Transcript Deflation: Definition - Mr. Stobbs' Virtual Economics

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
S
•MS continues to fall
•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
P3
•Banks now hold devalued assets
•Sold assets increase glut
Q3 Q2 Q1
MS3
MS1
D3 D2
D1
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-thishappen-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.