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Deflation is said to occur when general price levels fall.
The last important example of general deflation in the United States occurred during the Great Depression.
The US Consumer Price Index fell from a high of 18.000 in November 1925 to a low of 12.600 in March 1933, a drop of 30%, and prices stayed at these low levels throughout the decade, until World War II.
Those who had cash in 1925 and were able to keep it despite thousands of banks closing, would have earned about 30% in terms of buying power by 1933.
Great Depression: Family on the road after picking cotton, hoping for relief in next town.
On the other hand, people who had a mortgage outstanding in 1925 and still had the mortgage in 1933 would have found it much more difficult to sustain the payments.
New fears of deflation
Federal Reserve officials and central bankers around the world often regard deflation as a greater risk than inflation.
Fear of deflation is the reason that the Federal Reserve keeps short-term interest rates low while pumping money into the economy.
One explanation for fear of deflation is that central bankers have weaker tools to fight deflation, than inflation. The consequences of inflation are often less painful than the consequences of deflation.
Other reasons why central bankers are wary of deflation:
Great Depression: Many lost their life savings when banks failed.
- Since abandonment of the gold standard in 1971, inflation has become common and deflation rare. Most central bankers haven’t had a chance to deal with deflation ‘in the wild’, as it were.
- The primary recent US example of deflation, the Great Depression, was marked by a failure of government to deal effectively with the phenomenon.
- Economic history of the Great Depression has been, more often than not, severely distorted by politically motivated historians, with the task of burnishing the image of Franklin Roosevelt. This historical bias has seeped into academic economic theory.
Great Depression: One of many failed New Deal programs in which the government tried to create jobs in private sector.
There are cases where deflation has been cured quickly, such as the Depression of 1920-1921, when prices fell 15% and unemployment rose — but the economy recovered in just 18 months. Economists of different political persuasions have different interpretations of this fast recovery.
Since economists are more like cultists than scientists, a lack of consensus does not contribute to clear thinking.
Some would say that deflation is not that bad, unless one is a socialist who cannot accept common sense solutions (like not raising taxes on entrepreneurs or bad-mouthing business). A prolonged deflation like that which occurred during the Roosevelt years is what economists fear.
Under the Obama administration, US central bankers are now wary of both deflation and inflation.
What causes deflation?
There are different kinds of deflation that are brought about under different circumstances.
Here are some obvious causes and types of deflation:
| Type of deflation | Description |
| Excess of supply | Prices fall because of generalized factory under-utilization, agricultural super-production, high levels of commercial inventories, and other reasons for an excess of offer of goods and services relative to demand. |
| Shortage of money | Prices fall because of a rapid contraction in the money supply, such as the generalized failure of commercial banks in the 1930s, where millions of people lost their savings from one day to the next. |
| Shortage of income | Prices fall because of mass unemployment restricting consumer spending. |
| Shortage of credit | Prices fall in an environment in which transactions are usually supported by credit, which suddenly dries up for one reason of the other. |
| Massive de-leveraging | Prices fall because lenders and/or borrowers suddenly adopt preference for more conservative economic behavior. Lending institution tighten credit standards; households refrain from borrowing. |
Like inflation, deflation may have several explanations and multiple causes.
Reasons for concern in 2010
Under the Obama administration and in the wake of the Crash of 2010, US central bankers have reasons for concern as to the possibility of deflation, as in the Great Depression of the 1930s.
Here is an analysis of the various types of deflation described in the above table:
| Type of Deflation | Possible relevance in 2010 |
|---|---|
| Excess of supply | With a worldwide slowdown in business activity, free trade, and active neo-mercantilist policies of most nations, there is a real chance of competitive pressures forcing prices lower on many goods and services. |
| Shortage of money | Since there have been no massive banking failures, as in the 1930s, this is really not a concern. Instead, due to excessive ’stimulus programs’ of the Obama administration, there is a risk of an excess of money, leading to inflation. |
| Shortage of income | The Obama administration is following policies that are likely to lead to continued high unemployment and under-employment. These policies include:
|
| Shortage of credit | The massive economic stimulus programs require the government to either raise taxes to destructive levels or borrow, or both. Government borrowing needed to avoid inflation, is likely to result in less credit available for the private sector. Furthermore, new restrictions on credit cards, asset-backed securities, mortgages, and money market funds are all likely to reduce the supply of credit, which will be especially harmful to small businesses. |
| Massive de-leveraging | Both banks and households are modifying their behavior in expectation of hard times ahead. Lenders are reducing the level of debt to capital. Individuals are cutting back on the use of credit cards. The net effect will be a reduction in demand. |
This table suggests that while there is one strong reason to suspect that inflation is coming, there are four reasons while we might expect deflation.
The Federal Reserve is hard put to defend against the economic vandalism of Congress and a left-wing President.
Perhaps the most compelling argument for deflation is the income issue tied to expectations of continued unemployment, Obama’s continuous bashing of the private sector, trade union favoritism, and program for ever-higher taxes, including the highly regressive value added tax.
There is nothing the Federal Reserve can do to counter the anti-free enterprise bias of the President or any Congressional move to increase taxes or regulation of business.
In fact, the Feds tool chest to fight deflation is a pretty puny defense against the destructive blows to commercial confidence dealt by the President and his Party.
Asset devaluation is not deflation
Often confused with deflation, asset devaluation is something different again.
President Obama discusses job training for the unemployed. Does this make you feel better?
The fall in stock prices in the Crash of 2008, although painful to millions, was not deflation.
Nor was the sudden drop in the price of gold, after Reagan was elected President. Nor was the drop in home prices as a result of the excess of sub-prime mortgages.
Sometimes a drop in asset prices is accompanied by deflation, sometimes not. For example, when inflation kicks in, one can expect a drop in the value of long-term bonds.
Asset devaluations can lead to deflation, such as when home prices and stock portfolios drop, making people feel poorer, resulting in less spending, a fall in demand for goods and services, and, consequently, deflation.
However, often asset devaluation is a necessary evil, such as when the assets in question were simply over-valued. Believers in the Efficient Market Hypothesis may say this impossible, but that theory has long been discredited.
Investment strategy in deflation
In the case of inflation, it’s relatively easy to predict what will happen to certain asset classes.
Sometimes even cash is not a good idea. "Money to burn" showing Confederate Dollars.
For example, the value of long-term bonds will sink.
However, when deflation hits, the effect on different asset classes is not so obvious. For example, the value of money increases and so does the value of the principal on long-term bonds.
However, deflation usually brings greater unemployment, which decreases demand, which, in turn, reduces corporate profits and the credit rating of bonds.
Generally, the best place to be while waiting for deflation would be cash — providing that the bank is safe.
As I described in another article, a good place to be while waiting for inflation might be money market funds — essentially a form of cash.
Now the world seems to be in a situation in which central bankers and economists are confused as to whether we can expect inflation or deflation. An alert investor must keep an open eye on both.
What do you think?
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