Deflation Theory

Deflation Theory: A Reliable Foe
by Paul Mampilly


“…The scenarios presented amount to a very bleak picture. Some of this is rhetoric. Only time will demonstrate how much. I’m certain though that things change and solutions will be found. Our path to those solutions will cause significant economic and social change. Doomsday will be avoided at a steep price…”


Inflation has been a reliable barbarian for so many years. We know it so well. Each time it threatened, we knew how to beat it even if we sometimes lacked the will.

What o’ what shall we do without inflation? We fought it for so long, we didn’t know it had become a friend – a reliable foe. A foe that was a gentle redistributionist. It took from the present and gave to the future. If things swung too much one way or the other, we knew that the redress at least was simple: higher or lower interest rates.

But now we need inflation and it will not come. The bond market sees a something at the gate and believes it to be inflation. The Federal Reserve does not seem to know that inflation has waved us a long goodbye. The Fed cannot entice it back, not even with once in a lifetime low short-term interest rates. Worse, the Fed will be impotent when deflation comes. The preemptive action taken to stem the effects of the millennium bubble has left it depleted. The Fed has a miniscule 1.25% to combat the much larger deflation that is to come when the real estate and financial-complex bubble bursts.

Alas, alas. What is to happen to us? Here are a few examples of what the Classical School of Economists wrote of deflation (sourced from Deflation Theory by Thomas M. Humphrey):

Deflation Theory: DAVID HUME (1711-1776)

“A nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money, but [whose money] is on the increasing hand…The workman has not the same employment from the manufacturer and merchant; though he pays the same price for everything in the market. The farmer cannot dispose of his corn and cattle; though he must pay the same rent to his landlord. The poverty, and beggary, and sloth, which must ensue, are easily foreseen”

Deflation Theory: PEHR NICLAS CHRISTIERNIN (1725-1799)

“No one reduces the price of his commodities or his labor until the lack of sales necessitates him to do so. Because of this [condition] workers must suffer want and the industriousness of wage earners must stop before the established market price can be reduced.”

“Deflation…increase[s] the need for money because of speculation and hoarding. When it was known that bank notes were becoming more and more valuable as a result of reductions in the money supply and that all prices in time would consequently fall, everyone would await that time and in the interim would not purchase more than the bare essentials.”

“The price impact of a reduction in the money supply is not uniform: Not all prices fall; not all prices fall at the same time…Prices only fall for those goods that are less essential or that are in over supply.”

Deflation Theory: THOMAS ATTWOOD (1783-1856)

“If prices were to fall suddenly, and generally, and equally, in all things and if it was well understood that the amount of debts and obligations were to fall in the same proportion, at the same time, it is possible that such a fall might take place without arresting consumption and production, and in that case it would neither be injurious or beneficial in any great degree, but when a fall of this kind takes place in an obscure and unknown way, first upon one article and then upon another, without any correspondent fall taking place upon debts and obligations, it has the effect of destroying all confidence in property, and all inducements to its production, or to the employment of laborers in any way.”

The solutions offered by the Classicals (the way the economists of this school of thought are referred to) are three (approximately):

1. Let deflation ravage the economy wreaking destruction on wages, production. Let oversupply and the overvaluation of labor correct itself until there is no more oversupply. Then once demand revives due to the cheapness of products, a natural expansionary economic cycle will occur.

2. Pursue an expansionary monetary policy even if it destroys the value of the currency until money is no longer more highly valued than labor or other commodities.

3. Pursue a protectionist trade policy. This effectively raises prices by restricting cheaper imports. By doing so the production capacity of the country would be preserved.

This is a difficult topic and has received only minimal attention because this form of deflation has not been seen since The Great Depression. Japan’s current deflationary woes are different. There, domestic consumption and production declined. However, they are not dependent on external funding for their debt as we are today. The Japanese had prodigious savings to draw on even after the bursting of the bubble. As a result they were able to pursue the policy advocated by Atwood (see the article for full details) of an expansive monetary and fiscal policy. This has led to a very soft deflation in Japan. The population was spared the type of deprivations associated with The Great Depression.

Our deflation will be different. We receive significant funding from overseas. We don’t have the liberty to maintain a zero rate of interest; not even on short-term rates. Perversely, as deflation increases and our productive capacity decreases, interest rates will increase since foreign funding will have to be sustained. We could decrease our level of dependence on external funding – cut our spending both private and public. Or, we could default, a prospect that’s too terrible to envision.

Wages will decline as production is curtailed due to the anticipation of future lower prices. The lack of (inflationary) return and risk avoidance will cause all but the lowest cost producers to shut down. There is no incentive to produce if the producer must fund production with money that increases in value over time. Instead, he/she would rather keep his money and allow it to accrete passively. In addition, the price of the product declines while the producer’s capital is at work. Double punishment. Unless the cost of the inputs can decline at least as fast, the producer will choose to shut down his plant.

The scenarios presented amount to a very bleak picture. Some of this is rhetoric. Only time will demonstrate how much. I’m certain though that things change and solutions will be found. Our path to those solutions will cause significant economic and social change. Doomsday will be avoided at a steep price. These thoughts leave me longing for the days when I worried about inflation and bring to mind these lines from Constantine Cavafy:

“Why all of a sudden this unrest and confusion?

(How solemn the faces have become).

Why are the streets and squares clearing quickly,

and all return to their homes, so deep in thought?

Because night is here but the barbarians have not come.

And some people arrived from the borders,

and said that there are no longer any barbarians.

And now what shall become of us without any barbarians?

Those people were some kind of solution.”

Constantine P. Cavafy – Waiting for the Barbarians (1904)

Related Articles on Deflation Theory:

How High Can the Euro Rise?

E-Ring Hubris

The Material World

Paul Mampilly, CFA is the chief correspondent for