(There are far too many inadequate impressions about
deflation going around)
A policy culture dedicated to "stimulation" through forced credit
expansion with the attendant currency depreciation makes any discussion
about deflation seem alien. Unfortunately, even resorting to an economics
dictionary is not too helpful.
Disinflation, being benign, is described as a "planned reduction" in the
general price level. Being destructive, both inflation and deflation are
described as "sudden", laying off any blame upon misguided consumers.
The deliberate misunderstanding of the "flations" – either "in" or "de" –
was contrived by Keynes in the early 1930s. Until then, inflation was
considered as an inordinate expansion of credit – the result was rising
prices. In a series of letters to senior Fed staffers, he argued instead
that inflation was rising prices.
Lately, and mainly limited to the mainstream, there has been some
confusion about how credit could soar during the 1990s with so little CPI
inflation. Although credit was inflating against soaring financial assets,
pundits touted that you had to buy the stock market "because there is no
inflation". This was also the case in the 1920s' boom, which brings us to
some "rules" for deflation. There are only two types: minor and severe.
The minor type occurs when a raging mania in tangible assets becomes
unsustainable and collapses. Although painful, the deflation is mainly
limited to commodity and real estate prices. More recent examples occurred
in 1990-1991 and in 1920-1921. All together, there have been six since the
one in 1711 that set up the infamous South Sea Bubble of 1720.
In all cases, the minor deflation set up the exceptional abuse of the
credit markets otherwise known as a "New Financial Era". Each ended in a
dramatic climax that, except for ours, was identified in real time as a
bubble. The consequent deflation included both the main asset classes –
financial and tangible – and can be described as severe with profound and
lasting consequences.
As they
occurred in the senior financial centre (London and then New York), all
five examples from 1720 to 1929 were followed by initially severe
deflation within a prolonged credit contraction. This year's
outstanding recovery in the stock market and narrowing of credit spreads
seems to be defying history.
However, there are indications that the post-2000 bubble period has some
similarities with the prolonged initial contraction following the 1873
financial extravaganza. On a more generalized basis, some conditions
common and unique to all post-bubble periods have been developing. The
most obvious is the senior central bank following a massive decline in
short rates with a remarkable string of discount rate cuts.
Other identification is
provided by the statistically significant cluster of defaults. Sadly,
after claiming credit for the boom, suddenly chagrined politicians seek
solace in recriminatory legislation and attacking individual scapegoats.
(See comments on the 1618 severe deflation below.)
Those who are rushing to
form "super" agencies with a "super" fix now haven't taken the time to
realize that the SEC was formed in 1934 to prevent another runaway stock
market and consequent severe deflation.
Although such "prosperity"
must be considered as ephemeral, in all cases soaring tax revenues have
beguiled any government from acting responsibly or discovering malfeasance
until it was too late. Promoters of the 1934 SEC Act boasted it "would put
a cop at the corner of Wall and Broad Streets". Where were the "cops" in
1999 and 2000? Many have found their curiosity about financial markets
fully satisfied by rather personal theories about credit intervention
promoted in best-selling textbooks.
Fortunately, financial
history provides more practical instruction. It goes back a long way and
shows that there is very little that is new – including "New Financial
Eras". It is also a devastating critique on every interventionist theory.
Modern finance started in
the 1680s with the evolution of a stock market. This was formalized with
the advent of independent research with John Houghton's market letter in
1692 and the start of central banking with the Bank of England in 1694.
For hundreds of years prior to this, and without a stock market, the great
speculative moves were limited to tangible assets. But the basic timing
pattern was similar. Tangible assets reached an excess and rapidly
collapsed. Then, with business stagnating, many government loans became
unserviceable nine years later, resulting in a cluster of devastating
defaults. A prototypical "new era" started with the end of inflation in
1609. The immediate hard recession (but minor deflation) and subsequent
poor pricing abilities created widespread unemployment, particularly in
the cloth trade.
Then England
shipped basic cloths to the Netherlands, which was the financial and
commercial centre of the world. Those who didn't know better became
envious of the "value added" obtained by finishing the cloth in Flanders
and promoted a scheme to capture this by keeping and finishing the cloth
in England. Today, this would be the equivalent of taking Western Canada's
raw materials and making cars to sell to Japan. In a post-inflation
contraction, it is impossible to support existing, let alone additional,
capacity. With the sluggish economy, a promoter persuaded the British
Crown to finance the duplication in England of cloth-finishing facilities.
As business conditions began
to deteriorate in 1618, the King became apprehensive – particularly as
successful merchants described the scheme as "a Sepulcher – attractive
without, Dead bones within". Then in November of that fateful year, which
was seasonally appropriate for financial calamity, the Archbishop recorded
that the King told the advisor, "in could bloud before ye Council Table
yet if he had abused him by wrong information his 4 quarters should pay
for it ". As this meant "hanged, drawn and quartered", the Archbishop
continued with "ye poore Alderman stood infinitely amazed". As the scheme
included supporting the home industry by buying unfinished cloths, it
prompted other practical comment.
A well known letter-writer by the name of Chamberlain observed that it was
strange that "the wisdome of the state could be induced to [rely upon] the
vaine promises of ydle braines". Another rule of deflation is that it
prompts remedies by those without an intimate understanding of a great
boom and its consequent contraction.
Virtually all of the
available credit is employed during the mania. Credit does not drive
prices up, but the collateral value of soaring prices permits the credit
expansion. Then, as asset prices fall, diminishing collateral values and
falling commodity prices force a credit vacuum whereby those few
participants with the experience and character to get liquid during the
mania won't risk it until the contraction naturally ends. In more recent
terms, banks who wish to survive will only lend to AAA credits who, in
turn, protect that rating by not borrowing.
A credit vacuum is as rich a
territory for "ydle brains" as was the boom. In the post-1618 distress (or
severe deflation), Misselden, with inadequate experience, proposed " As it
is the scarcity that maketh the high rates of interest, so the plenty of
money will make the rates low." Virtually every distressful severe
deflation has prompted the same remedies. Prior to his "Mississippi
Bubble" of 1720, John Law, the first central banker to briefly enjoy a
personality cult, observed "Domestick trade depends upon money. A greater
quantity employes more people than a lesser quantity.". (It is worth
noting that in the 1720 bubbles England was on a gold standard so its
speculation was associated solely with credit creation. France was on John
Law's fiat currency and, even with 8 printing presses running, the central
bank was unable to extend the boom beyond nine years.)
With no fear of plagiarism,
Keynes also recommended the ancient misunderstanding that a credit vacuum
and deflation that normally follows the expenditure of available credit
during the mania can be turned around by the artificial injection of
credit by some very earnest agency. (Friedrich Hayek recalled that
when Keynes was contriving his remedies, he was totally ignorant of
financial history.) Other than direct experience, financial history is the
best teacher. Indeed, financial history itself can be considered as a due
diligence on the theory of credit intervention as it has been "discovered"
during each significant credit contraction.
It is essential to have a
clear understanding of the three "flations". Fortunately, history provides
sufficient evidence to provide sound usage of the terms. Inflation is an
extraordinary expansion of credit associated with soaring prices. This can
be against tangible or financial assets and the way history works is that
a bubble in real assets has preceded every bubble in financials by nine
years – but never both at the same time.
Disinflation is a more recent term and it has been reasonably used to
describe the lack of soaring prices for tangibles that is the feature of
every financial mania. Minor deflation has followed the great booms in
tangible assets and severe deflations have been the consequence of New
Financial Eras and their culminating bubbles. Will the new financial era
that ended in 2000 be followed by a traditional example of severe
deflation with weak prices for financial and tangible assets forcing a
credit contraction? Probability can provide some guidance.
While there is no guarantee
that it will happen, there is no guarantee that it won't.
