Deflation is a contraction in the amount of money and credit in an economy.
There are two main causes of deflation.
- A build-up of excess credit.
- A negatively trending social mood.
Build-Up of Excess Credit
In order for there to be a contraction on money and credit in an economy, there has to have been a build-up of money and credit in the first place. This can be thought of as the primary pre-condition of deflation. Over the last couple of centuries, a minority of economists, particularly from the Austrian school such as Ludwig von Mises and Friedrich Hayek, and more recently from so-called post-Keynesians like Steve Keen, have written about the dangers of excessive credit expansion. The idea that credit expansion will lead to credit contraction is far from a mere theoretical, academic concept though. One just has to glance at history to see that deflationary periods are preceded by a build-up of excess credit. In fact, a 1957 letter by bank credit and Elliott wave expert Hamilton Bolton summarized a study he had undertaken of major U.S. depressions since 1830. He found that:
- All (depressions) were set off by a deflation of excess credit. This was the one factor in common.
- Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
- Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
- None was ever quite like the last, so that the public was always fooled thereby.
- Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
- Credit is credit, whether non-self-liquidating or self-liquidating.
- Deflation of non-self-liquidating credit usually produces the greater slumps.
On Bolton's latter two points, self-liquidating credit is a loan that is paid back, with interest, from a productive economic activity. For example, a company borrows money to buy a new machine to increase production. The increased production creates the added-value to pay back the loan, with interest. Non-self-liquidating credit is where, for example, someone borrows to purchase a television -- no economic value is being added to the economy.
The build-up in excess credit will go on for as long as a) there is a general willingness for people to borrow and lend, and b) borrowers have the ability to pay back their loans with interest. The most important factor is the willingness of people to engage in credit activity and, when this changes, it will have been caused by a move towards negative social mood.
A Negatively Trending Social Mood
Trends in social mood are the cause of everything. The build-up of excess credit (inflation) that causes the subsequent deflation is, itself, driven by a positively trending social mood. People are optimistic about the future and so borrow and lend freely. The stock market goes up and companies' bonds are in great demand because social mood detects nothing but blue skies on the horizon.
At some point though, as the cycle matures, mood transitions from positive to negative. There is no "catalyst" for this mood change -- it happens subconsciously and naturally. But as the new negative mood sets in, society in general starts to become more cautious. This permeates into individual decisions regarding financial affairs. Lenders start to be less willing to lend, but borrowers also start to have a more cautious attitude. The process starts slowly, almost unnoticed, but gradually builds momentum until, as Bolton put it, "a major failure" brings the deflation to a head. The great credit crisis of 2008 did not just suddenly appear out of nowhere. Credit markets started to break down in 2007 when the willingness of lenders and borrowers began to wane.
The slowing in credit market and economic activity, caused by the negative trend in social mood, means that existing money is circulated less. Cash hoarding becomes prevalent as an increasingly cautious society sees the value in cash. As the prices of goods and services fall, a mind-set of delaying purchases emerges. This can lead to further cash hoarding, further price falls and a deflationary spiral.
As credit deflates, the money multiplier effect goes into reverse, causing the amount of bank deposits in the economy (money) to shrink as well.