What’s This Got to Do with Deflation?

Henry B. Stobbs, MFA

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Deflation: A Simple Definition to A Complex Problem

A persistent decrease in the general price level of goods and services that occurs when the inflation rate falls below zero percent.

0%

There’s Good news…

If the quantity of goods relative to the amount of money on hand increases, then the price of those goods will drop: the best example is the late 1990’s, when low productivity costs in China and elsewhere drove up the supply of “stuff” and drove down the general cost of those goods. As Wal-Mart says, Prices were falling!

And, there’s bad news…

Deflation of itself is neither good nor bad – the CAUSE determines whether people will benefit or suffer from its effects.

Deflation is considered a problem in a modern economy because a deflationary spiral can lead to recession and even depression.

Good Deflation / Bad Deflation

The Industrial Revolution of the 1800’s (increased productivity)

The Great Depression of the 1920’s (Stock market bled off liquidity, leading to a contraction of the economy, job losses, bank failures… a tragic, downward spiral)

Economic Preconditions

Deflation requires that there be a major societal buildup in the extension of credit and a corresponding increase in the assumption of debt. This is commonly referred to as a credit bubble.

And by Credit, We Mean…

Self-liquidating credit: a moderately short-term loan that is paid back with interest. Such loans are used to start or expand businesses, which in turn generate the means to pay back the loan. This sort of debt adds value to the economy.

And by Credit, We Mean… Non-self-liquidating credit is debt that:

Is not tied to production (homes, cars, boats, speculation)

Interest payments (debt service) on these loans stress some other form of production and erode the ability of consumers to choose how to spend their income

This kind of credit adds costs to the economy

Good, or Bad? How to Tell?

Decreasing money supply (“Tight money”, Part I - BAD

Increasing supply of goods - GOOD Decreasing demand for goods –

Maybe GOOD, maybe BAD Increasing demand for money

(“Tight” money, Part II) – Maybe GOOD, maybe BAD

Four Basic Types of Deflation

Cash Building Deflation is caused when people save more money, which decreases the use of money but increases the demand for money.  We call this demand side price deflation. 

Four Basic Types of Deflation

Growth Deflation occurs when there is a decrease in the Consumer Price Index and an increase in the supply of goods. This is called supply side price deflation.

Four Basic Types of Deflation

Bank Credit Deflation happens when there is a decrease in the credit supply of the bank and a contraction of the money supply from a nation’s central bank.

Four Basic Types of Deflation

Confiscatory Deflation is a freezing of bank deposits and a decrease of the money supply.

Monetary Deflation

… is caused primarily by a reduction in the velocity of money and/or the amount of per capita money supply or credit. Deflation can be caused also by a decrease in government, personal or investment spending, or a combination of factors.

Monetary Deflation

A deflationary spiral may be triggered when the central bank of a credit-based economy initiates higher interest rates, thereby popping an asset bubble, or by the collapse of a command economy that has been run at a higher level of production than it can support.

Portrait of a Deflation

MS3 MS1

D1

P1

S

D2

P3

•Drop in MS leads to less lending

•Demand falls faster than supply

•Prices fall

•MS continues to fall

•Demand for goods and services falls

•Supply glut leads to fall in prices

•Businesses can’t profit, so they liquidate

•Banks now hold devalued assets

•Sold assets increase glut

Cost of ProductionP2

D3Q3 Q1Q2

Lending

Deflation Survival Tips Barter Alternate currency arrangements Increased production of precious resources “Print” more money:

The Fed creates a fixed amount of money The Fed uses the money it “printed” to buy

securities (bonds), which lowers interest rates and “injects” more money into the economy

How Low Can You Go? Liquidity Traps

Central bank lowers interest rates all the way to 0%

Demand can no longer be stimulated by lowering interest rates

In order to artificially grow the money supply, “special arrangements” are made to “lend” money at a 0% nominal rate (which, because of negative inflation, may actually be quite high in real terms)

Examples: Japan in the 90’s, U.S. in the 30’s

Some History Lessons

“Those who do not remember the past are condemned to repeat it.”

7th U.S. President

1829 – 1837

The Recession of 1836, & the Panic of 1837

President Jackson refuses to renew the charter of the National Bank, so federal funds are deposited in state banks

State banks start lending paper money (without proper specie backing) to just about anybody who wants to buy land causing a speculative bubble and galloping inflation

Trying to control inflation and the wild speculation, Jackson issues an executive order effecting a “specie circular”: federal land purchases must be paid in gold or silver: this precipitates a banking crisis

The Recession of 1836, & the Panic of 1837

As people rush to convert greenbacks the money supply shrinks by about 30%. Banks have to call in loans to stay liquid

The value of paper money plummets, sending prices spiraling upward (and inflation follows). Interest rates rise 2 – 3% per month. Weaker banks fail.

The bubble bursts, as people begin to perceive the worthlessness of greenbacks: paper wealth becomes paper poverty

Van Buren inherits a mess: a general bank and business collapse sets in that will last for nearly a decade

And Now…We’re Off to See the Wizard! The

Wonderful Wizard of Oz!

William Jennings Bryan

Frank Baum

1910

July 9, 1896, Democratic National Convention, Chicago

“You come to us and tell us that the great cities are in favor of the gold standard. I tell you that the great cities rest upon these broad and fertile prairies. Burn down your cities and leave our farms, and your cities will spring up again as if by magic. But destroy our farms and the grass will grow in the streets of every city in the country… … we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.”

Oscar Zoroaster Phadrig Isaac Norman Henkel Emmannuel Ambroise Diggs

24, too!

O.Z.

An Economic Parable

Dorothy: “Everyman” American, or American libertyScarecrow: The powerless farmer, whose assets blow away in the wind, and who is a gullible victim of populismTin Woodman: Heartless industrialist, or every industrial workerCowardly Lion: William Jennings Bryan, politician who backed silver “bi-metal” causeWizard of Oz: US presidents of late 19th CenturyWicked Witch: A malign Nature, destroyed by the farmers' most precious commodity, water. Or simply the American West

An Economic Parable

Winged Monkeys: Native Americans or Chinese railroad workers, exploited in the name of Westward expansionOz: An abbreviation of 'ounce' or, as Baum claimed, taken from the O-Z of a filing cabinet?Emerald City: Greenback paper money, exposed as fraudMunchkins: Ordinary citizensDorothy’s slippers: originally silver: combined with the Yellow Brick Road, a symbol of the “Bi-metal” movement

The Great Deflation: 1873 - 1896 Also called the “Great Sag” and “the Great Depression” After the Civil War, the government tries to restore

normality by returning to the gold standard (parity) Other countries around the world also adopt the gold

standard World prices of goods, materials and labor plummet – by

1.7%/year in the U.S., by .08% in the U.K. Commodity producers, especially farmers, suffer

Bond prices rise dramatically, borrowers suffer early calls and defaults

America benefits greatly because it is in the early stages of industrialization - the Second Industrial revolution is born

Germany, France, Canada, and Sweden – but especially industrially developed Britain, suffer sharp business contractions throughout the 1870 – 1933 period

1930 – 1933: More Wizardry!

Sliding into the Great Depression: Some Likely Causes

Easy credit in the “Roaring Twenties” leads to excess indebtedness and “asset bubbles” –

Later, as the value of money rises, debtors as well as creditors rush to liquidate, but cannot keep up with the fall in prices – as they try to lessen their burden of debt but effectively increase it, because of the mass effect of the stampede to liquidate increases the value of each dollar owed, relative to the value of their declining asset holdings. Paradoxically, the more the debtors pay, the more they owed

Sliding into the Great Depression: Some Likely Causes

Consumers want to hold more money than the Federal Reserve is supplying, which leads to lower consumption

The economy is producing more than it consumes – great for profits and stocks (until the bubble bursts), lousy for everybody else: this overcapacity is a global problem with global consequences

Sliding into the Great Depression: Some Likely Causes

Prices are not flexible enough to fall immediately, so business contracts, causing a rise in unemployment

As businesses fail, stocks fall too … bad news, in the investment-crazy days of the “Roaring Twenties”

The Fed does not recognize what is happening and fails to take corrective action

Sliding into the Great Depression: Some Likely Causes

Consumers lose faith in the banks, causing runs and bank closings

The potential for runs causes local bankers to be more conservative with lending out reserves – the lack of reserves prevents the Fed from inflating the money supply and credit dries up

Sliding into the Great Depression: Some Likely Causes

The gold standard worsens matters because looser fiscal and monetary policy threaten the ability of countries, including the U.S. to pay their international debt obligations

Protective tariffs make matters worse, as retaliatory moves choke off exports and further restrict business

Using the Fisher Equation

The run-up to the Great Depression was characterized by a drop in both money supply (as credit) and the velocity of money so great that deflation took hold in spite of increases in money supply spurred by the Federal Reserve (Too little, too late)

Summary

The following slides would be good review for an exam!

Summary Deflation is A general decline in prices

over time below zero% inflation, often caused by a reduction in the supply of money or credit. It can also be caused by a decline in government, personal, or investment spending. Do not confuse deflation with disinflation.

The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression.

Summary Persistent declining prices can create

a vicious spiral of falling profits, closing factories, shrinking employment and incomes, and increasing defaults on private as well as corporate loans.

Central banks attempt to stop severe deflation in an attempt to keep the excessive drop in prices to a minimum. The Fed can use monetary policy to increase the money supply and raise prices, causing inflation.

Summary There are four basic types of deflation:

A fall of prices linked to increased productivity and an increasing supply of goods – this is good!

A decrease in the money supply, or “tight money” – this is bad!

A decrease in demand – maybe good, maybe not A decrease in the supply of goods and services –

maybe good, maybe not.

Summary Deflationary periods can be both short or

long, relatively speaking. Japan, for example, had a period of deflation lasting decades starting in the early 1990's.

The Japanese experienced a so-called liquidity trap when, having lowered interest rates all the way to zero percent (“special arrangements), the economy was still caught in a deflationary spiral.

Summary

Excessive non-self-liquidating credit can contribute to bad deflation. This is debt linked to non-productive assets, such as cars, boats, homes, and speculative instruments. This kind of debt adds costs to an economy.

Summary

Self-liquidating credit is based on short-term debt taken out to build or expand businesses. The debt is retired from the excess capital (profit) gained through the expansion or new business. This kind of debt adds wealth to an economy.

Summary

Some important economic crises marked by episodes of deflation include (but are not limited to): The Recession of 1836 and the Panic of

1837 The Panic of 1873 and the Great Sag of

1873 – 1896 The Great Depression of 1929 – 1939 The Global Recession of 2008 - ?

Summary

Excess debt + Deflation = Recession A prolonged and deep period of

recession is a Depression

Works CitedAmerican.com. “Deflation: Does This happen Often?” The American. 10 Oct. 2008. 15

Mar. 2009 http://www.american.com/archive/2008/october-10-08/does-this-happen-often.

Hubbard, Glenn R., and Patrick A. O’Brien. Essentials of Economics, 2nd Ed. Upper Saddle River: 2009, Pearson.

Investopedia.com. “Deflation.” 16 Mar. 2009 http://www.investopedia.com/terms/d/deflation.asp.

Rockford College. “George Santayana.” The Internet Encyclopedia of Philosophy. 20 Mar. 2009 http://www.iep.utm.edu/s/santayan.htm

Stobbs, Henry B. “Deflation.” Lesson Plan. 12 march 2009. Wikipedia.com. Photographs and illustrations. 19 Mar. 2009 http://wikipedia.com.