When Does Deflation Occur?

by Robert Prechter

  Webster's says, "Inflation is an increase in the volume of money and credit relative to available goods," and "Deflation is a contraction in the volume of money and credit relative to available goods." To understand inflation and deflation, we have to understand the terms money and credit.

   The price effects of inflation can occur in goods, which most people recognize as relating to inflation, or in investment assets, which people do not generally recognize as relating to inflation. The inflation of the 1970s induced dramatic price rises in gold, silver and commodities. The inflation of the 1980s and 1990s induced dramatic price rises in stock certificates and real estate. This difference in effect is due to differences in the social psychology that accompanies inflation and disinflation, respectively, as we will discuss briefly in Chapter 12.

The price effects of deflation are simpler. They tend to occur across the board, in goods and investment assets simultaneously.

   Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt). Austrian economists Ludwig von Mises and Friedrich Hayek warned of the consequences of credit expansion, as have a handful of other economists, who today are mostly ignored. Bank credit and Elliott wave expert Hamilton Bolton, in a 1957 letter, summarized his observations this way:

   In reading a history of major depressions in the U.S. from 1830 on, I was impressed with the following:

(a) All were set off by a deflation of excess credit. This was the one factor in common.

(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.

(c) 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.

(d) None was ever quite like the last, so that the public was always fooled thereby.

(f) Credit is credit, whether non-self-liquidating or self-liquidating.

(g) Deflation of non-self-liquidating credit usually produces the greater slumps. 

   Self-liquidating credit is a loan that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan - for business start-up or expansion, for example - generates the financial return that makes repayment possible. The full transaction adds value to the economy.

   Non-self-liquidating credit is a loan that is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income.

   As confidence and production decrease, the supply of credit contracts.

   The structural aspect of deflation and depression is also crucial. 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, spending and production cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward "spiral" begins, feeding on pessimism just as the previous boom fed on optimism. 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.

Next  - "Why Deflationary Crashes and Depressions Go Together."

To be taken directly to the second half of this article, click here 

   We invite you to subscribe regular reports on deflation and the U.S. economy, stocks, bonds, oil, gold/silver, and real estate markets,  with the  Financial Forecast Service. It is the most valuable investment forecasting service you can buy - period.

   As a Financial Forecast Service subscriber, you get instant access to three publications that deliver comprehensive market analyses in multiple time frames. Individual monthly subscriptions to these three publications would total $78, yet together they’re just $59 per month (You save $228 a year.)

   Here’s what you’ll get:

Bob Prechter's Conquer the Crash : a very practical book. In the first part, Bob studies widely-used economic indicators and explains why a deflationary crisis is a real possibility. The second half of the book describes ways you can protect your investments during the crisis and how to re-invest your money once the worst is over.

You also get a

FREE copy of Prechter and Frost's classic Elliott Wave Principle -- Key to Market Behavior when you subscribe ($29 value; shipping and handling charges apply). This book revolutionized market timing when it hit the street

in 1979, and is considered a masterpiece to this day. No investor should be without it.

Your subscription is risk-free.

Try it for 30 days: if you don't like it, ship the Elliott Wave Principle -- Key to Market Behavior book back to us in good condition and get a full refund of your subscription money (minus S&H). You can also get a pro-rata refund anytime during your subscription. If we don't hear from you, we'll continue to bill your credit card every quarter until you tell us to stop.