Tuesday, December 2, 2008

Deflation for dummies

Well, not really. It’s just that one of my readers asked for a description of the costs of deflation, so this post is a how-to on deflation. But I also take this opportunity to re-state my opinion that deflation poses only a small macro-economic threat if policymakers come through (I think that they will).

Deflation is a a nominal phenomenon and is determined by the quantity of money available in the economy relative to the demand for money. Deflation will result if:
  • Strong productivity growth is not matched by a likewise increase in the money supply.
  • Declining money supply due to restrictive monetary policy or a collapsing money multiplier.
Keynesian models allow for real shocks to the economy to affect price levels via aggregate demand. In this case, a crash in the housing market that affects aggregate consumption could cause price levels to decline as long as the Fed does not respond by cutting its nominal target to stimulate the macro-economy. Whatever the cause, deflation is a U.S. anomaly.

The chart lists annual inflation in the U.S. spanning back to the Great Depression. This 43-month recession saw deflation up to -10.74% and a severe contraction in economic activity; the average annual growth rate spanning 1930-1933 was -9.3%.

This is a perfect example to illustrate how deflation can be a serious problem. Driven by severely restrictive monetary policy (the central bank was not increasing the monetary base quickly enough), saving was wiped out and the availability of goods and services fell substantially.

The classic economic costs of deflation are:

  • With debt obligations being set in advance and deflation occurring unexpectedly – think of a fixed mortgage rate –all nominal variables fall (labor income), except for those tied to preset debt obligations. The resulting economic impact is a transfer of wealth from the debtor to the creditor. The deflation gives easy money to those who made the fixed loans, and causes difficulty in making payments for those who took out the loans. Debtor spending falls (must consume less to make the mortgage payments) and saving falls, but this is unlikely matched by an increase in spending and saving on the part of the creditors. The aggregate effect can be disastrous: spending contracts, saving is wiped out and default rates skyrocket.
  • Production and consumption decisions based on price expectations change. Consumers and firms do not know what to expect going forward, resulting in less demand and less production. If deflation becomes embedded in consumer expectations, consumers spending falls and economic growth suffers further.

Deflation is not an axiom of recessions. Prices fell during the 2001 recession and afterward because of the weak labor market. The rising unemployment rate put downward pressure on wages that dragged down price pressures, resulting in sharp disinflation (deflation on a monthly basis). Furthermore, prices fell in the 1981-1982 recession because Paul Volcker restricted the money supply with the exact intent of driving down inflation. However, during the 1980 recession, inflation hit 14.73% during the quarter that saw a -7.8% contraction.

Some say that the Fed is pushing on a piece of string: flooding the banking system with massive amounts of liquidity and seeing no stark improvement in the macro-economy. However, what the Fed is doing is maintaining positive money supply growth positive. As long as Bernanke keeps the liquidity hose on and the money multiplier doesn’t fall to zero, the money supply will not contract.

The money supply is growing and sharply reducing the probability that deflation – especially levels seen in the Great Depression – disrupts the macro-economy.

To be sure, the Fed is worried about deflationary pressures, as illustrated by its shift toward quantitative easing. However, the Fed is doing its job by keeping the money supply afloat. It’s Congress’ turn to step up with its $500 billion stimulus package to rescue the macro-economy.

Rebecca Wilder


  1. Someone said yesterday that deflation is so much harder to fix than inflation. It is stuborn and ingrained. The idea of tax cuts as part of the stimulus package would help.
    Thanks for the lesson --

  2. Hi Janie,

    Once deflation gets embedded into expectations, it's difficult to change. Japan only started to emerge from its deflation in 2006.

    As I stated in a previous post - for now, consumers still expect rather substantial inflation over the next year, which gives Ben's printing presses a better chance at succeeding in preventing deflation.


  3. Prior to 1933, the Federal Reserve Act's structural problems prevented it from expanding money and credit (bank credit contraction not-withstanding). I've never seen Friedman or Bernanke discuss it.

  4. In 1980, Paul Volcker, Past chairman of the Board of Governors of the Federal Reserve System, appeared before the House Domestic Monetary Policy Subcommittee.

    In response to a question as to why the Fed had supplied an excessive volume of legal reserves to the member banks in the third quarter 1980 (annual rate of increase 13.2%), Volcker's defense was that there are two types of legal reserves: 1) borrowed (reserves obtained by the banks through the Federal Reserve Bank discount windows), and 2) non-borrowed (reserves supplied the banking system consequent to open market purchases).

    He advised the congressmen to watch the non-borrowed reserves -- "Watch what we do on our own initiative." The Chairman further added --- "Relatively large borrowing (by the banks from the Fed) exerts a lot of restraint."

    This is of course, economic nonsense. One dollar of borrowed reserves provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves.

  5. I don't even believe required reserves are correct. The banks simply shifted applied or surplus vault cash into inter-bank demand deposits (so they would receive interest payments on their reserves).

  6. The rapid expansion of ATS & NOW accounts contributed an extraordinarily sharp increase in the transactions velocity of money in the 1st qtr of 1981. Nominal GNP hit 19.2%, the deflator hit +10%.

    It was not by happenstance that the decline in DDs Nov80-May81
    is almost eaxctly matched by the growth of CB ATS accounts, NOW accounts, MMFs & negotiable CDs.

    This was construed as a "time bomb", i.e., the depositors shifted their balances to highly liquid, interest-bearing checking accounts.

    Yields on AAA corporate bonds then peaked in Sept 81 (as monetary flows MVt correctly forecasted).

  7. During the Great Depression, the FED’s structural problems caused the commercial banking system's excess reserves to be quickly wiped out by massive “runs” on the banks (caused the contraction in the money supply).

    If failing to make the Federal Reserve a universal system was not enough of a handicap to effective monetary management, the Congress created twelve Federal Reserve Banks. It was not until 1933 that legislation was passed enabling the open market operations of the various banks to be coordinated.

    I.e., before 1933 one FRB could be expanding credit, creating bank reserves and laying the foundation for a multiple expansion of money, while another FRB was doing the opposite. Since 1933, all open market operations of the twelve FRBs are executed through the manager of the open market account in the FRB of New York (our Central Bank).

    From 1933-1942 the centralization of the open market power was of little consequence. So pervasive was the trauma of the Great Depression, and the lack of what the banks considered “bankable loans”, expansion of reserve bank credit typically led to more excess reserves rather than more loans and money.

    At the onset of the Great Depression, Federal Reserve Notes had to have a MINIMUM backing of 40 percent “eligible paper” and a MAXIMUM backing of 60 percent “eligible paper”

    In 1933 the Federal Reserve Note had to be collateralized by a least 40 percent in GOLD BULLION or COIN, and the remaining collateral had to consist of "eligible" commercial paper, principally TRADE and BANKER's ACCEPTANCES. The FED neither had sufficient gold nor the banks sufficient discountable “eligible paper” to meet the panic-inspired massive demands of the public for currency.

    Hence, bank failures were more than numerous; they would have been virtually universal if Roosevelt had not declared a “bank holiday” in March, 1933.

    It was not until 1933 that we began to unshackle our paper money from the numerous and unnecessary restrictions pertaining to its issuance. With the numerous types of paper money in circulation at the time, this would seem to have been a nonproblem. Here is the list: Gold Certificates, Silver Certificates, National Bank notes, United States notes, Treasury notes of 1980, Federal Reserve Bank notes, and Federal Reserve notes.

    With that array of paper money there should have been plenty to meet the liquidity demands placed on the banks by the public. But the volume of each type that could be issued was so circumscribed by restrictions that even the aggregate group could not begin to meet the panic demands of the public.

    The first tentative step was to reduce the gold requirement to 25 percent and allow U.S. government obligations to provide the remaining collateral. The framers of the Federal Reserve Act did not believe that the credit of the U.S. government was inferior to that of the Federal Reserve Banks and the short-term commercial paper of business.

    One of the pre-conditions the U.S. needed in 1929, was a much larger NATIONAL DEBT, and a willingness on the part of the Congress, the Administration, and the business community to tolerate an adequate expansion of the national debt. In 1929, the national debt was less than $17 billion, and the banks held only a SMALL proportion of that amount. We needed a LARGER debt and a much more rapidly expanding debt in the 1930's, not only to "prime-the-pump", but to meet the monetary management needs of the FED.

    The open market operations of the FED require a depth of market that will enable the FED to buy or sell billions of dollars worth of treasury bills on any given day without deeply disturbing the bill rates.

    It seems more than a coincidence, that during the Great Depression, which engulfed the country after 1929, and which remained with us for over a decade, that throughout this entire period there was no overall expansion in total net debt. At the end of the 30's net debt was actually less than it had been in 1929. Estimates of the Department of Commerce put the net debt figure as of the end of 1939 at $183.2 billion compared with a figure of $190.9 billion as of the end of 1929.

    During the 1940-1945 period total real debt expanded by approximately $193.5 billion. Thus in the short space of five years the total cumulative net debt in existence at the end of 1940 was more than doubled. Practically all of this expansion, or $185 billion, was accounted for by the expansion of the Federal Debt.

    After 1933, after we had central bank and a coordinated FED credit policy, the FED pumped billions of dollars of reserves into the banks; and nothing happened. There were years during this period when the excess legal reserves held by the member banks were larger than the volume of required reserves. The exercise of FED policy was likened "to pushing on a string". It was true, as the Keynesians insisted, that monetary policy didn't matter; fiscal policy was everything.

    Today the Federal Reserve Note has no legal reserve requirements, and the capacity of the FED to create IBDDs (interbank demand deposits) has no legal limit.

    There is only one restriction placed upon its issuance. No Federal Reserve Note can be put into circulation unless there is a prior transaction involving the relinquishing by the public of an equal volume of bank deposits, and an equal diminution of holdings of IBDDs (legal reserves) on deposit with the Federal Reserve District banks. In other words, the issuance of our paper money contains no inflationary bias. Its issuance does not increase the volume of money. It merely substitutes one form of money for another form.

  8. It amuses always to read the false beliefs of those indoctrinated by the Church of Academe.

    Dummies confuse Deflation with DEVALUATION.

    Deflation vs Devaluation

    Deflation is a process purposefully undertaken by Central Banks to reduce excess credit.

    When Central Bankers deflate, they increase reserve requirements and sop up cash from banks and they strive to increase interest rates, thus reducing the amount of cash for rent (aka credit, aka debt).

    DEVALUATION happens when investors and speculators cannot see where potential future payoffs shall take place.

    Thus, they refuse to bet (take capital position) on any future.

    On Economics

    Economics is the Science of Exchange of the right to claim one thing for another.

    Today, almost always, one of the two things that gets exchanged is the commodity of money.

    When one thing gets exchanged for another, we call that ratio a 'value'.

    When one of the two things exchanged is money, we give another name to word value. That name is 'price'.

    On Investors and Devaluation

    This is where investors are today.

    They are not exchanging money for future payoffs.

    Quite the opposite, they are selling already played bets. This causes a fall in price, a DEVALUATION.

    The Federal Reserve and Inflation

    The U.S. Central Bank, the Federal Reserve is INFLATING, engaging in INFLATION thus attempting to increase the Efficiency of Money, that is, the ratio of Money in Circulation (notes, coins) to New Growth in Commercial Credit.

    Bogus Keynsianism and Politics

    Keynsianism is a rhetorical doctrine used by the Political Class to justify Collectivist action.

    It's a bogus doctrine that supports bogus theories, all of which get proven false by the court of human interaction.

    Many have become indoctrinated to it through the Church of Academe with it's cult of high priests and initiates.

    On Money

    Folks never stop and then start to think about the phrase "money supply."

    Buyers and sellers act and swap Commodities, one for the other.

    Money is a commodity. It's the thing you trade for another thing, say money for wheat.

    Man must depend on the graces of nature to deliver wheat, even with his science of farming, while he can wily print as much money as he thinks he can scam others with until credit relationships break down.

    Where you find offers of money (supply), you find calls for money (demand). What gets swapped (sold) is money down now for a promise to pay more money through time.

    Said another way, notes and coins that you can spend now get swapped for the right to collect more notes and coins in any future.

    What becomes key, is that NEW money down now cannot arise unless attached to some claim on money of a future.

    Folks only take on new money now when they know they must pay it back in any future. Folks only give up new money down now when they know that they have the right to claim that money back in the future.

    On Money and Capital

    When Money Men swap money for the right to collect more notes and coins in any future, money buys capital. Capital comes from cash rented (money down now) put to use for manufacturing, mining or farming.

    Capital is not a thing that you have that you invest. There is only money, a commodity, which can be swapped for rights to other commodities -- wheat, corn, gold, shirts, pants, brake pads, future money. When men swap now money for rights to future money, we call those rights -- CAPITAL.

    The man who buys capital, buys a right to claim either a stream of payment -- a bond -- or the payoff of a bet -- expected dividend. Capital comes from cash rented used for manufacturing, farming or mining.

    The Cash Rentee who sells his rights to future income (Capital) gets cash down now sold to him from the Now Money Seller. Next, the Cash Rentee buys resources -- workers and their labor capital, metals, fuel.

    Money is the highest form of Credit and Credit is another word for Debt. Credit and Debt are other names for Capital.

    On Central Banking
    A Central Bank holds a Monopoly Charter for the manufacture and distribution of the Commodity of Money.

    Since money is the common way by which men engage in Economics (the science of exchange of one enforceable right for another), any change to the Price of Money (the value of the ratio of money down now spent to buy money in a designated future), changes all relationships between the Commodity Money and all other commodities.

    On Inflation

    Central Bankers launch Inflation when wanting to increase internal trade (Home Economy) through these: increased number of opened contracts, increased rate of cash payment for transaction settlement.

    A wanted increase in Commercial Credit relative to Money is the wanted EFFECT of inflation.

    Under Central Bank systems, Central Bankers cheapen the price of money hoping that existing money migrates to credit and not to futures betting.

    Central Bankers seek to expand Capital Opportunties (inflate) through cash renting for manufacturing and production (mining, farming) purposes.

  9. "I don't even believe required reserves are correct" -- my mistake.

    A growth in required reserves would ordinarilly reflect an increase in reservable liabilities (net transactions accounts).

    I.e., an increase in required reserves could involve 2 different senarios, resulting in 2 different outcomes.

    First, depositors could shift their deposit accounts (their deposit classification preferences) from (TDs) into (DDs), (ATS), (NOW), share draft, etc...i.e., no change in the money stock. Not likely.

    Second, an increase in required reserves would reflect an increase in the money stock...probable.


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