DEFLATION

Article 3-1
Introduction

Originally published February 2, 2015
Last edited December 8, 2016
By Michio Suginoo
Deflation increases the purchasing power of money while inflation decreases it. In other words, deflation invokes risk-free power from money; hyperinflation degrades money into a highly risky asset. Deflation or inflation can change our psychology as it pertains to money.

Deflation (inflation) is a manifestation of a sustained decline (rise) of price level and can be proxied by an annual percent change in general price levels, such as an annual percent change in consumer price index (CPI). A sustained change in price levels can be caused by multiple factors, including monetary, demand, supply, or a combination of all three. The following introductory chapter places this price reality into historical context by reviewing historical inflation/deflation data from the UK. The remainder of this section takes a brief look at the types of causes of sustainable changes in price levels.
[Historical Inflation/Deflation in UK]
The chart below provides an overview of the rate of change in UK’s price level and inflation rate since the turn of the 19th century. During this period, there were several transformations in international currency regimes. The chart reveals how the history of inflation/deflation in the UK transformed within the context of monetary regime change.
This chart, following a convention by some academics (e.g. Borio & Filardo, 2004; Bordo, Lane, & Redish, 2004), divides the inflation history starting in 1821 into three eras according to the transformation of currency regime: the UK’s classical gold standard era between 1821-1913; the inter-war era between 1918 and 1938; and the post-classical gold standard era following the Bretton Woods Conference, or the end of World War II. (The latter period can be further divided into two subperiods: Bretton-woods system and thereafter.) In between those periods, there were two interruptions caused by world wars.
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Since the breakout of WWI, the gold standard has been gradually and significantly compromised and unconstrained: it started losing its widely perceived automatic adjustment mechanism. As the international currency regime relaxed its gold convertibility restraint among major economies, the world gradually gravitated toward floating fiat currency regime. The announcement by US President Richard Nixon in 1972, abolishing the USD’s gold convertibility, was nothing but confirmation of the trend. The gradual changes in monetary regime seem to have transformed price behaviour. In this context, deflation has come to disappear from the scene.

In brief, in the UK, numerous instances of deflation can be observed throughout the 19th century; however, deflation almost disappeared with World War II. It appears as if the modern fiat-money regime eradicated deflation as a monetary phenomenon.

What would be the implications, if deflation re-emerged despite the current fiat-money regime? Besides monetary phenomena, what would account for deflation? Or can any non-monetary deflationary force be eradicated by monetary control in a deterministic way?
Brief Basic Review
Deflation, a sustained change in price level, can be caused by multiple factors, including monetary, demand, supply, or a combination of all three. The first factor, “monetary,” can be illustrated using the well-known example of hyperinflation in the Weimar Republic. Under the rigid constraints of heavy “post-WWI reparation debt burden” which used the fixed gold exchange rate as denominated currency, its populist regime failed its monetary management through discretionary money printing. Compounded by non-monetary causes (e.g., a shortage of domestic supply of basic consumer products), it exacerbated inflationary price consequences. The result was hyperinflation: 211,427,400,987% between 1922 and 1923 (Mitchell, 2007).

The second factor, “demand factor,” could emerge in multiple contexts. One example of “demand factor” can be illustrated by demographic change. Demographic change, compounded by other factors, historically demonstrates a revolutionary price change that results in long-term consequences. Another example can be related with financial leverage. During the post-bubble “deleveraging process” after the Global Financial Crisis, demand destruction was an inevitable consequence of a preceding systemic bubble accounting for deflationary pressure. During the preceding finance-fed bubble, the price of collateral assets kept rising. When the bubble burst, the price trend reversed its course and led to asset deflation.
 
Asset deflation causes a decline in the collateral value while the outstanding loan balance on the liabilities side remains the same. Thus, it impairs the loan-to-value ratio (LTV), which measures the proportion of collateral value to the outstanding debt. It would compel borrowers looking to restore the LTV ratio to choose between pledging additional collateral or repaying the existing debt. Since the latter choice makes better economic sense under asset deflation, it would force borrowers to engage in debt liquidation. This would lead to a series of fire sales of collateral assets for debt liquidation, putting further downward pressure on asset prices. The further decline in asset prices would reinforce the momentum of debt liquidation. This would trigger a chain reaction of asset-deflation and debt-liquidation. In the course of the event, borrowers would lose their financial capacity to consume, leading to a decline in demand and penetrating the broader economy. The consequence would be demand-driven deflation.

A prominent example of the third factor, “supply,” would be the oil shock of the 1970s. In terms of monthly average, the crude oil composite price provided by the World Bank Commodity Data (The World Bank, July 2015) circa October 1973 showed that when OPEC proclaimed an oil embargo, the crude oil price surged about 50% from around $2.70 (in October) to around $4.10 (in November), reaching $13 in January 1974. Another occasion of supply shock arose at the culmination of the Iranian Revolution: when the Shah departed Iran for exile in January 1979, oil prices jumped from $15 to $17.45, and in May 1979, a month after Ayatollah Khomeini became Supreme Leader under a new theocratic republican constitution, the price further advanced to $33.50. This series of geopolitical risks in the Middle East caused a supply shock and accounted for a twelve-fold price surge—from $2.70 in October 1973 to $33.50 in November 1979 (World Bank, July 2015). The chart shows that this microeconomic price surge penetrated the macroeconomic price increase. Another example of supply cause can be illustrated by the collapse of the ephemeral oligopoly's collusion price (Click to Article 2-1: Oligopoly Price Cycle), a recent case between 2013 and 2015 in primary resource sectors.
 
David Hackett Fischer, an academic historian and eloquent novelist, made the following remark (Fischer, 1996):

​​ “Historians tend to think of inflations in pluralistic terms, as rising from a broad variety of causal conditions. ... Economics ... seeks knowledge through generalization. History is an idiographic discipline. It studies things in their particulars. The two approaches are different, but also complementary. Together they can help us understand the many varieties of price-inflation, and also their common characteristics.”
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Overall, in reality, all three factors—monetary, demand, and supply—can might work in combination. The general price can be a manifestation of all three, rather than that of a single cause.
Reference
  • Bernstein, P. L. (2000). The power of gold: the history of an obsession. New York,  John Wiley & Sons, Inc​
  • Bordo, M. D. & Schwartz A. J. (1994, September). The specie standard as a contingent rule: some evidence for core and peripheral countries, 1880-1990. NBER Working Paper No. 4860. doi: 10.3386/w4860
  • Bordo, M.D., Lane, J.L., Redish, A. (2004, February) Good versus bad deflation: lessons from the gold standard era. NBER Working Paper No. 10329. doi: 10.3386/w10329
  • Borio, C. & Filardo, A. J (2004, March) Back to the future? Assessing the deflation record. BIS Working Paper, No 152. Retrieved from: www.bis.org.
  • Mitchell, B. R. (2007). International Historical Statistics, Europe, 1750-2005 (6 ed.). Basingstoke, Hampshire: Palgrave Macmillan
  • Rothbardo, M. N. (2010, October 5) The monetary breakdown of the west. Retrieved from: http://mises.org
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