Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Silver Bull Market Update - 7th Aug 20
This Inflation-Adjusted Silver Chart Tells An Interesting Story - 7th Aug 20
The Great American Housing Boom Has Begun - 7th Aug 20
Know About Lotteries With The Best Odds Of Winning - 7th Aug 20
Could Gold Price Reach $7,000 by 2030? - 6th Aug 20
Bananas for All! Keep Dancing… FOMC - 6th Aug 20
How to Do Bets During This Time - 6th Aug 20
How to develop your stock trading strategy - 6th Aug 20
Stock Investors What to do if Trump Bans TikTok - 5th Aug 20
Gold Trifecta of Key Signals for Gold Mining Stocks - 5th Aug 20
Stock Market Uptrend Continues? - 4th Aug 20
The Dimensions of Covid-19: The Hong Kong Flu Redux - 4th Aug 20
High Yield Junk Bonds Are Hot Again -- Despite Warning Signs - 4th Aug 20
Gold Stocks Autumn Rally - 4th Aug 20
“Government Sachs” Is Worried About the Federal Reserve Note - 4th Aug 20
Gold Miners Still Pushing That Cart of Rocks Up Hill - 4th Aug 20
UK Government to Cancel Christmas - Crazy Covid Eid 2020! - 4th Aug 20
Covid-19 Exposes NHS Institutional Racism Against Black and Asian Staff and Patients - 4th Aug 20
How Sony Is Fueling the Computer Vision Boom - 3rd Aug 20
Computer Gaming System Rig Top Tips For 6 Years Future Proofing Build Spec - 3rd Aug 20
Cornwwall Bude Caravan Park Holidays 2020 - Look Inside Holiday Resort Caravan - 3rd Aug 20
UK Caravan Park Holidays 2020 Review - Hoseasons Cayton Bay North East England - 3rd Aug 20
Best Travel Bags for 2020 Summer Holidays , Back Sling packs, water proof, money belt and tactical - 3rd Aug 20
Precious Metals Warn Of Increased Volatility Ahead - 2nd Aug 20
The Key USDX Sign for Gold and Silver - 2nd Aug 20
Corona Crisis Will Have Lasting Impact on Gold Market - 2nd Aug 20
Gold & Silver: Two Pictures - 1st Aug 20
The Bullish Case for Stocks Isn't Over Yet - 1st Aug 20
Is Gold Price Action Warning Of Imminent Monetary Collapse - Part 2? - 1st Aug 20
Will America Accept the World's Worst Pandemic Response Government - 1st Aug 20
Stock Market Technical Patterns, Future Expectations and More – Part II - 1st Aug 20
Trump White House Accelerating Toward a US Dollar Crisis - 31st Jul 20
Why US Commercial Real Estate is Set to Get Slammed - 31st Jul 20
Gold Price Blows Through Upside Resistance - The Chase Is On - 31st Jul 20
Is Crude Oil Price Setting Up for a Waterfall Decline? - 31st Jul 20
Stock Market Technical Patterns, Future Expectations and More - 30th Jul 20
Why Big Money Is Already Pouring Into Edge Computing Tech Stocks - 30th Jul 20
Economic and Geopolitical Worries Fuel Gold’s Rally - 30th Jul 20
How to Finance an Investment Property - 30th Jul 20
I Hate Banks - Including Goldman Sachs - 29th Jul 20
NASDAQ Stock Market Double Top & Price Channels Suggest Pending Price Correction - 29th Jul 20
Silver Price Surge Leaves Naysayers in the Dust - 29th Jul 20
UK Supermarket Covid-19 Shop - Few Masks, Lack of Social Distancing (Tesco) - 29th Jul 20
Budgie Clipped Wings, How Long Before it Can Fly Again? - 29th Jul 20
How To Take Advantage Of Tesla's 400% Stock Surge - 29th Jul 20
Gold Makes Record High and Targets $6,000 in New Bull Cycle - 28th Jul 20
Gold Strong Signal For A Secular Bull Market - 28th Jul 20
Anatomy of a Gold and Silver Precious Metals Bull Market - 28th Jul 20
Shopify Is Seizing an $80 Billion Pot of Gold - 28th Jul 20
Stock Market Minor Correction Underway - 28th Jul 20
Why College Is Never Coming Back - 27th Jul 20
Stocks Disconnect from Economy, Gold Responds - 27th Jul 20
Silver Begins Big Upside Rally Attempt - 27th Jul 20
The Gold and Silver Markets Have Changed… What About You? - 27th Jul 20
Google, Apple And Amazon Are Leading A $30 Trillion Assault On Wall Street - 27th Jul 20
This Stock Market Indicator Reaches "Lowest Level in Nearly 20 Years" - 26th Jul 20
New Wave of Economic Stimulus Lifts Gold Price - 26th Jul 20
Stock Market Slow Grind Higher Above the Early June Stock Highs - 26th Jul 20
How High Will Silver Go? - 25th Jul 20
If You Own Gold, Look Out Below - 25th Jul 20
Crude Oil and Energy Sets Up Near Major Resistance – Breakdown Pending - 25th Jul 20
FREE Access to Premium Market Forecasts by Elliott Wave International - 25th Jul 20
The Promise of Silver as August Approaches: Accumulation and Conversation - 25th Jul 20
The Silver Bull Gateway is at Hand - 24th Jul 20
The Prospects of S&P 500 Above the Early June Highs - 24th Jul 20
How Silver Could Surpass Its All-Time High - 24th Jul 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

The Theory Of Deflation

Economics / Deflation Apr 23, 2013 - 06:13 AM GMT

By: Andrew_McKillop


This holds that deficiency of aggregate demand leads to over-production and unemployment, further depressing demand, and deflating the economy. By aggregate demand, this means personal and business as well as State consumption spending, and aggregate investment expenditure.

Staying with classic theories, private investment is governed by the marginal efficiency of capital and the real rate of interest. Deflation will occur when investment declines, for three main reasons, which are low marginal efficiency of capital, low profitability of capital and high real rates of interest.

The classic theories, we can note exist since as early as the 1870s, and particularly since "the panic of 1873" which mixed and mingled economic crisis, with a monetary and gold crisis, and a meltdown of stock market confidence across newly meshed (by telegraph) international financial markets. After this crisis, some economies like the UK took 15 years to get back to their crisis-year output levels.

In the classic theories, a main driver of the switch from expansion to contraction, and from inflation to deflation was declining returns from each increment of capital invested, that is declining marginal efficiency of capital. Why this happens, the theories say, is because of  increasing scarcities of materials, energy and equipment, as well as labour shortages driving up wage costs. More credit is then needed to obtain the same increment of output and profits.

Even in the last 25 years of the 19th century, in the early industrial countries, increasing abundance of output caused by breakneck industrial expansion led to investment returns falling below expectations. In other words there was market saturation due to industrial oversupply, itself due to investment based on expectations of fast future market growth - which did not happen.

The later "classic Keynesian" solution was to crank up demand by any artifice or trick in the book. But equipping every household with 2 washing machines, 3 cars, 4 wide screen TVs and 16 cellphones has its limits, even for Jack and Jill Sixpack Consumer Nothings. The basic cause of deflation - which Keynes called depression - lies in his idea of a so-called "psychological law of consumption". In other words humans are greed-obsessed animals who always want much more of anything than they can use or enjoy, but this is opposed by the "utility function" of increasing consumption.  According to Keynes' modified law, consumers tend not to spend the whole of the increment of their increasing incomes, when they increase, on increased consumption of consumer goods.

As income increases and a society becomes "wealthy", the community spends a smaller proportion of its increased income on consumer goods. In turn of course this causes stocks of unsold goods to rise, with a further hit to business expectations of growth and returns on capital.

Much closer to us than this, to our current deflationary context, classic theories of deflation from the 19th century featured the role of rising rates of interest. When prices tend to fall, for any reason, cash becomes more important than credit. Consumers typically delay purchases in the expectation of falling prices. For this activity they certainly do not want or need credit, resulting in what is called liquidity preference. To be sure, this soon extends out from consumer goods, to stocks, securities or any other kind of asset the price of which is tending to fall.

The result is simple. Increasing liquidity preference but reduced spending results in the rise of rates of interest, which also reduces investment.

Contractionary monetary policy - which today has a special meaning for stock exchange traders as the merest possibility that QE will be stopped - also raises interest rates, and contracts the demand for credit. This is the exact equivalent of a "physical" reduction in money supply, making "fiat" money more attractive than inflation-related assets, like gold.

We can understand the range of contractionary monetary policy by including the measures which are possible and can be used. These are raising the base rate, selling government securities, raising the cash reserve ratio of private banks, reducing the convertibility of national currencies, and others. Closely related to this, in fact, cutting government expenditure is always a result - and a secondary cause - of deflation in the economy.

When a government decides to cut public expenditure it will also reduce national income and employment by a larger amount, for Keynesians, but by some amount even for "Austrian School" economists, due to the total money supply falling. This will discourage investment and adversely affect the country's economic activity, and will tend to protect or bolster the national money.

Increasing income inequality is a result of both deflation and hyperinflation - causing the "Keynesians" to actively, or obsessionally seek "modest inflation" at all times. Positive feedback is certain because the marginal propensity to consume of high income earners is always less than that of the poor. Growing inequalities of income will always reduce aggregate consumption expenditure and will reinforce a deflationary situation.

In ur current social and political context in the "western mature democracies", government borrowing from the public, usually forced and not democratically consented, results in the transfer of wealth from the public to the government. The public is impoverished, reducing aggregate demand, bringing down prices in the economy.

For at least a century, economists and others have argued that waves or cycles of expansion and contaction in the economy are above all a mass psychology function or process. Adding problems to the analysis, these economic changes can be treated as cyclic, secular, structural or other.

Some economists feel that deflation and depression are the result of "waves of pessimism" wafting through society, also shown by declining rates of innovation and invention. During the optimistic conditions of economic boom, the mood is towards making huge investments in eccentric projects.

The mass psychology explanation of deflation is that Happy Time investors of the boom phase fail to find buyers for their products, suffer losses, grow pessimistic, and curtail their productive activities. Their failure then "serves a lesson" to others, who replace the previous error of mindless optimism, with the opposite error of black pessimism. In society this process has many related side effects, including political and cultural spinoff. In addition, certainly since the late 19th century, periods of deflation-depression some other non-economic and non-monetary factors such as rebellions, war, earthquakes, climate and weather change and crop failures can reinforce deflationary conditions.

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2013 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

Andrew McKillop Archive

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules