Understanding Deflation

What is deflation?

Some economists define inflation as rising prices and deflation as falling prices. We do not think these are useful definitions. Production efficiency, for example, can lead to falling prices, and a shortage in wartime can lead to rising prices. What if the price of one good is rising while another is falling? What does one call that? Prices for goods, services and even credit do not inflate or deflate; they just go up and down.

Another common definition is that inflation is a rise in the total volume of money and credit with respect to the total volume of available goods and services. This is just another way of saying that inflation is rising prices and deflation is falling prices, and it is just as useless. The volume of money and credit could be falling, but the volume of goods and services could be falling even faster, in which case economists using this definition would be forced to call it "inflation." But nothing would be inflating; it would be deflating.

We opt for a useful definition relating to monetary conditions. Therefore:

- Inflation is an expansion in the total supply of money and credit. - Deflation is a contraction in the total supply of money and credit.

Get the full definition of Deflation >

What is money?

Money is something that serves as a unit of account, a store of value and final payment. Today there is no money in the system, because debts are not a reliable store of value. In today's debt-money system, people refer to cash notes as money, because they serve as a unit of account and as final payment. But they do not serve as a store of value. After all, fiat money was created to steal value.

What is credit?

Credit is an agreement transferring the right to access money from the owner of the money to someone else. A bank deposit is a credit from the depositor to the bank, giving the bank the right to access that money. A mortgage loan is a credit from the bank to the consumer, giving the consumer the right to access money on deposit at the bank.

What is debt?

A debt is the borrower's agreement to pay money to the creditor.

What is default?

A borrower who can't pay his obligation is said to be in default. When he cannot pay interest or principal, he has defaulted on the loan agreement.

Why is default dangerous?

Default means the creditor loses some or all of his money. When the entire financial system is gorged with debt, default can be systemic, causing huge amounts of perceived debt-values to disappear.

For the past ten years, I've mostly seen a lot of predictions of more inflation or even hyperinflation. Why do you guys disagree?

One good reason is that the consensus is calling for the opposite, and in finance the consensus is often wrong. But most of us base our opinion on the belief that the amount of outstanding debt worldwide is unpayable.

I do remember hearing about deflation briefly in 2008, during the worst of the "liquidity crunch," but not since. Isn't the big threat over?

No. Remember, in 2006-2007, most people thought then that deflation was impossible. That's when real estate peaked and dropped in half, commodities and stocks crashed 57%, and short term interest rates went to zero. Most people can't see around the corner. We base our work on precursors of deflation, not the event itself. By the time you can see it, it's too late.

Everyone says that since 2008 the Fed has been printing money like crazy, creating inflation. Isn't that right?

The Fed has monetized a lot of debt: about $2 trillion worth. But this is not precisely equivalent to printing money. The bonds the Fed holds back the money it creates. Its monetization is indeed inflationary, but not necessarily permanently so. The Fed can create new money only with good debt, and our case is that there is hardly any of that left. If some of the debt it holds begins to sour, it might have to divest itself of some of it, in which case it would have to call in the money that debt was backing. In other words, the Fed still operates as a bank, albeit a privileged one.

Two trillion dollars' worth is a lot of new money. Isn't that the definition of inflation?

No. Most deflationary crashes emerge from periods of high indebtedness. They happen when the amount of outstanding credit contracts. New money can be enough to balance the retirement of old debt, and that's what the Fed has nearly managed to do. But it hasn't created net inflation, because at the same time more than $2 trillion worth of debt has melted away. If the Fed could create inflation at will, real estate would not be down by half, commodities would not be down 40%, and rates on T-bills would be pushing 20%, not sitting at zero. And think about it: These results have occurred despite unprecedented monetization by the Fed and record federal-government spending. What will happen when those trends slow down or reverse?

I have always read that credit is the grease in the gears of the economy. Is that right?

Conventional economists excuse and praise the debt-money system under the erroneous belief that expanding money and credit promotes economic growth, which is terribly false. It appears to do so for a while, but in the long run, the swollen mass of debt collapses of its own weight—which is deflation—and destroys the economy. We saw a grim "preview" of that during the 2007-2009 deflationary plunge. One could say rather that credit is the molasses in the gears of the economy.

I thought the reason credit is desirable is that new production would pay off the loans, keeping the economy humming. Isn't that the theory?

In a free market, most creditors would probably lend to producers, in which case you would be right. But most debt today comprises loans to governments for buying votes, investors for buying stock, and consumers for buying homes, cars, boats, furniture and services such as education. None of those loans has any production tied to it. Even a lot of corporate debt today is tied to financial activity rather than to production. When a strong business borrows, it uses the money to create new capital. But these government and consumer loans have eaten up capital. It's gone. All those borrowers have spent the future, and no magician can get it back.

Why does anyone want inflation?

Monetarists say that credit inflation is necessary to keep the economy expanding. But the real reason for inflation is that it is a method of stealing value from savers' accounts and wallets without their knowing it.

Why do bankers want "lenders of last resort" such as the Fed and the FDIC?

So they can lend more aggressively, get rich speculating with other people's money and not have to bear the consequences of failure. The plan was that the Fed and the FDIC would always be there to bail out profligate banks. But the plan has a moral hazard: The safer potential lenders think they are, the more they lend, until the system is gorged with debt. We think the debt is so huge now that central banks and government institutions such as the FDIC will be unable to stop a systemic credit meltdown.

Isn't the government making things better by lending money to everyone who needs it, for example for home loans and college loans?

The government's aggressive easy-lending policy has cruelly enticed extremely marginal borrowers into the ring. It forces prices of homes and education higher and makes debt-slaves of home-buyers and college students. Its lending makes the debt problem far worse.

The Fed Chairman keeps talking about the Fed's "policy tools" to create more inflation. What are those?

Its main tool is creating more debt. That is not a solution to the debt problem.

How much debt is in the world? Hasn't the Fed bought up a lot of it?

According to the Fed's flow of funds report, at the end of Q1 for 2012, Total Credit Market debt was just under 55 trillion. But when you count all the debt worldwide, including pensions, Medicare and financial derivatives, it's over a quadrillion dollars' worth. Since 2008, the Fed has monetized 0.2% of it. And already some of its Board members are nervous about the risk.

I keep hearing that the huge debt is no problem because we just "owe it to ourselves."

Tell that to the creditors. There is a lender and a borrower for every dollar of credit, and the lender expects to get his money back.

Why can't credit just expand forever?

Two things are required to produce an expansionary trend in credit. The first is increasing confidence, and the second is the ability to pay interest. After over seven decades of credit expansion, confidence reached its limit in 2006-2008. Since then confidence has slipped, and bank lending and consumer borrowing have contracted (the only exception being in education loans, but we think that's about to end). As confidence slips, deflation accelerates, and the economy contracts. A contracting economy stresses debtors' ability to pay interest and ultimately principal. Once debtors start defaulting, all these trends get worse. That's why the Fed and the government bailed out so many bad debtors in 2008. They knew the system was in trouble. But they can't bail out everyone, and in our view virtually all debts are at risk. We think the next bout of deflation and economic contraction will prove it.

Will deflation be slow or fast?

Every time a bank lends money, it gets deposited into other banks, which re-lend those "new" deposits, producing a "multiplier effect" on the total value of bank deposits. Thanks to their belief in lenders of last resort, bankers have lent and re-lent about 97% of their deposits. When borrowers begin defaulting, the "multiplier effect" of will go into reverse. The potential reverse leverage in our banking system is an important precursor for a deflationary crash.

What is the best investment during deflation?

Deflation brings down financial values, such as the values of stocks, commodities and property. Elliott Wave International's main recommendation has been safety in cash and cash equivalents. (See Chapter 18 of Conquer the Crash for a description.)

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