The Theory Of Deflation

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 our 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.

If a business arrives in an area whose prices are 30% lower than all the other related business there will be a tremendous pressure for all other related businesses to drop there prices in order to compete.

Consider that China has arrived on the global marketplace with a currency undervalued relative to other currencies. There is likewise tremendous pressure on other countries to devalue their currency in order to compete. The resulting deflation if managed can actually increase the health of an economy.

Forth paragraph:

In the classic theories, a main driver of the switch..., and from inflation to deflation was declining returns from ...capital invested... 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...output and profits.

If my understanding is correct, deflation effects manufactures while the costs of necessities are immune. That seems to be what's going on now; necessities like food, transportation and raw materials are increasing, while the prices of manufactured goods are declining.

You can buy a computer for a fraction of what it once cost, but a visit to the grocery store or gas pump will leave you staggering.

"You can buy a computer for a fraction of what it once cost"

That's been the case with electronics since Jack Kilby, Texas Instruments,invented the intergrated circuit in 1958. I met Jack.

This holds that deficiency of aggregate demand leads to over-production and unemployment, further depressing demand, and deflating the economy.

This article goes wrong with the very first sentence. People believe, because of the fallacy of composition, that because a particular industry or firm can suffer from over-production, that the economy as a whole, in the long run, can suffer from over-production. This cannot happen because the same expenditure of money can buy any volume of goods, depending only on the price level.And so, a lower aggregate demand can buy the same amount of goods as a higher demand, if prices are low enough.

The absurdity of blaming depressions and their accompanying impoverishment on overproduction implies that people cannot afford homes or apartments because they have built too many of them, that they cannot buy food because they have grown too much, that they cannot purchase cars or appliances because they have manufactured too many, in a word, that they are poor because they are rich

China has been building “ghost cities” in an effort to create the illusion of wealth. I wonder if they’ll end up moving poor peasants without electricity into those gleaming cities to prevent riots.
They’d have done better to build sewer and clean water infrastructure through the countryside than building millions of apartments for 200-300K US.

while there are pressures on western economies to deflate there are corresponding pressures on china (and other emerging economies) to inflate. We are seeing that today. I think you are correct to believe china may face problems adjusting to the new realities.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.