The Economic Effects Of Deflation

There is a lot of talk about deflation nowadays, but very few people do understand the real meaning of its definition. One reason might be the fact, that there are several types of deflation and subsequently a clear understanding by the public is lacking. The terms of "inflation" and "deflation" are quite often superficially defined as an expansion or contraction of the money supply which is not really correct because the money supply can be somewhat controlled by Central bankers. It has more to do with constant increase, respectively decrease of price levels neither due to productivity gains or losses but more so with the attitude of the consumer towards spending and of banks in granting or not granting of loan facilities. Last but not least, it has further to do with the fundamental economic and financial health of a nation, whether it is a net importer or exporter of capital. However, all forms of deflation have one factor in common: They can and usually do have a devastating effect on the monetary system. I plan to have a series on the various categories of deflation and start with discussion on the "Confiscatory Deflation". Taking the events during the crisis of the 1930s as a base, one comes to the following conclusion:

Confiscatory Deflation

It is - in effect - a predatory attack on the cash reserves of individual citizens by the political elite linked together in an unholy alliances with the administrative and monetary authorities under their control. Yet, the cash reserves of people are the fuel for future investments, by spending it to keep the economy going and with it provide a guarantee of continued wealth of a nation. Interestingly enough, such predatory attacks are quite often ignored by those who are afraid of deflation despite the fact that we have experienced such phenomena during the last two decades in Brasil, the previous Soviet Union, Ecuador and Argentina which was hit twice (1980 and at present). These predatory attacks are often initiated by the political elite for the support of an unhealthy financial and economic system which is in desperate need of reforms. Behind this move is either the lack of courage to initiate painful measures to strike a proper balance between government expenditure and general income or to admit that the visionary political dreams lack a realistic base and that promises previously made can neither be kept nor less so maintained into the future. Instead, they pretend that business is going on as usual, that disruptions are only of temporary nature and have nothing to do with fundamental structural problems.

If a government is spending money to maintain and protect the status quo which is in desperate need of reform, it might temporarily save jobs but such a move does not create sufficient new values which are necessary for future growth. It creates a climate of stagnation and/or even further retraction. In such an environment, people tend to protect their possessions by saving more money than is necessary based on their income. This build up of cash or short-term investment positions are starting a vicious circle: It creates over-capacities in the economy; falling prices and lesser returns or even loss on investments will incur. Despite these negative incidents, the situation is only becoming really serious if adjustments to the new income conditions are being prevented by either authorities or unions prohibiting e.g. reduction in wages and/or redundancy and/or increase in working hours. Banks being faced with more and more defaults on outstanding loans might get into precarious stage due to the so-called "fractional reserve banking" which means that only part of the deposits are covered by reserves. This easily creates a panic among customers and subsequently a run on the banks. The customers actually only want their "cash property" back. In such a situation, governments usually react with more regulations such as limiting the withdrawal possibilities on bank accounts, the export of funds abroad. They might try to pump more money into an already sagging economy which is fundamentally inflationary in the first place. Secondly, it usually does not work since allocation of these surplus funds is beyond control of the Central Banks. It is like putting a sick person up in a luxury hotel instead of treating his illness properly which could result in a "growth deflation". This definition will be the subject of another column.

Argentina is a typical and extreme example of a so-called "confiscatory deflation" because it dispossessed most citizens in the end. One could think that this conclusion is far fetched and would never apply to the industrialised world. The lack of reforms and the prevention of necessary adjustments like wage (cost ) decreases, etc. as outlined above, have made the US economy shrink over 30 % between 1929 to 1933. An ardent observer realises that we - at present - are following the same pattern. More and more production facilities are - for competitive reasons - moved abroad, thus weakening the secondary sector of the economy in favour of services. It makes a nation more and more dependent on import of even basic goods.

While this system seemingly seems to work initially as long as these imports are either compensated with services rendered or can be paid in one's own currency, it leads to a dangerous dependency on necessary goods from abroad and in the second case to a dilution of inner values previously created. These imports can only be paid through an increase in the money supply through printing and/or foreign borrowing. The huge US balance of payment deficits are a clear symptom of the discrepancy between the continued issue of monetary debt and the shrinking or stagnating of productive capacity. It will eventually lead to a massive erosion of the inner value of "paper" money, especially when foreigners are no longer willing or able to compensate the lack of savings in the US or to finance the growing government deficit. At some point it will lead to an economic and financial disaster.

This is the reason why every thrifty person should have his own "reserve of last resort" and under personal control by owning physical gold through a onetime investment or savings plan and have it stored in a safe place.

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Kurt W. Kamber

11 February 2003