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The Elliott Wave principle - what is it? Prechter on Elliott Waves More about Elliott Wave Interview on the coming economic crash Deflation-Deflation Elliott Wave books Elliott Wave and Real Estate Mortgage Lending Problems and the Elliot Wave The Fed's a Lousy Wizard Subprime Mortgages, a 1-2 punch Recognizing Financial Manias Best Investments in a Recession?-New! What to do in a Recession-New!
When Does Deflation Occur?
Conquer the Crash2nd Edition, Chapter 9
by Robert Prechter
Defining Inflation and Deflation
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.
Defining Money and Credit
Moneyis a socially accepted medium of exchange, value storage and final payment. A specified amount of that medium also serves as a unit of account. According to its two financial definitions, credit may be summarized as a right to access money. Credit can be held by the owner of the money, in the form of a warehouse receipt for a money deposit, which today is a checking account at a bank. Credit can also be transferred by the owner or by the owner's custodial institution to a borrower in exchange for a fee or fees - called interest - as specified in a repayment contract called a bond, note, bill or just plain IOU, which is debt. In today's economy, most credit is lent, so people often use the terms"credit" and "debt" interchangeably, as money lent by one entity is simultaneously money borrowed by another.
Price Effects of Inflation and Deflation
When the volume of money and creditrises relative to the volume of goods available, the relative value of each unit of money falls, making prices for goods generally rise.
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.
The Primary Precondition of Deflation
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.
(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and someunder great government deficits.
(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.
Contrary to nearly ubiquitous belief, such lending is almost always counter-productive; it addscosts to the economy, not value. If someone needs a cheap car to get to work, then a loan to buy it adds value to the economy; if someone wants a new SUV to consume, then a loan to buy it does not add value to the economy. Advocates claim that such loans "stimulate production," but they ignore the cost of the required debt service, which burdens production. They also ignore the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).
Near the end of a major expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount ofinvoluntary debt liquidation because almost no one expects deflation before it starts.
What Triggers the Change to Deflation
A trend of credit expansion has two components: the generalwillingness to lend and borrow and the general ability of borrowers to pay interest and principal. These
As confidence and production decrease, the supply of credit contracts.
The psychological aspect of deflation and depression cannot be overstated. When the social mood trend changes from optimism to pessimism, creditors, debtors, producers and consumers change their primary orientation fromexpansion to conservation.As creditors become more conservative, they slow their lending. As debtors and potential debtors become more conservative, they borrow less or not at all. As producers become more conservative, they reduce expansion plans. As consumers become more conservative, they save more and spend less. These behaviors reduce the "velocity" of money, i.e., the speed with which it circulates to make purchases, thus putting downside pressure on prices. These forces reverse the former trend.
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
A Global Story
The next four chapters Conquer the Crash present a discussion that will allow you to understand today's money and credit situation and why deflation is due. I have chosen to focus on the history and conditions of the United States because (1) I have more knowledge of them, (2) the U.S. provides the world's reserve currency, making its story the most important, (3) the U.S. has issued more credit than any other nation and is the world's biggest debtor, and (4) to discuss other countries' financial details would be superfluous. If you understand one country's currency, banking and credit history, to a significant degree you understand them all. Make no mistake about it: It's a global story. Wherever you live, you will benefit from this knowledge.
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.
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The Elliott Wave Theorist:Bob Prechter’s original monthly newsletter that started it all. He may forecast the reversal of a 14-month trend, or he may present “Elliott” from physics to social theory. But no matter what, Bob stands you on the cutting edge of Elliott and the markets themselves. - $20/month individually.
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