Inflation, Disinflation and Deflation

By: Bob Hoye | Mon, Jun 23, 2003
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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? Will gold provide the liquidity needed in such a crisis as well as the typical outstanding performance seen in other post-bubble periods? History suggests yes and probability can provide some guidance. While there is no guarantee that it will happen yet again, there is no guarantee that it won't.


 

Bob Hoye

Author: Bob Hoye

Bob Hoye
Institutional Advisors

Bob Hoye

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