Inflation Versus Deflation: Part One

Benjamin Roth’s Depression Diary chronicles the impressions of an Ohio lawyer during the Great Depression. He paints a poignant picture of things that happened to investors in that era. “For over a year now,” he writes in 1931, “people have been buying stocks at what they think are bargain prices.” But, he adds later in 1936, “these early buyers were badly mistaken and many of them were wiped out.”

The process that took stock values down by 90% from 1929 to 1932, and depressed the prices of virtually everything else, is known as “deflation.” The story makes plain the danger of investing in any financial asset during a deflationary spiral: if that asset’s market has not truly bottomed, you risk great losses. Today one frequently hears in the financial news what a bargain good companies are selling for on the stock market. Roth’s journal entries provide a scary backdrop to this advice.

Last week I alluded to a debate that his been raging for several years within the contrarian financial community between the inflationaistas and the deflationistas. Both sides have always agreed that excess consumer and government debt would lead to an economic crisis.  They continue to disagree about the outcome, even as the outcome unfolds before our eyes.

Roth’s diary should clue us in to the fact that either outcome, deflation or inflation,  bears more than academic curiosity. Either one can change the results of any particular savings and investment strategy. It matters even — or rather, especially — if all you ever do is save money in a passbook savings account or Certificate of Deposit. Deflation would magnify the purchasing power of your savings , whereas inflation would diminish it. Generally, the strategies for dealing with inflation and deflation have little overlap. In making up your mind about how to proceed, you’ll want to have some idea about the probability of one outcome over the other.

My discussion will be lengthy and will occupy this week’s and next week’s blog entries. It will challenge your attention span and your willingness to follow technical detail.  So please bear with me. I promise to reward your attention with a greater understanding of current economic events.

Credit: Bubbles And Contraction

To understand how a deflationary spiral works, you have to understand the inflationary bubble that precedes it. The bubble begins with the availability of cheap credit. First the central bank lowers the interest rate on short term loans.  Then, through the mechanics of fractional reserve lending, the member commercial banks offer lower interest rates on long term loans to their customers. As more money enters the system, nominal asset prices rise. But eventually prices get so high that buyers stop buying and the bubble reverses itself. The weakness in such bubbles lies in the understatement of risk by lenders.

Let’s look closer at this phenomenon through the lens of the subprime mortgage meltdown.  Subprime mortgage lenders (and apparently rating agencies) assumed that the economy would remain strong enough for borrowers to sustain their mortgage payments. They also assumed that the values of homes would remain high enough to cover the mortgages in the case of default.

Of course, the inevitable happened.  Home prices got so high that, even at low interest rates, buyers stopped buying, and prices began to fall. And when initially low “teaser rates” on mortgages re-adjusted to their higher long-term rates, borrowers became unable to make their mortgage payments. An increase in defaults put more homes on the market in distressed circumstances, reducing the value of homes to below the amount of the mortgages that financed them.

Such loan defaults end up as losses on the balance sheets of the banks, causing some of them to go out of business. If those banks owe money, their creditors also suffer losses. As loan defaults cascade through the banking system, banks hoard their cash to maintain the integrity of their balance sheets and become reluctant to lend.  When they lend, they do so at prohibitively high interest rates.

The contraction of credit wreaks havoc on other financial assets.  In our day, hedge funds had attempted to magnify their earnings by borrowing heavily against their assets. As credit tightened due to subprime mortgage losses, the hedge funds’ creditors  raised borrowing rates and demanded additional collateral even for relatively safe investments. To raise cash, the hedge funds had to sell off holdings in stocks and commodities, resulting in price declines.

Credit contraction also slows down economic activity. For example, the banks’ unwillingness to extend letters of credit has seriously affected international trade. Many businesses depend on short-term loans known as commercial paper in order to function on a day-to-day basis. Commercial paper, too, has suffered from the credit contraction.

As businesses fail or contract from the paucity of credit, they lay people off. Fewer people have money to spend or are afraid to spend it for fear of losing their jobs, slowing the economy even further.

If it continues unchecked, credit contraction leads to the general price decline known as deflation.

Inflation And Deflation Are Monetary Phenomena

Almost everyone has heard of the law of supply and demand. Very simply, the more scarce a product or service, the higher its price. The requirement that plastic surgeons go through many years and hundreds of thousands of dollars in medical training makes them relatively scarce. But almost anyone can, with enough motivation, clean a house. Thus you pay a plastic surgeon thousands of dollars for the few hours of time it takes her to fix your nose,  whereas the house cleaner earns $10 per hour.

The price effects of inflation and deflation differ quite a bit from supply-demand dynamics. For many economists,  and for the purpose of our discussion, changes in the money supply cause inflation and deflation. The great economist Milton Friedman is famous for saying that “Inflation is always and everywhere a monetary phenom­enon.”  That is, inflation results from an increase in the supply of money relative to the goods and services in the economy; deflation results from a decrease of money supply.

With this point in mind, remember that, in our system, all money is debt. All money flowing through the system began as the transfer of money from a creditor to a debtor. If everyone in the world paid off their loans at once, all money would disappear from the economy. Availability of credit increases the money supply and thus creates “economic growth,” while the unavailability of credit results in economic contraction. Please watch Paul Grigon’s documentary, Money As Debt, for a really good explanation of this concept.

So, credit contraction plays the lead role in the drama of a deflationary spiral.

For the moment, although the price of oil and other commodities has dropped, true deflation has not yet taken hold of the economy. The prices of food, housing, and health care remain relatively stable. But if the contraction of credit continues, the supply of money to the economy will eventually decrease and all prices will fall.

How To Save Or Invest For Deflation

In investing and saving, inflation and deflation have different consequences. In deflation, the dollar-denominated value of everything drops. Relative to goods and services, then, the purchasing power of cash increases. But since less of it flows through the economy, cash is hard to come by.

Although I do not believe that true deflation has taken hold at this point, the desire for cash in a credit contraction might explain the behavior of investors in US bonds. The demand for short-term US bonds has pushed their yield almost to zero. When transaction fees are figured in, investors are paying a premium over par value for these securities because of their perceived safety.

In inflation, on the other hand, cash becomes less valuable because prices expressed in the currency become higher. In such an environment, it becomes advantageous to buy stocks, commodities, and real estate because their prices will rise in nominal value, thus preserving the original value of the investment.

I should add that deflationista extraordinaire Mish Shedlock believes gold to be a good investment for both deflation and inflation because of its true role as money.  Robert Prechter, on the other hand, insists that even precious metals will decline in nominal value under deflation.

What Can Be Done?

Though complicated by the many intracacies of modern economics and finance, the argument between the deflationistas and the inflationistas boils down to one fundamental question: will the monetary authorities succeed in reflating the economy?

Once deflation sets in, stopping it becomes very difficult. The deflationistas assume that the monetary authorities are ultimately powerless against the economic forces driving deflation. They foresee a sustained period of monetary contraction resulting in a global depression with chronic and high unemployment. The inflationistas argue that the monetary authorities will succeed in getting money to move through the economy again and thus put the economy back on the inflationary track to “growth.”

To make up your own mind about this question, you will need to understand  how the Federal Reserve seeks to accomplish this goal. I shall examine the Fed’s strategy in my next blog entry.

© 2008 Philip Glaser


2 Responses to “Inflation Versus Deflation: Part One”

  1. Jim Casler Says:

    Phil, you, and others, have left out what I consider the most important factor in this situation. It is best summed up in three words:
    Nobody has money. Over the course of the last two-and-a-half decades, epople have lost good jobs and have been forced to take lower-paying jobs in an attempt to make ends meet. High-paying jobs have been exported to places like Mexico, and when those workers became too expensive, to India and China. A person with a job stocking shelves at Wal-Mart isn’t going to meeting the mortgage payments of the person who had a job with an automobile manufacturer or a defense contractor.
    A recent census report is the first mention that have heard so far that touches on this. As housing prices have risen over the past couple of decades, wages have been declining.
    A consumer economy depends on a large base of people with enough money to purchase goods and services. They can incur debt, but they must be able to pay the bills in order for the system to work. For the last couple of decades, those who own and manage American business have been knocking the legs out from under our economic system by ruthlessly depriving it of that base of consumers who can afford the goods and services the economy provides. UNtil that problem is recognized, it will not be addressed, and until it is addressed, things will not improve.

    • Philip Glaser Says:

      Hi Jim,

      Thanks so much for your thoughtful comment. You raise a good point. I have been focusing my attention rather narrowly on monetary inflation. But monetary inflation emerges from a complex of interrelated economic dynamics. The same process of globalization that enables the finance of unsustainable debt levels by foreign creditors has also facilitated the export of good paying manufacturing, technology, and even white collar jobs (such as legal research services). Meanwhile, the credit bubble lured many consumers and homeowners into levels of debt that they could not, given their limited means, afford to service.

      Your characterization of our economy as being “consumer” based, however, begs an important question, one that raises the discussion to a higher level. The monetary authorities and mainstream economists believe that consumer activity drives economic growth. As the Limits To Growth school pointed out in the early 1970s, economies cannot continue to grow forever because of the finitude of the natural resources upon which growth feeds. The barrier of peak oil is the first and most prominent of a number of natural resource barriers that we will encounter in the coming decades. The belief in infinite growth goes hand in hand with fractional reserve banking: all money in our economy begins as credit; expansion of credit by definition means expansion of money; and expansion of money causes inflation.

      These problems point in the direction of a common solution that, I believe, addresses the issue you raise: the reversal of the globalization process through localization. Import and export on the scale that we know it today depends on cheap energy for transportation. The dramatic fall in energy prices over the last few months obscures a significant problem that lies ahead of us. In the short term, prices have fallen so deeply that oil companies are giving up on research and discovery projects because the reward on those investments has disappeared. Some are shutting down rigs and buying oil on the commodities market and stockpiling it until the price goes back up. But the long term outlook reveals a much deeper and troubling problem: continuous and steady growth in the populations and economies of China and India drives increasing demand for a diminishing supply of oil. Under even the most optimistic estimates of future oil discoveries, there simply is not enough oil in the earth to supply all the demands. Eventually, I believe, all countries will be forced to localize their manufacturing and focus their attention more heavily on food production and simple survival. In the long run, our society will have to gravitate towards an economic model based on modest growth through savings and investment in the technologies that will make it possible to survive on less material consumption. If unsustainable credit bubbles go hand in hand with the belief in consumer based growth, perhaps the economic model that we’ll need in order to survive will have fewer and less dramatic ups and downs. In any case, the solution for all of us, I believe, is to get a head start on this phase of evolution by decreasing our consumption and focusing our energies on local food production, self-sufficiency, and healthy bonds of family and community.

      From The Tower,


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