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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.

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