Inflation vs Deflation

Inflation and deflation are two of the most misunderstood economic conditions.  The recognition of each is typically gauged with prices.  Higher prices mean inflation.  Lower prices mean what exactly?  We never see lower prices do we?  My economic laws tell us much about inflation and deflation.

Before you can experience deflation you have to have inflation.  The picture below is a metaphor for the amount of credit inflation in our economy.  To fill that blimp, you need a great deal of air.  Let’s picture the blimp as full of newly created credit. 

In “normal” times most of the credit created in the economy comes from the banking system.  Banks make loans and consumers and businesses borrow.  In order for that lending and borrowing to occur, there must be confidence [Economic Law #1].  Borrowers have confidence that they can repay and lenders have confidence of debt repayment.  If the economy grows then sufficient value is created to repay debt.  Without sufficient cash flow, there is little hope of debt repayment.  This is why we can categorize debt as self-liquidating and non-self-liquidating.

Self-liquidating debt is used for productive purposes.  The debt usage promotes higher productivity or value creation.  This type of debt generates cash flow that is used to meet debt servicing and eventually retire the debt.  The cycle can continue as long as debt usage enhances the ability to meet debt service.

Non-self-liquidating debt is consumptive.  Borrowing for the purposes of consumption does not generate cash flow to meet debt servicing.  A home equity loan used to pay for a vacation or household goods is an example of this type of debt.  Neither the vacation nor the household goods will generate cash to service debt.  Purchasing a car may fall into this type of debt if more is spent than required to have basic transportation needs.  This is certainly a qualitative evaluation.  Financing home purchases also falls into this category albeit qualitatively.  The term “McMansion” comes to mind.  A great deal of the credit filling that blimp is of the non-self-liquidating variety.  This is confidence on steroids and accounts for the meteoric rise and subsequent fall in housing.  Housing finance became overly consumptive.  The result was a fall in prices or what is commonly an effect of deflation. 

The U.S. last experienced a pronounced deflation during the Great Depression.  The air let out during the Great Depression was the volume of a beach ball.  The potential for the 21st century is the aforementioned blimp.  The blimp provides a sense of scale.  The Wizards tried desperately to keep the blimp inflated through massive purchases of Treasury Bonds and mortgage backed securities.  Unless you lived in the Land of the Rising Sun, you might not hear much about deflation.  Deflation will become a prominent part of the American lexicon in the years ahead.  Wherever there was credit inflation we will see deflation.  This is what happens during deleveraging. 

Let’s look more specifically at inflation and deflation.  Inflation is an increase in the volume of outstanding money and credit.  We experienced a great deal of inflation with the majority being credit inflation.  Credit exists in banking cyberspace.  If you log in to check your bank balance, that is credit in cyberspace (yes you are a creditor to your bank and an unsecured one at that).  Your outstanding mortgage balance is credit.  Your car loan is credit.  The cyberspace credit is easy to create and the Fed has done everything in its power to make it as easy as possible through low interest rates and interest rate sensitive asset purchases.  When people talk about inflation they talk about prices going up.  Yes, that is the consequence of inflation but not inflation itself.  Our inflation has been very concentrated in financial assets which means the price of those assets has gone up.  But inflation can make the price of other things go up too.  Consider the price of higher education and the massive amounts of credit made available for this purpose. 

Deflation is the opposite of inflation—a decrease in the volume of outstanding money and credit.  If someone pays off a loan, then it does not appear in banking cyberspace so it is a reduction in credit.  If a bankruptcy occurs and a creditor is not paid their due, that is a reduction in credit.  If a loan is restructured, that is also a reduction in credit.  If there is less credit in banking cyberspace, there are fewer units of money chasing goods and services, which means they will have a lower price, other things being equal.  Credit can also experience a contraction of sorts if lenders don’t want to lend and borrowers don’t want to borrow (i.e.) they are saturated with debt.  This is why deflation is also a psychological phenomenon.  If you question the psychological component, consider how large bank reserves are and how that money has not necessarily made its way into the economy.  In a recent paper published by the St. Louis Federal Reserve, analysts postulated that Americans were hoarding money.    This hoarding is evident in the reduced velocity of money. 

We can also have inflation or deflation for reasons other than credit expansion or contraction.  If a hard freeze hits Florida and ruins the orange crop, you can bet oranges will be more expensive.  Conversely, if the groves in Florida unexpectedly produce double the anticipated harvest, we would anticipate lower prices.

There will be more reluctance to create or accept the credit levels of our recent history until the catharsis occurs that normalizes debt levels in the economy to match asset values and productive capacity to repay.  Some of the debt existing in the economy has little chance of being repaid.  Anticipate debt restructuring for businesses and individuals.  During a deflationary period, cash is king.  If you have cash, you will be able to buy financial assets or businesses for less.  In the meantime recognize that you may find yourself in an environment where some prices could rise within a broader deleveraging economy.  Those areas of the economy that witnessed the most credit absorption will be at most risk for deflation.