Deflation 2010

From The New York Times, May 30:

 

"Economists...are beginning to worry that a danger of deflation in Europe, similar to the one that strangled Japanese growth for much of the 1990s, is a bigger threat than inflation.

 

Prices fell in Ireland in April...Spanish core inflation already turned negative in April."

 

As European authorities respond to the debt emergency with spending cuts, their sluggish economies will probably become even more sluggish. Less spending can lead to lower prices. The price declines lead to buying lags, as consumers hope for even lower prices -- which perpetuates the deflationary cycle.

 

And this deflationary scenario all starts with that huge debt build-up.

 

USA Today recently displayed data on public debt as a percentage of select national economies:

 

• Zimbabwe 304%
• Japan 192%
• Greece 108%
• France 80%
• Germany 77%
• U.K. 69%
• U.S. 58%*

(*Does not include Treasury debt held by Social Security Administration and the Federal Reserve.)

 

Bloomberg news reports this about the United States:

"The cost of living in the U.S. unexpectedly dropped in April for the first time in more than a year ..The 0.1 percent fall in the consumer price index was the first decrease since March 2009."

 

Telegraph.go.uk, May 26: "US money supply plunges at 1930s pace... The M3 money supply in the U.S. is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history."

Deflation is suddenly in the news again. It's a good moment to catch up on a few definitions, as well as strategies on how to beat this rare economic condition. 

 

What Makes Deflation Likely Today?

Bob Prechter, Deflation Survival Guide, free Club EWI eBook

 

Following the Great Depression, the Fed and the U.S. government embarked on a program...both of increasing the creation of new money and credit and of fostering the confidence of lenders and borrowers so as to facilitate the expansion of credit. These policies both accommodated and encouraged the expansionary trend of the ’Teens and 1920s, which ended in bust, and the far larger expansionary trend that began in 1932 and which has accelerated over the past half-century. Other governments and central banks have followed similar policies. The International Monetary Fund, the World Bank and similar institutions, funded mostly by the U.S. taxpayer, have extended immense credit around the globe.

 

Their policies have supported nearly continuous worldwide inflation, particularly over the past thirty years. As a result, the global financial system is gorged with non-self-liquidating credit. Conventional economists excuse and praise this system under the erroneous belief that expanding money and credit promotes economic growth, which is terribly false. It appears to do so for a while, but in the long run, the swollen mass of debt collapses of its own weight, which is deflation, and destroys the economy. A devastated economy, moreover, encourages radical politics, which is even worse.

 

The value of credit that has been extended worldwide is unprecedented. Worse, most of this debt is the non-self-liquidating type. Much of it comprises loans to governments, investment loans for buying stock and real estate, and loans for everyday consumer items and services, none of which has any production tied to it. Even a lot of corporate debt is non-self-liquidating, since so much of corporate activity these days is related to finance rather than production.

 

 

Figure 11-5 is a stunning picture of the credit expansion of wave V of the 1920s (beginning the year that Congress authorized the Fed), which ended in a bust, and of wave V in the 1980s-1990s, which is even bigger.

 

...it has been the biggest credit expansion in history by a huge margin. Coextensively, not only is there a threat of deflation, but there is also the threat of the biggest deflation in history by a huge margin. ...

 

 

In economics, deflation is a decrease in the general price level of goods and services.^[1] Deflation occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money – allowing one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation decreases, but still remains positive).^[2] As inflation reduces the real value of money over time, conversely, deflation increases the real value of money – the functional currency (and monetary unit of account) in a national or regional economy.
Currently, mainstream economists generally believe that deflation is a problem in a modern economy because of the danger of a deflationary spiral (explained below).^[3] Deflation is correlated with recessions including the Great Depression, as banks defaulted on depositors. Additionally, deflation may cause the economy to enter the liquidity trap. However, historically not all episodes of deflation correspond with periods of poor economic growth.^[4]

Effects of deflation

In the IS/LM model (that is, the Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply and demand curve for goods and services, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity.
Since this idles capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand, and to borrow at interest rates which are below those available to private entities.
In more recent economic thinking, deflation is related to risk:  where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. This can produce the theoretical condition, much debated as to its practical possibility, of a liquidity trap. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency producing higher prices for imports without necessarily stimulating exports to a like degree.
In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation. It may be attributed to a dramatic contraction of the money supply, or to adhere to a gold standard or other external monetary base requirement.
Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency. In this sense it is the opposite of inflation, which is similar to taxing currency holders and lenders (savers) and using the proceeds to subsidize borrowers. Thus inflation may encourage short term consumption. In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with recession and (more rarely) long term economic depressions.
In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types of investments, the costs of deflation to borrowers have grown larger. Deflation discourages investment and spending, because there is no reason to risk on future profits when the expectation of profits may be negative and the expectation of future prices is lower. Consequently deflation generally leads to, or is associated with a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent just to hold on to money, and not to spend or invest it.
Deflation is, however, the natural condition of hard currency economies when the rate of increase in the supply of money is not maintained at a rate commensurate to positive population (and general economic) growth. When this happens, the available amount of hard currency per person falls, in effect making money more scarce; and consequently, the purchasing power of each unit of currency increases. The late 19th century provides an example of sustained deflation combined with economic development under these conditions.
Deflation also occurs when improvements in production efficiency lower the overall price of goods. Improvements in production efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit margins, resulting from the production improvements that they make. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.
While an increase in the purchasing power of one's money sounds beneficial, it amplifies the sting of debt, since—after some period of significant deflation—the payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as a phantom amplification of a loan's interest rate. If, as during the Great Depression in the United States, deflation averages 10% per year, even a 0% loan is unattractive as it must be repaid with money worth 10% more each year. Since

Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.,

the usual methods of regulating the money supply may be ineffective, as even lowering the short-term interest rate to zero may result in a "real" interest rate which is rather high; thus other mechanisms must be brought into play to increase the supply of money such as purchasing assets or quantitative easing (printing money). As the current Chairman of the United States Federal Reserve, Ben Bernanke, said in 2002, "...sufficient injections of money will ultimately always reverse a deflation."^[5]
Hard money advocates argue that if there were no "rigidities" in an economy, then deflation should be a welcome effect, as the lowering of prices would allow more of the economy's effort to be moved to other areas of activity, thus increasing the total output of the economy.
Since deflationary periods favor those who hold currency over those who do not, they are often matched with periods of rising populist sentiment, as in the late 19th century, when populists in the United States wanted to move off the gold standard and onto a silver or bimetal standard because the supply of silver was increasing relatively faster than the supply of gold (making silver inflationary (or less deflationary) compared to gold).
Effects of deflation

1. Decreasing nominal prices for goods and services.
2. Cash money and all monetary items increase in real value over time.
3. Discourages bank savings and decreases investment.
4. Enriches creditors at the expenses of debtors.
5. Benefits fixed income earners.
6. Associated with recessions and unemployment.

Deflationary spiral

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.^[6] Since reductions in general price level are called deflation, a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. The Great Depression was regarded by some as a deflationary spiral. Whether deflationary spirals can actually occur is controversial.
A deflationary spiral is the modern macroeconomic version of the general glut controversy of the 19th century. Another related idea is Irving Fisher's theory that excess debt can cause a continuing deflation.

Causes of deflation

In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

Basic types of deflation

Some types of deflation can be distinguished.
On the demand side:

• Growth deflation. (Increase in the supply of goods. Decrease in CPI).
• Cash building (hoarding) deflation (More savings of cash. Decrease in velocity of money. Increase in the demand for money)

On the supply side:

• Bank credit deflation. (Decrease in the bank credit supply by bankruptcy or contraction of the money supply by the central bank)

Money supply side type deflation

From a monetarist perspective deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person.

Credit deflation

In modern credit-based economies, a deflationary spiral may be caused by the (central bank) initiating higher interest rates (i.e., to 'control' inflation), thereby possibly popping an asset bubble. In a credit-based economy, a fall in money supply leads to markedly less lending, with a further sharp fall in money supply, and a consequent sharp fall-off in demand for goods. Demand falls, and with the falling of demand, there is a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets which have fallen dramatically in value since the (mortgage) loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans (as in Japan, most recently). This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

Effects of scarcity of 'official' money

In unstable currency economies, barter and other alternate currency arrangements such as dollarization are common, and therefore when the 'official' money becomes scarce (or unusually unreliable), commerce can still continue (e.g., most recently in Russia and Argentina). Since in such economies the central government is often unable, even if it were willing, to adequately control the internal economy, there is no pressing need for individuals to acquire official currency except to pay for imported goods. In effect, barter acts as protective tariff in such economies, encouraging local consumption of local production. It also acts as a spur to mining and exploration, since one easy way to make money in such an economy is to dig it out of the ground.

Special arrangements (?)

When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to (artificially) increase the money supply.

Examples of credit deflation

This cycle has been traced out on the broad scale during the Great Depression. International trade contracted sharply, severely reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures. A similar situation in Japan, beginning with the stock and real estate market collapse in the early 1990s, was arrested by the Japanese government preventing the collapse of most banks and taking over direct control of several in the worst condition. These occurrences are the matter of intense debate.

Risk of severe deflation during post-2000 recession

There are economists who argue that the post-2000 recession had a period where the US was at risk of severe deflation, and that therefore the Federal Reserve central bank was right in holding interest rates at an "accommodative" stance from 2001 on.