangling borrowers.  It could be investors assigning lower values to assets.

After large numbers of borrowers are unable to pay their debts, a psychological component takes hold.  The confidence expressed during the credit expansion turns to pessimism.  A downward spiral ensues.

The last bullet point is instructive.  In this article, I describe how just a single investor can make money disappear, figuratively speaking.  Thus, the asset you thought was worth, say $100, is now worth $50.  The value you thought you owned no longer exists even though you took no direct action to make that happen.

Deflationary Signs

If deflation is a reduction of outstanding credit in the economy, how will we know when it arrives?   Here are four signs:

Dr. Frankenstein

The Global Financial Crisis (GFC) of 2008 ushered in a grand experiment, which created a monetary monster.  The GFC initially sparked deflation and our monetary Wizards acted by expanding the money supply to levels heretofore unseen.  The same occurred in March of 2020 resulting from public policy surrounding an airborne virus. 

Thus, we stand at risk of the greatest credit deflation in history.  When an economy grows debt beyond the point where it is sustainable, deflation follows.  It is a natural outcome.    

The United States government sensed deflation and attempted to counteract the effects of the deflationary spiral through their own spending; they replaced consumer spending.  Unfortunately, there is no rainy-day fund to save the economy.  Our government borrowed and added to its formidable debt pile – they borrowed money to deal with borrowed money.  In the final analysis, it is impossible for the U.S. government to wholly replace private spending and investment.  The Fed Wizards understood this and took their own action by expanding their balance sheet.  While greater in scope than government efforts, their actions further created an economic Frankenstein.

The economy eventually needs to reconcile its deflationary winds.  The Wizards think otherwise, making us unwitting subjects in a monetary experiment. 

“The lack of money is the root of all evil.”

 - Mark Twain

 

 

References

Jim Mosquera, Escaping Oz: Navigating the crisis, Chapter 3