What Is a Deflationary Spiral?

When social mood shifts, so too do lenders', borrowers' and investors' plans for the future, shifting from expansion to conservation to preservation. Money flow slows and defaults rise. Default and fear of default result in a cascade of debt liquidation known as a deflationary crash or spiral. The graphic below adds details as the process unfolds:

Deflationary Spiral

Psychological Explanation of a Deflationary Spiral:

The psychological explanation of this phenomenon as to what drives a deflationary crash or deflationary spiral can be found in Robert Prechter's New York Times Bestseller book "Conquer the Crash 2020: You can SURVIVE and PROSPER in a Deflationary Depression." Here is an excerpt from that book:

********

The psychological aspect of deflation and depression cannot be overstated. When the trend of social mood changes from optimism to pessimism, creditors, debtors, investors, producers and consumers all change their primary orientation from expansion to conservation. As creditors become more conservative, they slow their lending. As debtors and potential debtors become more conservative, they borrow less or not at all. As investors become more conservative, they commit less money to debt investments. As producers become more conservative, they reduce expansion plans. As consumers become more conservative, they save more and spend less. These behaviors reduce the "velocity" of money, i.e., the speed with which it circulates to make purchases, thus putting downside pressure on prices. The psychological change reverses the former trend.

The structural aspect of deflation and depression is also a factor. The ability of the financial system to sustain increasing levels of credit rests upon a vibrant economy. At some point, a rising debt level requires so much energy to sustain -- in terms of meeting interest payments, monitoring credit ratings, chasing delinquent borrowers and writing off bad loans -- that it slows overall economic performance. A high-debt situation becomes unsustainable when the rate of economic growth falls beneath the prevailing rate of interest on money owed and creditors refuse to underwrite the interest payments with more credit.

When the burden becomes too great for the economy to support and the trend reverses, reductions in lending, borrowing, investing, producing and spending cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default prompt creditors to reduce lending further. The resulting cascade of debt liquidation is a deflationary crash. Debts are retired by paying them off, "restructuring" or default. In the first case, no value is lost; in the second, some value; in the third, all value. In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities and real estate, causing their prices to plummet. The process ends only after the supply of credit falls to a level at which it is collateralized acceptably to the surviving creditors.

********

Example of a Deflationary Spiral:

One of the best-known deflationary spirals took place in the United States of America between 1929-1932. This is more commonly known as The Great Depression.

The Great Depression: United States of America 1929-1932

In many ways, one might argue that the word deflation is associated most closely with this period of time. Starting in America with the infamous Wall Street Crash of 1929, a global economic depression took hold, the effects of which lasted throughout the 1932 and culminated with World War II, the costliest military conflict in modern history in terms of human lives.

The seeds of the Great Depression were sown in the 1920s with a buildup of excess money and debt. In 1920, total U.S. debt as a percentage of gross domestic product (GDP) was already high at around 150%, but, by 1929, it had grown to 180%. The extremely positive trend in social mood during the Roaring '20s meant that attitudes towards debt changed. Martha Olney, a professor of Economics at the University of California, Berkeley, notes the rise in the purchase of consumer durables and cars during the 1920s and states that:

"By the mid-1920s, buying on credit was considered normal, not sinful."

Outstanding mortgage debt grew by more than eight times from 1920 to 1929, according to Charles E. Persons whose article titled, "Credit Expansion, 1920 to 1929, and Its Lessons" was published in The Quarterly Journal of Economics in November 1930. Persons concluded:

"The past decade has witnessed a great volume of credit inflation. Our period of prosperity was based on nothing more substantial than debt expansion."

After debt expansion, comes debt contraction (that is, deflation). Looking at the Great Depression from the perspective of a socionomist, we can see that the positive trend in social mood, as measured in this case by the sociometer of the U.S. stock market, topped out on September 3, 1929, and, by November 13, the Dow Jones Industrials index had fallen by 48%. That, however, was just the beginning. After a coincidental 48% bounce in the Dow into April 1930, the negative trend in social mood really took hold. Over the next 27 months, the Dow would plummet another 85%. In less than three years, the stock market had lost almost 90% of its value. The U.S. economy was devastated. From 1929 to 1932, U.S. industrial production fell by 46%, wholesale prices fell by 32%, foreign trade dropped by 70%, and the amount of people unemployed rose by 607%. It was a similar story in Europe. Global GDP fell by an estimated 15% (by comparison, global GDP fell by less than 1% during the 'Great Recession' of 2008-2009.)

Depression Era Soup Kitchen

Source: Wikimedia Commons. Unemployed men line up outside a depression soup kitchen opened in Chicago by Al Capone, 1931

A Deflationary Spiral took hold from 1929 to 1932 whereby debt liquidation and distress-selling led to a contraction of the money supply as bank loans were paid off (those which were not defaulted upon). These actions then led to a fall in the level of asset prices and in the net worth of businesses, precipitating bankruptcies and yet more debt liquidation. The loss of confidence led people to hoard their money and no longer demand credit.

The ramifications of the collapse in social mood that caused deflation were felt throughout the 1930s as societies fractured. The rise of fascism in Europe and the descent into World War II can be linked directly to the same mood which led to the deflation of the excess debt that had been built up during the 1920s.

Notice from the chart below that the velocity of money had been slowing for over a decade before the deflationary spiral really set in with the 1929 crash and its aftermath. Note also that commodities topped out in 1919. A similar situation exists in 2020 with commodities having topped out in 2008. Indeed, in 2020, money velocity has been slowing for over two decades, meaning that this deflationary spiral might possibly be far deeper than the Great Depression.

Slowing Money Circulating Portends a Deflationary Spiral

How Long Will a Deflationary Spiral/Crash Last?

Each one is different and there is no way to accurately predict when they might end. Of course, deflationary periods don't last forever. Eventually, social mood becomes more positive, prompting more confidence among lenders and borrowers, which results in the expansion of credit once again.