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Deflation Definition

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					What’s 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%
There’s 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 1990’s, 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, there’s 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
  1800’s (increased productivity)
 The Great Depression of the 1920’s
  (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 nation’s
  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                               •MS continues to fall
                          S                  •Demand for goods and services falls
                                             •Supply glut leads to fall in prices
P1                                           •Businesses can’t profit, so they
                                             liquidate
P2                     Cost of Production    •Banks now hold devalued assets

P3                                           •Sold assets increase glut



           Q3 Q2 Q1
                          D3 D2             D1
     MS3         MS1
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 90’s, U.S. in the
  30’s
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 Now…We’re 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
Dorothy’s 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-this-
     happen-often.
Hubbard, Glenn R., and Patrick A. O’Brien. 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.