How the Psychology of Deflation Becomes Entrenched

The psychology of deflation is reinforcing.

Fearful consumers spend less. Banks lend less. The economy contracts. Business profits fall. Job layoffs rise. Those out of work tighten their purse strings. Merchants lower prices to attract customers. Lower prices mean lower profits and more layoffs. You can see how the deflationary psychology can spiral out of control.

Consider Japan: The world's third-largest economy -- recently displaced as the second-largest by China -- appeared to be on an economic roll in the 1980s. Remember when Japanese investors bought controlling interest in Rockefeller Center in Manhattan? The Oct. 30, 1989, deal came within two months of the Nikkei's top. Since then, Japan has suffered from deflation.

A Dec. 16 Reuters article notes that despite the Central Bank of Japan's aggressive monetary policy, the psychology of deflation remains firmly entrenched.

A bargain-hunting psychology [in Japan] is so entrenched after two decades of stop-start economic growth, 15 years of falling wages and nearly 15 years of deflation that the government will struggle to convince people their incomes will improve enough for them to buy more expensive goods. ... Consumers have spent so many years worrying about incomes and job security that finding ways to spend less has become a habit.

Sound familiar?

The economic slowdown in the United States has not been nearly as long as Japan's. Yet, Elliott Wave International contends that the U.S. is in the early stages of a deflationary trend.

Deflationary psychology is already apparent.

The National Foundation for Credit Counseling conducted a November web poll in which 1,413 respondents participated.

The results revealed that 50 percent of consumers intend to spend less on holiday purchases this year than last ... while thirty-seven percent plan to spend nothing at all, as they fear further financial distress.

The Federal Reserve is pulling out all the stops to jump-start the economy.

The Fed just made a dramatic announcement: It is going to buy $45 billion worth of Treasury bonds every month. This is in addition to the $40 billion worth of mortgages it has already said it will buy every month. ...

From 2008 to 2012, the Fed increased its balance sheet by $1.8 trillion, a bit less than $1 trillion every two years. So, it is doubling the rate of asset purchases that has held since mid-2008.

The Elliott Wave Theorist, Interim Report, December 2012

And now the Fed is doing what it accused Japan of not doing.

The Fed and prominent economists have repeatedly -- and arrogantly -- asserted that Japan's persistent deflation resulted from the central bank's error in not lowering interest rates fast enough.

Conquer the Crash, second edition, p. 376

Yet, despite the Fed's persistently aggressive monetary easing policy and with interest rates near 0%, the U.S. economy remains sluggish.

Elliott Wave International's Robert Prechter has long warned that the answer is not more easy money; it's all-out credit contraction.

The proper models for the developing economic experience are those that accompanied the stock market setbacks of 1720-1722 in England, 1835-1842 and 1929-1932 in the United States and from 1990 forward in Japan. In two of those cases (1720-1722 and 1929-1932), the contraction was a relentless, acute, brief, all-out depression. In the other two cases (1835-1842 and 1990 to date), the economy contracted over a longer period in two or more steps, with recoveries in between. Either style of progression could happen.

Conquer the Crash, second edition, p. 83