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What Is Deflation? PDF Print E-mail
Written by AIER Research Staff   
Friday, 16 May 2008 09:05
Genuine deflation is a decrease in money and credit relative to available goods. An excess demand for money manifests itself as an excess supply of everything else. When there is less money available, the markets will clear at lower prices.
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When the monetary unit was a specific amount of gold, credit-fed speculative booms inevitably led to deflationary busts. As asset values decreased, the resulting defaults and bankruptcies wiped out depositors’ funds that the financial intermediaries loaned to the speculators, thereby shrinking the money supply and promoting a classic deflation—falling price levels, contracting money supplies, and a decline in output, employment, and income.
However, deflation does not imply a brief period of falling house prices or stock prices (for example), as might occur during a typical business-cycle slow-down such as the current one. It entails a prolonged downward spiral of such events as occurred in the U.S. during the Great Depression.
 
In our view, the probability of future deflation is small, given that there is no longer any link between the dollar and gold, as was the case before 1933. A dollar is now a paper “IOU nothing.” Government authorities can now create money at their own discretion irrespective of actual market conditions.
  
Requirements for Deflation
 
One possible circumstance that could lead to deflation would involve the bankruptcy of a major nonfinancial or financial corporation that would be large enough to trigger a wave of other failures. The failures would presumably then destroy the confidence of creditors and depositors such that new credit would be unavailable and the economy would come to a grinding halt. The size of the failing firm is critical because bankruptcies occur all the time, especially during recessions, with creditors absorbing the associated losses without themselves toppling. However, both Enron and K-Mart failed with no systemic consequences during the last recession.
 
Today there are no obstacles to official bailouts. Authorities have made it clear that they will take whatever steps are necessary to prevent losses stemming from bankruptcies from affecting banks and their depositors (or in the case of Bear Stearns, their creditors and derivatives counterparties), whether by creating additional bank reserves or by substituting government debt for unsound credits. (The losses of specific lenders holding uncollectible debts do not go away—they are diffused among all holders of fixed dollar claims, taxpayers, or both.)
 
The recent actions of the politicians and Fed underscore this viewpoint. When a crisis threatened to wipe out the large hedge fund Long-Term Capital Management in 1998, the Fed quickly arranged for a private-sector bailout. Likewise, the Fed acted quickly to flood the banking system with reserves in response to the popping of the housing bubble last summer.

Some argue that, despite policymakers’ efforts, the public could lose confidence in the economy and financial system. If the loss of confidence were severe, the public would increase its demand for cash more rapidly than monetary officials would be able to create it. Cash balances would thus build up (i.e., hoarding would ensue), overall sales would drop, and the economy would fall into a tailspin.
 
However, hoarding cash is reasonable only if holders expect prices in terms of currency to fall. This seems unlikely if the government were to incur larger deficits and if the banking system were to flood the economy with paper dollars. As this series of events evolved, the public would more likely want to use paper dollars as quickly as possible for acquiring tangible things; they would not want to hold paper dollars whose supply was becoming increasingly excessive. Such developments would constitute hyperinflation, not deflation.
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