Whats This Got to Do with Deflation?

Henry B. Stobbs, MFA

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Deflation:
A Simple Definition to A Complex Problem
A persistent decrease in the general price
level of goods and services that occurs
when the inflation rate falls below zero
percent.

0%

Theres Good news

If the quantity of goods relative to
the amount of money on hand
increases, then the price of those
goods will drop: the best example is
the late 1990s, when low productivity
costs in China and elsewhere drove
up the supply of stuff and drove
down the general cost of those goods.
As Wal-Mart says, Prices were falling!

And, theres bad news

Deflation of itself is neither good nor
bad the CAUSE determines whether
people will benefit or suffer from its
effects.
Deflation is considered a problem in a
modern economy because a
deflationary spiral can lead to
recession and even depression.

Good Deflation / Bad Deflation

The Industrial Revolution of the
1800s (increased productivity)
The Great Depression of the 1920s
(Stock market bled off liquidity,
leading to a contraction of the
economy, job losses, bank failures a
tragic, downward spiral)

Economic Preconditions
Deflation requires that there be a
major societal buildup in the
extension of credit and a
corresponding increase in the
assumption of debt. This is
commonly referred to as a credit
bubble.

And by Credit, We Mean

Self-liquidating credit: a moderately
short-term loan that is paid back with
interest. Such loans are used to start
or expand businesses, which in turn
generate the means to pay back the
loan. This sort of debt adds value to
the economy.

And by Credit, We Mean

Non-self-liquidating credit is debt that:
Is not tied to production (homes, cars,
boats, speculation)
Interest payments (debt service) on
these loans stress some other form of
production and erode the ability of
consumers to choose how to spend their
income
This kind of credit adds costs to the
economy

Good, or Bad? How to Tell?

Decreasing money supply (Tight
money, Part I - BAD
Increasing supply of goods - GOOD
Decreasing demand for goods
Maybe GOOD, maybe BAD
Increasing demand for money
(Tight money, Part II) Maybe
GOOD, maybe BAD

Four Basic Types of Deflation

Cash Building Deflation is
caused when people save more
money, which decreases the use of
money but increases the demand for
money. We call this demand side
price deflation.

Four Basic Types of Deflation

Growth Deflation occurs when there is
a decrease in the Consumer Price
Index and an increase in the supply
of goods. This is called supply side
price deflation.

Four Basic Types of Deflation

Bank Credit Deflation happens when
there is a decrease in the credit
supply of the bank and a contraction
of the money supply from a nations
central bank.

Four Basic Types of Deflation

Confiscatory Deflation is a freezing of
bank deposits and a decrease of the
money supply.

Monetary Deflation
is caused primarily by a

reduction in the velocity of money

and/or the amount of per capita
money supply or credit. Deflation

can be caused also by a decrease in

government, personal or investment
spending, or a combination of factors.

Monetary Deflation
A deflationary spiral may be
triggered when the central bank of
a credit-based economy initiates
higher interest rates, thereby
popping an asset bubble, or by the
collapse of a command economy
that has been run at a higher level
of production than it can support.

Portrait of a Deflation
Drop in MS leads to less lending
Demand falls faster than supply
Prices fall

Lending

S
P

MS continues to fall
Demand for goods and services falls
Supply glut leads to fall in prices

Businesses cant profit, so they

liquidate

P2

Cost of Production

P3

Banks now hold devalued assets

Sold assets increase glut

Q3 Q2 Q1
MS3

MS1

D3 D2

D1

Deflation Survival Tips

Barter
Alternate currency arrangements
Increased production of precious resources
Print more money:
The Fed creates a fixed amount of money
The Fed uses the money it printed to buy
securities (bonds), which lowers interest rates
and injects more money into the economy

How Low Can You Go?

Liquidity Traps
Central bank lowers interest rates all the
way to 0%
Demand can no longer be stimulated by
lowering interest rates
In order to artificially grow the money
supply, special arrangements are made to
lend money at a 0% nominal rate (which,
because of negative inflation, may actually
be quite high in real terms)
Examples: Japan in the 90s, U.S. in the 30s

Some History Lessons

Those who do not remember
the past are condemned to
repeat it.

7th U.S. President

1829 1837

The Recession of 1836, & the Panic of 1837

President Jackson refuses to renew the charter of
the National Bank, so federal funds are deposited in
state banks
State banks start lending paper money (without
proper specie backing) to just about anybody who
wants to buy land causing a speculative bubble and
galloping inflation
Trying to control inflation and the wild speculation,
Jackson issues an executive order effecting a specie
circular: federal land purchases must be paid in
gold or silver: this precipitates a banking crisis

The Recession of 1836, & the Panic of 1837

As people rush to convert greenbacks the money
supply shrinks by about 30%. Banks have to call in
loans to stay liquid
The value of paper money plummets, sending prices
spiraling upward (and inflation follows). Interest rates
rise 2 3% per month. Weaker banks fail.
The bubble bursts, as people begin to perceive the
worthlessness of greenbacks: paper wealth becomes
paper poverty
Van Buren inherits a mess: a general bank and
business collapse sets in that will last for nearly a
decade

And NowWere Off to See the Wizard! The

Wonderful Wizard of Oz!
1910
William
Jennings
Bryan

Frank
Baum

July 9, 1896, Democratic National

Convention, Chicago
You come to us and tell us that the great
cities are in favor of the gold standard. I
tell you that the great cities rest upon
these broad and fertile prairies. Burn
down your cities and leave our farms,
and your cities will spring up again as if
by magic. But destroy our farms and the
grass will grow in the streets of every
city in the country we shall answer
their demands for a gold standard by
saying to them, you shall not press down
upon the brow of labor this crown of
thorns. You shall not crucify mankind
upon a cross of gold.

Oscar Zoroaster Phadrig Isaac Norman

Henkel Emmannuel Ambroise Diggs

O.Z.
24, too!

An Economic Parable
Dorothy: Everyman American, or American liberty
Scarecrow: The powerless farmer, whose assets blow
away in the wind, and who is a gullible victim of populism
Tin Woodman: Heartless industrialist, or every industrial
worker
Cowardly Lion: William Jennings Bryan, politician who
backed silver bi-metal cause
Wizard of Oz: US presidents of late 19th Century
Wicked Witch: A malign Nature, destroyed by the
farmers' most precious commodity, water. Or simply the
American West

An Economic Parable
Winged Monkeys: Native Americans or Chinese railroad
workers, exploited in the name of Westward expansion
Oz: An abbreviation of 'ounce' or, as Baum claimed, taken
from the O-Z of a filing cabinet?
Emerald City: Greenback paper money, exposed as fraud
Munchkins: Ordinary citizens
Dorothys slippers: originally silver: combined with the
Yellow Brick Road, a symbol of the Bi-metal movement

The Great Deflation: 1873 - 1896

Also called the Great Sag and the Great Depression
After the Civil War, the government tries to restore
normality by returning to the gold standard (parity)
Other countries around the world also adopt the gold
standard
World prices of goods, materials and labor plummet by
1.7%/year in the U.S., by .08% in the U.K. Commodity
producers, especially farmers, suffer
Bond prices rise dramatically, borrowers suffer early calls
and defaults
America benefits greatly because it is in the early stages of
industrialization - the Second Industrial revolution is born
Germany, France, Canada, and Sweden but especially
industrially developed Britain, suffer sharp business
contractions throughout the 1870 1933 period

1930 1933: More Wizardry!

Sliding into the Great Depression:

Some Likely Causes
Easy credit in the Roaring Twenties leads to
excess indebtedness and asset bubbles
Later, as the value of money rises, debtors as
well as creditors rush to liquidate, but cannot
keep up with the fall in prices as they try to
lessen their burden of debt but effectively
increase it, because of the mass effect of the
stampede to liquidate increases the value of
each dollar owed, relative to the value of
their declining asset holdings. Paradoxically,
the more the debtors pay, the more they
owed

Sliding into the Great Depression:

Some Likely Causes
Consumers want to hold more money than
the Federal Reserve is supplying, which
leads to lower consumption
The economy is producing more than it
consumes great for profits and stocks
(until the bubble bursts), lousy for
everybody else: this overcapacity is a
global problem with global consequences

Sliding into the Great Depression:

Some Likely Causes
Prices are not flexible enough to fall
immediately, so business contracts,
causing a rise in unemployment
As businesses fail, stocks fall too bad
news, in the investment-crazy days of the
Roaring Twenties
The Fed does not recognize what is
happening and fails to take corrective
action

Sliding into the Great Depression:

Some Likely Causes
Consumers lose faith in the banks, causing
runs and bank closings
The potential for runs causes local bankers
to be more conservative with lending out
reserves the lack of reserves prevents
the Fed from inflating the money supply
and credit dries up

Sliding into the Great Depression:

Some Likely Causes
The gold standard worsens matters
because looser fiscal and monetary policy
threaten the ability of countries, including
the U.S. to pay their international debt
obligations
Protective tariffs make matters worse, as
retaliatory moves choke off exports and
further restrict business

Using the Fisher Equation

The run-up to the Great Depression
was characterized by a drop in both
money supply (as credit) and the
velocity of money so great that
deflation took hold in spite of
increases in money supply spurred by
the Federal Reserve (Too little, too
late)

Summary

The following slides would

be good review for an
exam!

Summary
Deflation is A general decline in prices
over time below zero% inflation, often
caused by a reduction in the supply of
money or credit. It can also be caused by
a decline in government, personal, or
investment spending. Do not confuse
deflation with disinflation.
The opposite of inflation, deflation has
the side effect of increased
unemployment since there is a lower level
of demand in the economy, which can
lead to an economic depression.

Summary
Persistent declining prices can create
a vicious spiral of falling profits, closing
factories, shrinking employment and
incomes, and increasing defaults on
private as well as corporate loans.
Central banks attempt to stop
severe deflation in an attempt to keep
the excessive drop in prices to a
minimum. The Fed can use monetary
policy to increase the money supply and
raise prices, causing inflation.

Summary
There are four basic types of deflation:
A fall of prices linked to increased productivity
and an increasing supply of goods this is good!
A decrease in the money supply, or tight
money this is bad!
A decrease in demand maybe good, maybe not
A decrease in the supply of goods and services
maybe good, maybe not.

Summary
Deflationary periods can be both short or
long, relatively speaking. Japan, for
example, had a period of deflation lasting
decades starting in the early 1990's.
The Japanese experienced a so-called
liquidity trap when, having lowered interest
rates all the way to zero percent (special
arrangements), the economy was still
caught in a deflationary spiral.

Summary
Excessive non-self-liquidating credit
can contribute to bad deflation. This
is debt linked to non-productive
assets, such as cars, boats, homes,
and speculative instruments. This
kind of debt adds costs to an
economy.

Summary
Self-liquidating credit is based on
short-term debt taken out to build or
expand businesses. The debt is
retired from the excess capital
(profit) gained through the expansion
or new business. This kind of debt
adds wealth to an economy.

Summary
Some important economic crises
marked by episodes of deflation
include (but are not limited to):
The Recession of 1836 and the Panic of
1837
The Panic of 1873 and the Great Sag of
1873 1896
The Great Depression of 1929 1939
The Global Recession of 2008 - ?

Summary
Excess debt + Deflation = Recession
A prolonged and deep period of
recession is a Depression

Works Cited
American.com. Deflation: Does This happen Often? The American. 10 Oct. 2008. 15
Mar. 2009 http://www.american.com/archive/2008/october-10-08/does-thishappen-often.
Hubbard, Glenn R., and Patrick A. OBrien. Essentials of Economics, 2nd Ed. Upper
Saddle River: 2009, Pearson.
Investopedia.com. Deflation. 16 Mar. 2009
http://www.investopedia.com/terms/d/deflation.asp.
Rockford College. George Santayana. The Internet Encyclopedia of Philosophy. 20
Mar. 2009 http://www.iep.utm.edu/s/santayan.htm
Stobbs, Henry B. Deflation. Lesson Plan. 12 march 2009.
Wikipedia.com. Photographs and illustrations. 19 Mar. 2009 http://wikipedia.com.