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What’s This Got to Do with Deflation? Henry B. Stobbs, MFA Copyright Notice Certain materials in this presentation are included under the fair use exemption of the U.S. Copyright Law and have been prepared with the multimedia fair use guidelines and are restricted from further use. 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.