WEBVTT 00:00:00.000 --> 00:00:02.160 Welcome to the Deep Dive, where we cut through 00:00:02.160 --> 00:00:04.459 the noise and get straight to the impactful takeaways 00:00:04.459 --> 00:00:06.580 from the detailed research you've shared with 00:00:06.580 --> 00:00:10.699 us. Today's topic is one of the most counterintuitive 00:00:10.699 --> 00:00:14.439 and frankly frightening concepts in all of macroeconomics. 00:00:14.480 --> 00:00:16.920 I think so too. It's this idea that something 00:00:16.920 --> 00:00:20.399 that sounds wonderful on a personal level, you 00:00:20.399 --> 00:00:22.980 know, falling prices, is often a signal that 00:00:22.980 --> 00:00:25.890 the entire financial system is Well, seizing 00:00:25.890 --> 00:00:27.929 up. It is. We've analyzed your source material. 00:00:28.070 --> 00:00:30.190 And our mission for this deep dive is to get 00:00:30.190 --> 00:00:32.490 a really thorough understanding of deflation, 00:00:32.609 --> 00:00:35.130 what some have called the economic phantom that 00:00:35.130 --> 00:00:37.829 makes money too valuable. OK, so let's unpack 00:00:37.829 --> 00:00:40.009 that right away, because if you walk into a store 00:00:40.009 --> 00:00:42.689 and everything is 10 percent cheaper than it 00:00:42.689 --> 00:00:45.530 was last year, my immediate gut instinct is great. 00:00:45.950 --> 00:00:48.390 My money goes further. We're all hardwired to 00:00:48.390 --> 00:00:50.890 love sales. Of course. So why is deflation, where 00:00:50.890 --> 00:00:52.829 the general price level is actually decreasing 00:00:52.829 --> 00:00:55.289 and the inflation rate falls below zero, why 00:00:55.289 --> 00:00:57.750 is that considered such a huge red flag by central 00:00:57.750 --> 00:01:00.719 bankers all over the world? That is the absolute 00:01:00.719 --> 00:01:04.019 core paradox we have to confront here. Deflation 00:01:04.019 --> 00:01:08.140 is a measurable increase in the real value of 00:01:08.140 --> 00:01:10.959 the monetary unit. So while inflation is constantly 00:01:10.959 --> 00:01:12.959 working to reduce the value of your currency. 00:01:13.079 --> 00:01:14.659 Eating away at your savings. Right. It's eating 00:01:14.659 --> 00:01:16.879 away at it. Deflation does the complete opposite. 00:01:17.019 --> 00:01:19.980 You can literally buy more goods next month than 00:01:19.980 --> 00:01:23.299 you can today with the same dollar. But, and 00:01:23.299 --> 00:01:26.760 this is the big but. This is where the macroeconomic 00:01:26.760 --> 00:01:29.459 nightmare begins. It means you have to sell more 00:01:29.459 --> 00:01:32.680 goods or work more hours or cut more costs to 00:01:32.680 --> 00:01:34.719 finance any payments that are fixed in nominal 00:01:34.719 --> 00:01:37.519 terms. And the big one there is always debt. 00:01:37.700 --> 00:01:40.099 OK, so let's make that concrete. If I'm a small 00:01:40.099 --> 00:01:42.540 business owner, maybe I sell T -shirts and the 00:01:42.540 --> 00:01:44.739 price of my shirts is falling, let's say, 5 % 00:01:44.739 --> 00:01:46.879 a year. But the payment I owe on the bank loan 00:01:46.879 --> 00:01:49.040 I took out last year, that dollar amount doesn't 00:01:49.040 --> 00:01:51.840 change. It's fixed. It's fixed. So suddenly that 00:01:51.840 --> 00:01:54.280 mortgage payment or that business loan represents 00:01:54.280 --> 00:01:57.480 a much, much larger chunk of my actual revenue 00:01:57.480 --> 00:01:59.879 that I have to generate. Exactly. You are paying 00:01:59.879 --> 00:02:02.730 back dollars that are. for lack of a better term, 00:02:02.829 --> 00:02:05.269 fatter or more valuable than the dollars you 00:02:05.269 --> 00:02:07.530 originally borrowed. And before we go any further, 00:02:07.670 --> 00:02:09.729 we really need to be crystal clear about the 00:02:09.729 --> 00:02:12.650 terminology here, because the media, well, it 00:02:12.650 --> 00:02:14.750 often gets this wrong. Oh, yeah. Let's clarify 00:02:14.750 --> 00:02:17.689 deflation versus disinflation. Disinflation is 00:02:17.689 --> 00:02:20.009 just a slowdown in the inflation rate. So if 00:02:20.009 --> 00:02:22.930 inflation was, say, 10 % last year and this year 00:02:22.930 --> 00:02:26.129 it's down to 3%, that's disinflation. Prices 00:02:26.129 --> 00:02:28.210 are still going up, just not as fast. Still positive. 00:02:28.389 --> 00:02:31.189 Still positive. Deflation means the rate is actually 00:02:31.189 --> 00:02:33.569 negative. The price index is falling. And that 00:02:33.569 --> 00:02:36.430 is the real danger zone. Got it. So negative 00:02:36.430 --> 00:02:39.150 is the problem. This, I think, brings us to the 00:02:39.150 --> 00:02:41.750 central idea in the sources about deflationary 00:02:41.750 --> 00:02:44.370 shocks. I mean, is there any scenario where deflation 00:02:44.370 --> 00:02:47.349 is actually OK? Well, the consensus among economists 00:02:47.349 --> 00:02:50.169 is that sudden, unexpected deflationary shocks 00:02:50.169 --> 00:02:53.189 are almost universally bad in a modern debt -fueled 00:02:53.189 --> 00:02:55.550 economy. Why is that? Is it all about the debt? 00:02:55.879 --> 00:02:59.000 It's primarily about the massive immediate increase 00:02:59.000 --> 00:03:01.500 in the real burden of debt, which acts like a 00:03:01.500 --> 00:03:04.379 profound break on the entire economy. It severely 00:03:04.379 --> 00:03:07.340 aggravates recessions. It can lead to asset liquidation, 00:03:07.500 --> 00:03:11.250 mass unemployment. It basically sets up the conditions 00:03:11.250 --> 00:03:13.750 for what we call the deflationary spiral. The 00:03:13.750 --> 00:03:15.569 spiral. We're going to be talking a lot about 00:03:15.569 --> 00:03:18.629 that, I imagine. We are. And it is arguably one 00:03:18.629 --> 00:03:21.069 of the most destructive forces a leveraged economy 00:03:21.069 --> 00:03:23.969 can possibly face. We need to understand that 00:03:23.969 --> 00:03:27.009 this isn't just theory. The entire economic policy 00:03:27.009 --> 00:03:30.949 framework of the last, what, 90 years, from Keynesian 00:03:30.949 --> 00:03:33.990 stimulus to modern quantitative easing, is a 00:03:33.990 --> 00:03:36.289 direct result of trying to find ways to actively 00:03:36.289 --> 00:03:38.969 prevent this spiral from ever taking hold. Because 00:03:38.969 --> 00:03:41.409 history shows it doesn't just fix itself. It 00:03:41.409 --> 00:03:43.530 doesn't fix itself quickly enough. And the damage 00:03:43.530 --> 00:03:45.250 it does in the meantime can be catastrophic. 00:03:45.469 --> 00:03:48.289 That sets the stage perfectly. So if the spiral 00:03:48.289 --> 00:03:51.650 is the scary destination, let's look at how we 00:03:51.650 --> 00:03:53.349 even get there. We're moving into the core mechanics 00:03:53.349 --> 00:03:56.530 now. How does this entire massive economic machine 00:03:56.530 --> 00:03:59.289 start tipping into a deflationary state in the 00:03:59.289 --> 00:04:01.900 first place? Fundamentally, deflation happens 00:04:01.900 --> 00:04:05.560 when there's a persistent imbalance. An imbalance 00:04:05.560 --> 00:04:08.680 between the sheer volume of production and the 00:04:08.680 --> 00:04:10.659 amount of money available to actually buy that 00:04:10.659 --> 00:04:14.180 production. Or, just as importantly, how quickly 00:04:14.180 --> 00:04:16.199 that money is moving through the system. The 00:04:16.199 --> 00:04:19.220 velocity of money. Exactly. Your sources outline 00:04:19.220 --> 00:04:21.339 the general causes, which you can really boil 00:04:21.339 --> 00:04:24.160 down to three broad categories. Okay, walk us 00:04:24.160 --> 00:04:26.180 through those fundamental drivers. So first, 00:04:26.379 --> 00:04:29.660 you have high supply. This just means X. production 00:04:29.660 --> 00:04:31.639 relative to what people are actually demanding. 00:04:31.939 --> 00:04:35.160 If manufacturers flood the market with cars or 00:04:35.160 --> 00:04:38.040 TVs, prices have to fall to clear that inventory. 00:04:38.300 --> 00:04:40.860 Makes sense. Too much stuff. Second, you've got 00:04:40.860 --> 00:04:43.579 low demand. This is the flip side. Consumption 00:04:43.579 --> 00:04:46.579 just decreases. Maybe it's due to fear, uncertainty 00:04:46.579 --> 00:04:48.879 about the future, a shock to household income 00:04:48.879 --> 00:04:51.680 like mass layoffs. People just stop buying things 00:04:51.680 --> 00:04:54.220 and businesses have no choice but to cut prices 00:04:54.220 --> 00:04:56.300 to try and entice them back. And the third one, 00:04:56.360 --> 00:04:58.439 you said it's often the most dangerous. It is. 00:04:58.519 --> 00:05:01.480 The third is a decreased money supply. And this 00:05:01.480 --> 00:05:03.779 is usually driven by a credit crunch. Banks just 00:05:03.779 --> 00:05:06.879 stop lending or maybe careless investment leads 00:05:06.879 --> 00:05:08.899 to a flight of capital out of the country. I 00:05:08.899 --> 00:05:10.899 mean, if there's less money chasing the same 00:05:10.899 --> 00:05:12.959 amount of goods, the price of those goods has 00:05:12.959 --> 00:05:15.139 to fall. Right. And you also see it caused by 00:05:15.139 --> 00:05:18.899 things like net capital outflow, some money leaving 00:05:18.899 --> 00:05:22.040 a country or even just. Really intense competition 00:05:22.040 --> 00:05:24.579 forcing price wars. All of those feed into it. 00:05:24.579 --> 00:05:26.959 They all disrupt that core balance. I get the 00:05:26.959 --> 00:05:29.220 supply and demand side, but this is where that 00:05:29.220 --> 00:05:31.959 central paradox really hits me. The sources call 00:05:31.959 --> 00:05:35.139 it the learner's dilemma. If prices are falling, 00:05:35.279 --> 00:05:37.620 wouldn't the rational response for me as a consumer 00:05:37.620 --> 00:05:40.680 be to rush out and grab those bargains? Why does 00:05:40.680 --> 00:05:43.759 it cause consumption to stall? Because consumers, 00:05:43.959 --> 00:05:46.600 when they're facing systemic deflation, are rational 00:05:46.600 --> 00:05:49.300 at the individual level. But their collective 00:05:49.300 --> 00:05:51.759 rationality leads to a completely irrational 00:05:51.759 --> 00:05:54.959 economic outcome. Think about it this way. If 00:05:54.959 --> 00:05:56.699 you're shopping for a new refrigerator today, 00:05:56.779 --> 00:05:58.860 and you are absolutely convinced that that same 00:05:58.860 --> 00:06:01.199 refrigerator will be 5 % cheaper six months from 00:06:01.199 --> 00:06:04.529 now, what do you do? I wait. A hundred percent. 00:06:04.629 --> 00:06:07.089 Why wouldn't I? You wait. And if millions of 00:06:07.089 --> 00:06:09.230 people wait on buying new cars, new equipment, 00:06:09.410 --> 00:06:13.170 real estate, durable goods, that simple rational 00:06:13.170 --> 00:06:15.829 decision creates a massive collective problem. 00:06:16.009 --> 00:06:17.970 It kills demand in the present. It completely 00:06:17.970 --> 00:06:21.089 kills it. That waiting drastically reduces aggregate 00:06:21.089 --> 00:06:23.529 demand right now. This idles productive capacity. 00:06:24.069 --> 00:06:26.810 Factories slow down. It reduces corporate investment 00:06:26.810 --> 00:06:30.009 because, well. Future profits look bleak. And 00:06:30.009 --> 00:06:32.250 that reduction in demand then forces companies 00:06:32.250 --> 00:06:35.009 to drop their prices even further to try and 00:06:35.009 --> 00:06:37.740 sell anything at all. That's terrifying. It really 00:06:37.740 --> 00:06:40.339 is a self -fulfilling prophecy. My totally rational 00:06:40.339 --> 00:06:42.600 choice to save a few hundred dollars by waiting 00:06:42.600 --> 00:06:45.060 becomes the very force that reduces my neighbor's 00:06:45.060 --> 00:06:47.540 income, which forces him to wait, and so on and 00:06:47.540 --> 00:06:50.100 so on. Precisely. That is the engine of the vicious 00:06:50.100 --> 00:06:52.839 cycle. And this behavior, this waiting, leads 00:06:52.839 --> 00:06:55.199 directly to the problem of hoarding and what 00:06:55.199 --> 00:06:57.720 economists call the liquidity trap. Okay, explain 00:06:57.720 --> 00:07:00.160 that connection for us. Why is deflation linked 00:07:00.160 --> 00:07:02.800 so closely to risk aversion and hoarding cash? 00:07:03.339 --> 00:07:05.720 Because when money itself is increasing in value 00:07:05.720 --> 00:07:08.339 when the cash under your mattress is actually 00:07:08.339 --> 00:07:12.259 yielding a positive real return just by sitting 00:07:12.259 --> 00:07:15.100 there holding cash becomes an incredibly safe 00:07:15.100 --> 00:07:18.180 and again highly rational investment strategy 00:07:18.180 --> 00:07:20.860 for the individual. So doing nothing is the best 00:07:20.860 --> 00:07:23.740 investment. It becomes the safest and best investment. 00:07:23.860 --> 00:07:26.899 If you can get a guaranteed, say, 2 % or 3 % 00:07:26.899 --> 00:07:29.379 real return just by holding cash and waiting 00:07:29.379 --> 00:07:32.220 for prices to drop, why would you risk your money 00:07:32.220 --> 00:07:35.300 on a new factory, a new business, or a volatile 00:07:35.300 --> 00:07:38.180 stock market? The risk -reward calculation gets 00:07:38.180 --> 00:07:41.160 completely warped. So the economy suffers a massive 00:07:41.160 --> 00:07:43.439 loss of faith in any kind of productive investment. 00:07:44.040 --> 00:07:47.160 Cash is king because cash itself is appreciating. 00:07:47.420 --> 00:07:49.800 Correct. And this is what ties the central bank's 00:07:49.800 --> 00:07:52.639 hands. Their main tool, their primary lever, 00:07:52.800 --> 00:07:55.560 is lowering the short term interest rate to incentivize 00:07:55.560 --> 00:07:57.740 borrowing and spending. But once that rate hits 00:07:57.740 --> 00:08:00.639 zero, they enter the dreaded liquidity trap. 00:08:00.879 --> 00:08:02.560 They've run out of road. They run out of road. 00:08:02.660 --> 00:08:05.319 The central bank can't normally charge a significantly 00:08:05.319 --> 00:08:07.819 negative interest rate on the cash that banks 00:08:07.819 --> 00:08:09.560 hold in their reserves. Because people would 00:08:09.560 --> 00:08:11.939 just pull it out. They just pull it out physically. 00:08:12.199 --> 00:08:14.000 I mean, why keep your money in a bank that charges 00:08:14.000 --> 00:08:15.560 you for it when you can just stick it in a vault? 00:08:15.639 --> 00:08:18.120 It completely breaks them. model. So if the nominal 00:08:18.120 --> 00:08:21.399 interest rate is zero, but deflation is running 00:08:21.399 --> 00:08:25.199 at, say, 2%, the real interest rate, what borrowers 00:08:25.199 --> 00:08:28.000 are actually paying back in real terms, is still 00:08:28.000 --> 00:08:30.899 a positive 2%. That's it. The central bank has 00:08:30.899 --> 00:08:33.100 run out of ammunition to make borrowing any cheaper. 00:08:33.460 --> 00:08:36.419 Zero interest often fails to stimulate the economy 00:08:36.419 --> 00:08:39.340 adequately because the real cost of debt remains 00:08:39.340 --> 00:08:41.919 stubbornly high. And what about in a globalized 00:08:41.919 --> 00:08:44.440 world? Does that add another wrinkle? It adds 00:08:44.440 --> 00:08:46.960 a huge wrinkle. In an open economy, this zero 00:08:46.960 --> 00:08:49.100 rate environment encourages what's known as a 00:08:49.100 --> 00:08:52.559 carry trade. Investors borrow money at zero or 00:08:52.559 --> 00:08:55.340 near zero rates in the deflating country, let's 00:08:55.340 --> 00:08:57.679 say Japan, and then they invest it somewhere 00:08:57.679 --> 00:09:00.340 else, somewhere with a higher, safer return. 00:09:00.600 --> 00:09:02.179 So the money just leaves the country that needs 00:09:02.179 --> 00:09:05.600 it most. It flees. Now, this does devalue the 00:09:05.600 --> 00:09:08.379 deflating country's currency, which makes imports 00:09:08.379 --> 00:09:10.620 more expensive and can help a little with inflation. 00:09:10.879 --> 00:09:13.360 But it doesn't necessarily stimulate domestic 00:09:13.360 --> 00:09:16.240 exports enough to compensate for the overwhelming 00:09:16.240 --> 00:09:18.820 disincentive for people inside the country to 00:09:18.820 --> 00:09:21.740 spend or invest. The hoarding continues and the 00:09:21.740 --> 00:09:24.080 economy just remains stuck in that trap. Now 00:09:24.080 --> 00:09:25.960 that we really understand the mechanics of the 00:09:25.960 --> 00:09:28.960 spiral, let's explore how the sources categorize 00:09:28.960 --> 00:09:32.019 deflation. It seems it's not just one simple 00:09:32.019 --> 00:09:35.100 event, but there are, what, six distinct faces 00:09:35.100 --> 00:09:38.039 based on its root cause. We should probably start 00:09:38.039 --> 00:09:39.980 with the really strange one, the one that sounds 00:09:39.980 --> 00:09:43.820 almost good, growth deflation. Yes, growth deflation 00:09:43.820 --> 00:09:46.220 is the ultimate paradox. It's really the only 00:09:46.220 --> 00:09:48.500 type that economists might not immediately panic 00:09:48.500 --> 00:09:50.200 about, though, while they still fundamentally 00:09:50.200 --> 00:09:52.919 prefer mild positive inflation. Why is it different? 00:09:53.120 --> 00:09:55.419 This type is defined as an enduring decrease 00:09:55.419 --> 00:09:58.340 in the real cost of goods and services. And it's 00:09:58.340 --> 00:10:01.279 driven not by a collapse in demand, but by staggering 00:10:01.279 --> 00:10:03.600 technological progress and hyper competition. 00:10:03.919 --> 00:10:06.820 And the crucial difference here is the productivity 00:10:06.820 --> 00:10:09.700 gains are so enormous that they actually offset 00:10:09.700 --> 00:10:12.240 that impulse to delay purchases. Is that it? 00:10:12.299 --> 00:10:14.919 That's the idea. People still buy because the 00:10:14.919 --> 00:10:16.960 goods are so much cheaper and so much better 00:10:16.960 --> 00:10:19.379 in quality than they were before. The supply 00:10:19.379 --> 00:10:22.799 curve just shifts outward massively. Is there 00:10:22.799 --> 00:10:24.899 a historical example of this actually happening? 00:10:25.059 --> 00:10:27.960 Oh, yes. The key historical example is the structural 00:10:27.960 --> 00:10:31.220 deflation that we saw from the 1870s right up 00:10:31.220 --> 00:10:34.100 until the major economic upswing that began around 00:10:34.100 --> 00:10:37.299 1895. What was going on then? What drove that 00:10:37.299 --> 00:10:39.730 specific episode? It was the second industrial 00:10:39.730 --> 00:10:42.590 revolution. You had phenomenal gains in productivity 00:10:42.590 --> 00:10:45.429 from new mass manufacturing techniques, enormous 00:10:45.429 --> 00:10:48.350 economies of scale. And this is critical, dramatically 00:10:48.350 --> 00:10:50.950 reduced transportation costs with the global 00:10:50.950 --> 00:10:53.690 expansion of railroads and steamships. So it 00:10:53.690 --> 00:10:55.330 became cheaper to make things and cheaper to 00:10:55.330 --> 00:10:58.759 move them. Massively cheaper. This led to oversupplied 00:10:58.759 --> 00:11:01.000 markets and constant competitive price cuts. 00:11:01.240 --> 00:11:03.840 An American economist, David A. Wells, writing 00:11:03.840 --> 00:11:07.220 in 1890, he documented this process extensively. 00:11:07.519 --> 00:11:10.039 He argued that the reduction in prices was directly 00:11:10.039 --> 00:11:12.700 attributable to these massive technology driven 00:11:12.700 --> 00:11:15.860 efficiency improvements. It was a complete structural 00:11:15.860 --> 00:11:18.980 repricing of global commerce. That makes perfect 00:11:18.980 --> 00:11:20.879 sense for that era, which was largely on a gold 00:11:20.879 --> 00:11:23.559 standard. But your sources contrast this with 00:11:23.559 --> 00:11:27.000 the post -World War II era. We had incredible 00:11:27.000 --> 00:11:29.759 productivity gains in the 50s and 60s, but we 00:11:29.759 --> 00:11:32.809 didn't see deflation. Why the difference? That's 00:11:32.809 --> 00:11:35.070 a critical insight for understanding modern policy. 00:11:35.269 --> 00:11:37.509 The 19th century economy was largely constrained 00:11:37.509 --> 00:11:39.929 by the gold standard. This meant the money supply 00:11:39.929 --> 00:11:42.769 was relatively rigid. It was tied to the physical 00:11:42.769 --> 00:11:45.529 stock of gold that a country held. So when productivity 00:11:45.529 --> 00:11:48.049 surged, those gains had nowhere to go but to 00:11:48.049 --> 00:11:50.169 drive prices down. The amount of money was fixed, 00:11:50.169 --> 00:11:52.110 but the amount of stuff was exploding. Exactly. 00:11:52.450 --> 00:11:55.950 But after the 1930s and certainly after the world 00:11:55.950 --> 00:11:59.049 moved to fiat currency systems, central banks 00:11:59.049 --> 00:12:01.610 gained the flexibility to actively manage the 00:12:01.610 --> 00:12:04.990 money supply. So when productivity surged after 00:12:04.990 --> 00:12:08.769 WWII, central banks could and did expand the 00:12:08.769 --> 00:12:10.850 money supply enough to keep inflation positive, 00:12:10.970 --> 00:12:14.110 even if it was low. They prevented those cost 00:12:14.110 --> 00:12:16.730 cuts from ever tipping the economy into outright 00:12:16.730 --> 00:12:19.049 deflation. So they deliberately target something 00:12:19.049 --> 00:12:21.200 like 2 percent inflation. to give themselves 00:12:21.200 --> 00:12:23.820 a safety buffer. That's precisely why they do 00:12:23.820 --> 00:12:26.539 it. It's a buffer against this deflationary risk. 00:12:26.779 --> 00:12:30.340 So growth deflation is possible, but modern policy 00:12:30.340 --> 00:12:32.399 is essentially designed to prevent it from becoming 00:12:32.399 --> 00:12:35.159 negative deflation. OK, that makes sense. Let's 00:12:35.159 --> 00:12:37.220 shift to the types that actively crash the system, 00:12:37.360 --> 00:12:40.139 starting with bank credit deflation. This is 00:12:40.139 --> 00:12:43.019 a classic supply side credit contraction. It 00:12:43.019 --> 00:12:44.899 happens when the supply of bank credit suddenly 00:12:44.899 --> 00:12:47.529 dries up. This can happen from a wave of mass 00:12:47.529 --> 00:12:49.549 bank failures, which literally removes money 00:12:49.549 --> 00:12:52.169 from circulation. Or more often today, it's caused 00:12:52.169 --> 00:12:54.350 by a sudden, sharp increase in the perceived 00:12:54.350 --> 00:12:56.669 risk of defaults. So banks just get scared to 00:12:56.669 --> 00:12:59.669 lend. They get very scared. If banks believe 00:12:59.669 --> 00:13:01.950 that corporate loans or consumer mortgages won't 00:13:01.950 --> 00:13:04.570 be repaid, they immediately tighten their lending 00:13:04.570 --> 00:13:08.539 standards. They restrict credit. And since new 00:13:08.539 --> 00:13:11.000 credit is how the modern financial system generates 00:13:11.000 --> 00:13:13.759 new money, when that pipeline stops, the money 00:13:13.759 --> 00:13:16.460 supply contracts. And that leads us logically 00:13:16.460 --> 00:13:19.879 to the most famous theory of all debt deflation, 00:13:20.039 --> 00:13:22.480 which is I mean, it's impossible to talk about 00:13:22.480 --> 00:13:24.240 without mentioning Irving Fisher. Absolutely. 00:13:24.360 --> 00:13:26.840 The economist Irving Fisher developed this theory 00:13:26.840 --> 00:13:29.980 in 1933 while he was trying to make sense of 00:13:29.980 --> 00:13:32.470 the trauma of the Great Depression. His idea 00:13:32.470 --> 00:13:34.990 of debt deflation is associated with the end 00:13:34.990 --> 00:13:38.450 of massive long -term credit cycles. Think of 00:13:38.450 --> 00:13:40.990 the huge asset bubbles of the 1920s. What's the 00:13:40.990 --> 00:13:43.330 core mechanism? His theory states that when a 00:13:43.330 --> 00:13:46.690 massive credit bubble bursts, individuals, companies, 00:13:46.830 --> 00:13:48.970 attempt to pay down their debt at the same time 00:13:48.970 --> 00:13:52.129 in a desperate bid for solvency. A mass deleveraging 00:13:52.129 --> 00:13:55.659 event. Yes. And this mass effort to deleverage 00:13:55.659 --> 00:13:58.620 crushes spending. It reduces the velocity of 00:13:58.620 --> 00:14:02.059 money and it forces fire sales of assets. People 00:14:02.059 --> 00:14:05.100 have to sell anything they can to get cash. These 00:14:05.100 --> 00:14:07.799 asset sales drive prices down across the board 00:14:07.799 --> 00:14:10.419 stocks, real estate commodities. The falling 00:14:10.419 --> 00:14:13.360 prices then increase the real burden of whatever 00:14:13.360 --> 00:14:16.419 debt is left, which forces more people to sell 00:14:16.419 --> 00:14:19.100 assets and liquidate, reinforcing that downward 00:14:19.100 --> 00:14:21.220 cycle. That's another one of those vicious feedback 00:14:21.220 --> 00:14:24.379 loops. Fisher called it the paradox of thrift 00:14:24.379 --> 00:14:27.259 taken to its absolute extreme. The more everyone 00:14:27.259 --> 00:14:29.480 tries to save and pay down debt to fix their 00:14:29.480 --> 00:14:32.039 own situation, the worse the entire system gets. 00:14:32.139 --> 00:14:33.840 That sounds like a powerful multiplier effect. 00:14:34.200 --> 00:14:36.360 Now let's look at this from the monetarist view 00:14:36.360 --> 00:14:39.259 money supply side deflation. Right. From a strict 00:14:39.259 --> 00:14:41.620 monetarist perspective, like Milton Friedman's, 00:14:41.700 --> 00:14:44.639 deflation is caused by one of two things. Either 00:14:44.639 --> 00:14:46.840 a reduction in the total quantity of money supply 00:14:46.840 --> 00:14:49.929 per person. Or a drop in the velocity of money. 00:14:50.009 --> 00:14:52.190 And velocity is just how fast money is changing 00:14:52.190 --> 00:14:54.570 hands. It's the rate at which money is exchanged 00:14:54.570 --> 00:14:56.990 from one transaction to another. If people get 00:14:56.990 --> 00:14:59.210 scared and stop spending, if they just hold on 00:14:59.210 --> 00:15:01.909 to their cash, velocity collapses. The sources 00:15:01.909 --> 00:15:04.309 use the early U .S. experience before the Civil 00:15:04.309 --> 00:15:06.470 War to really illustrate that scarcity of money 00:15:06.470 --> 00:15:09.470 supply. The early U .S. provides a powerful, 00:15:09.610 --> 00:15:12.490 tangible example of what an unstable money supply 00:15:12.490 --> 00:15:16.309 can do. Before 1862, the U .S. had no single 00:15:16.309 --> 00:15:18.529 national currency and suffered from a severe 00:15:18.529 --> 00:15:21.429 lack of fiscal coinage. The vast majority of 00:15:21.429 --> 00:15:24.269 commerce relied on bank notes issued by literally 00:15:24.269 --> 00:15:27.190 thousands of individual private banks. And the 00:15:27.190 --> 00:15:30.149 value of those notes, it depended entirely on 00:15:30.149 --> 00:15:32.129 the solvency of the bank that issued it. A system 00:15:32.129 --> 00:15:34.669 built entirely on trust. A very fragile trust. 00:15:34.950 --> 00:15:37.759 During financial panic, like the ones in 1818 00:15:37.759 --> 00:15:41.279 or 1837 banks would fail en masse. When a bank 00:15:41.279 --> 00:15:43.740 failed, its notes became either completely worthless 00:15:43.740 --> 00:15:45.919 or were heavily discounted by merchants relative 00:15:45.919 --> 00:15:48.480 to gold or silver. So this wasn't just a drop 00:15:48.480 --> 00:15:51.299 in velocity. It was a physical, measurable shrinking 00:15:51.299 --> 00:15:53.860 of the usable money supply, sometimes overnight. 00:15:54.100 --> 00:15:56.559 And that directly caused these steep deflationary 00:15:56.559 --> 00:15:59.139 periods as money became incredibly scarce and 00:15:59.139 --> 00:16:01.720 valuable. That's a system where if faith is lost, 00:16:01.960 --> 00:16:04.960 the entire circulatory system just fails. It 00:16:04.960 --> 00:16:07.559 does. And while modern central banking uses a 00:16:07.559 --> 00:16:09.919 far more complex definition of the money base, 00:16:10.120 --> 00:16:13.039 that historical inverse correlation is fascinating. 00:16:13.740 --> 00:16:15.840 Historically, a decrease in the monetary base 00:16:15.840 --> 00:16:18.039 sometimes led to an increase in money velocity 00:16:18.039 --> 00:16:20.379 as people race to spend less valuable money. 00:16:20.659 --> 00:16:23.639 But in modern crises, we usually see the absolute 00:16:23.639 --> 00:16:26.580 worst case scenario, both the supply of money 00:16:26.580 --> 00:16:29.559 and its velocity drop at the same time, which 00:16:29.559 --> 00:16:32.120 just multiplies the deflationary force. This 00:16:32.120 --> 00:16:34.519 brings us to credit deflation, which feels like 00:16:34.519 --> 00:16:37.029 the drop. of most of the crises we've seen recently, 00:16:37.149 --> 00:16:39.389 and it's usually tied to central bank policy. 00:16:39.590 --> 00:16:41.730 This is often the initial trigger. It starts 00:16:41.730 --> 00:16:43.769 when a central bank raises interest rates, maybe 00:16:43.769 --> 00:16:46.490 aggressively, to fight high inflation or to try 00:16:46.490 --> 00:16:49.389 and pop an asset bubble. In our modern high leverage 00:16:49.389 --> 00:16:52.110 economy, that higher rate immediately slows down 00:16:52.110 --> 00:16:54.269 lending. The cost of borrowing goes up. It goes 00:16:54.269 --> 00:16:56.830 up. So less lending means less new money being 00:16:56.830 --> 00:16:59.830 created. Confidence falls, velocity weakens, 00:16:59.830 --> 00:17:02.789 and aggregate demand just plummets. Businesses 00:17:02.789 --> 00:17:04.890 suddenly face a supply glut. as all their buyers 00:17:04.890 --> 00:17:07.890 vanish, forcing them to slash prices. And where 00:17:07.890 --> 00:17:10.589 does this become the true undeniable spiral? 00:17:10.849 --> 00:17:13.269 The spiral connection is reached when falling 00:17:13.269 --> 00:17:16.809 prices push businesses below their cost of production 00:17:16.809 --> 00:17:19.859 or critically. below the amount they need to 00:17:19.859 --> 00:17:22.519 service their debt. So they have to start liquidating 00:17:22.519 --> 00:17:24.960 assets. And the banks, which suddenly own all 00:17:24.960 --> 00:17:27.220 this foreclosed collateral homes, factories, 00:17:27.460 --> 00:17:31.240 equipment, they receive these dramatically devalued 00:17:31.240 --> 00:17:33.019 assets. And if the banks try to sell them all 00:17:33.019 --> 00:17:35.440 at once. They flood the market, which makes the 00:17:35.440 --> 00:17:38.930 deflation even worse. So the sources note that 00:17:38.930 --> 00:17:41.390 to prevent this glut and to, frankly, keep up 00:17:41.390 --> 00:17:44.089 appearances of solvency, banks in places like 00:17:44.089 --> 00:17:47.250 Japan, America during the 2008 crisis and Spain, 00:17:47.450 --> 00:17:50.069 they often just withhold these non -performing 00:17:50.069 --> 00:17:52.450 assets from sale. But that has its own consequences. 00:17:52.730 --> 00:17:54.769 It does. It means they can't clear their balance 00:17:54.769 --> 00:17:56.970 sheets, which forces them to restrict new lending, 00:17:57.150 --> 00:17:59.769 which further kills demand. It's a paralyzing 00:17:59.769 --> 00:18:02.470 impasse. This sounds strikingly similar to those 00:18:02.470 --> 00:18:04.849 U .S. 19th century financial cycles we talked 00:18:04.849 --> 00:18:07.460 about. It is the exact same fundamental mechanism, 00:18:07.700 --> 00:18:10.180 just in different clothes. The sources detail 00:18:10.180 --> 00:18:13.200 how in the 19th century U .S., inflation and 00:18:13.200 --> 00:18:15.140 deflation correlated with these capital flows. 00:18:15.579 --> 00:18:18.059 Money was loaned heavily from the financial centers 00:18:18.059 --> 00:18:19.980 in the Northeast out to the commodity regions 00:18:19.980 --> 00:18:22.640 in the West and South. Prices would rise during 00:18:22.640 --> 00:18:24.680 the lending boom. And then the crash would come. 00:18:25.160 --> 00:18:28.440 When the panics hit, like in 1818 and 1839, the 00:18:28.440 --> 00:18:30.720 banks in the Northeast would call in those loans 00:18:30.720 --> 00:18:33.839 sharply. That sudden systemic credit contraction 00:18:33.839 --> 00:18:37.099 caused commodity prices to crash, which directly 00:18:37.099 --> 00:18:39.619 triggered deflation. And the Great Depression 00:18:39.619 --> 00:18:42.480 amplified this by adding that layer of global 00:18:42.480 --> 00:18:45.740 trade rigidity. Precisely. The deflation of the 00:18:45.740 --> 00:18:48.779 Great Depression was caused by this massive overcapacity 00:18:48.779 --> 00:18:51.200 hitting an immovable wall of severely contracted 00:18:51.200 --> 00:18:54.980 demand. And it was amplified by huge global policy 00:18:54.980 --> 00:18:57.680 errors like the Smoot -Hawley parafact in the 00:18:57.680 --> 00:19:00.240 U .S., which just decimated international trade. 00:19:00.460 --> 00:19:03.059 It removed a crucial source of external demand 00:19:03.059 --> 00:19:05.720 and triggered the waves of bank failures and 00:19:05.720 --> 00:19:07.920 credit contraction that followed. OK, finally, 00:19:08.000 --> 00:19:09.819 we have a type of deflation that's externally 00:19:09.819 --> 00:19:13.480 imposed. Currency pegs and monetary unions. This 00:19:13.480 --> 00:19:15.769 one. is crucial for understanding global economics 00:19:15.769 --> 00:19:19.630 today. If country A pegs its currency to country 00:19:19.630 --> 00:19:22.930 B and country B has much higher productivity 00:19:22.930 --> 00:19:26.109 growth, country A suddenly becomes uncompetitive. 00:19:26.309 --> 00:19:28.970 Its prices are relatively too high. And since 00:19:28.970 --> 00:19:30.990 they can't devalue their currency because of 00:19:30.990 --> 00:19:33.390 the peg, they have to adjust internally. So if 00:19:33.390 --> 00:19:35.200 they can't change the exchange rate. They're 00:19:35.200 --> 00:19:37.900 forced to change their internal costs. Yes, they 00:19:37.900 --> 00:19:41.279 must lower their factor prices. That means wages, 00:19:41.359 --> 00:19:43.559 rent and other internal production costs have 00:19:43.559 --> 00:19:46.619 to come down to maintain competitiveness. Cutting 00:19:46.619 --> 00:19:49.559 wages and input costs fosters a deflationary 00:19:49.559 --> 00:19:52.220 environment domestically. It's a very painful 00:19:52.220 --> 00:19:54.299 process required to stay aligned with the foreign 00:19:54.299 --> 00:19:57.359 currency. We saw this exact mechanism play out 00:19:57.359 --> 00:19:59.819 across certain eurozone member states after 2008 00:19:59.819 --> 00:20:02.380 and in Hong Kong after the Asian financial crisis. 00:20:02.640 --> 00:20:05.539 They are in effect importing. deflation by fixing 00:20:05.539 --> 00:20:07.819 their exchange rate to a stronger more productive 00:20:07.819 --> 00:20:10.259 currency block now that we've locked down the 00:20:10.259 --> 00:20:13.039 how of deflation let's pivot to the catastrophic 00:20:13.039 --> 00:20:16.019 what happens next the actual economic consequences 00:20:16.019 --> 00:20:18.900 the sources really stress that the pain of deflation 00:20:18.900 --> 00:20:21.619 centers squarely on the borrower It does because 00:20:21.619 --> 00:20:24.180 deflation is truly welcome only in a system with 00:20:24.180 --> 00:20:26.799 very little debt. And since modern economies 00:20:26.799 --> 00:20:30.019 are fundamentally debt driven, deflation amplifies 00:20:30.019 --> 00:20:32.980 what the sources call the sting of debt. When 00:20:32.980 --> 00:20:35.819 prices are falling, every future debt payment 00:20:35.819 --> 00:20:38.140 represents a greater amount of real purchasing 00:20:38.140 --> 00:20:40.279 power than it did when you originally took out 00:20:40.279 --> 00:20:42.630 that debt. Let's use that specific example from 00:20:42.630 --> 00:20:44.730 the sources to make this really tangible. If 00:20:44.730 --> 00:20:48.009 deflation is averaging 10 % year, which it did 00:20:48.009 --> 00:20:49.789 during the worst period of the Great Depression, 00:20:50.109 --> 00:20:52.390 what does that actually do to an ordinary loan? 00:20:52.690 --> 00:20:55.990 It makes that loan absolutely toxic. A 10 % annual 00:20:55.990 --> 00:20:58.349 deflation rate meant that even if a bank offered 00:20:58.349 --> 00:21:01.269 you a loan with 0 % interest. An interest -free 00:21:01.269 --> 00:21:03.369 loan. An interest -free loan. You are still paying 00:21:03.369 --> 00:21:05.549 back money that was effectively 10 % more valuable 00:21:05.549 --> 00:21:08.450 each year. That is a 10 % real interest rate, 00:21:08.529 --> 00:21:10.519 regardless of the nominal rate. rate written 00:21:10.519 --> 00:21:12.859 on the paper. And that realization just freezes 00:21:12.859 --> 00:21:15.900 lending. It kills all economic activity and it 00:21:15.900 --> 00:21:18.700 pushes otherwise solvent businesses into insolvency. 00:21:18.839 --> 00:21:20.819 Wow. That really changes the way I think about 00:21:20.819 --> 00:21:24.240 credit. Even a zero nominal rate is incredibly 00:21:24.240 --> 00:21:27.039 expensive in that environment. And this circles 00:21:27.039 --> 00:21:29.440 us back perfectly to the zero bound problem. 00:21:29.579 --> 00:21:32.359 It does. When central banks hit that zero lower 00:21:32.359 --> 00:21:35.019 bound on short term nominal interest rates, they've 00:21:35.019 --> 00:21:37.180 exhausted their conventional means of easing 00:21:37.180 --> 00:21:40.640 policy. Deflation then guarantees that the real 00:21:40.640 --> 00:21:43.079 interest rate, the rate that truly matters to 00:21:43.079 --> 00:21:46.400 borrowers, remains significantly positive. It 00:21:46.400 --> 00:21:48.819 keeps debt servicing difficult and it actively 00:21:48.819 --> 00:21:51.140 restricts new investment. So monetary policy 00:21:51.140 --> 00:21:53.799 just stops working. It stops working. And this 00:21:53.799 --> 00:21:56.279 is why during severe deflation, political and 00:21:56.279 --> 00:21:58.700 fiscal measures, particularly debt restructuring 00:21:58.700 --> 00:22:00.960 or massive government spending, become the only 00:22:00.960 --> 00:22:03.220 tools left in the toolbox. OK, let's look at 00:22:03.220 --> 00:22:05.559 the flip side. Savings and investment. We talked 00:22:05.559 --> 00:22:08.059 about hoarding cash. But how does deflation specifically 00:22:08.059 --> 00:22:11.099 discourage productive investment, even if the 00:22:11.099 --> 00:22:13.700 cost of capital is near zero? It's purely about 00:22:13.700 --> 00:22:16.390 the expectation of future profit. Investment 00:22:16.390 --> 00:22:18.710 is all about betting capital today on future 00:22:18.710 --> 00:22:21.750 returns. So if I, as a factory owner, anticipate 00:22:21.750 --> 00:22:23.849 that the widgets I produce next year will sell 00:22:23.849 --> 00:22:26.650 for 3 % less than they do today, the incentive 00:22:26.650 --> 00:22:29.250 to borrow money, buy new equipment and expand 00:22:29.250 --> 00:22:32.410 my capacity just evaporates. Why bother? The 00:22:32.410 --> 00:22:35.190 net return on my investment is being eroded by 00:22:35.190 --> 00:22:38.210 guaranteed falling prices. And this results in 00:22:38.210 --> 00:22:40.170 a pervasive discouragement of private investment 00:22:40.170 --> 00:22:42.809 across the entire economy and a catastrophic 00:22:42.809 --> 00:22:45.400 collapse in aggregate demand. And as you said, 00:22:45.519 --> 00:22:48.759 holding money is actively rewarded. It is. This 00:22:48.759 --> 00:22:51.039 is the behavior that mainstream economists find 00:22:51.039 --> 00:22:54.859 so dangerous. While, you know, the Austrian school 00:22:54.859 --> 00:22:57.339 might see some deflation as a necessary correction 00:22:57.339 --> 00:22:59.960 of malinvestment, the vast majority of economists 00:22:59.960 --> 00:23:02.279 agree with that. Quote, your sources provided 00:23:02.279 --> 00:23:05.220 from Friedrich Hayek. He said it is agreed that 00:23:05.220 --> 00:23:07.480 hoarding money is deflationary in its effects. 00:23:07.980 --> 00:23:10.240 No one thinks that deflation is in itself desirable. 00:23:10.460 --> 00:23:12.599 So even a libertarian champion of free markets 00:23:12.599 --> 00:23:14.759 acknowledged that this psychological incentive 00:23:14.759 --> 00:23:18.140 to hoard cash just destroys the economy's circulatory 00:23:18.140 --> 00:23:21.099 system. He did. It paralyzes everything. The 00:23:21.099 --> 00:23:23.319 sources make a very sharp distinction between 00:23:23.319 --> 00:23:26.500 the effects of deflation and its opposite, inflation, 00:23:26.839 --> 00:23:30.559 specifically on wealth transfer. This feels like 00:23:30.559 --> 00:23:32.259 a crucial nugget of knowledge for our listeners. 00:23:32.730 --> 00:23:35.089 This is the ultimate differentiator that determines 00:23:35.089 --> 00:23:38.470 who wins and who loses. Deflation transfers wealth 00:23:38.470 --> 00:23:40.970 from borrowers and holders of illiquid assets. 00:23:41.369 --> 00:23:44.369 Think farmers with mortgage land or factory owners 00:23:44.369 --> 00:23:47.190 with heavy equipment to savers and holders of 00:23:47.190 --> 00:23:50.089 liquid assets or currency. The system rewards 00:23:50.089 --> 00:23:53.329 holding cash. The inevitable consequence is generalized 00:23:53.329 --> 00:23:56.130 underinvestment. And inflation just completely 00:23:56.130 --> 00:23:58.170 flips that transfer on its head. Absolutely. 00:23:58.529 --> 00:24:01.049 Inflation transfers wealth from currency holders 00:24:01.049 --> 00:24:03.849 and lenders, the savers to borrowers, including 00:24:03.849 --> 00:24:06.349 governments who borrow vast sums of money. The 00:24:06.349 --> 00:24:09.190 system rewards spending immediately. The consequence 00:24:09.190 --> 00:24:12.029 of prolonged high inflation is often overinvestment, 00:24:12.089 --> 00:24:14.349 where capital floods into low -quality projects, 00:24:14.470 --> 00:24:16.630 creating bubbles like the dot -com boom or the 00:24:16.630 --> 00:24:18.630 housing crisis, because everyone is desperate 00:24:18.630 --> 00:24:21.210 to buy something, anything, before their currency 00:24:21.210 --> 00:24:24.980 loses more value. So, to put it simply... Deflation 00:24:24.980 --> 00:24:27.819 leads to stagnation and underinvestment and inflation 00:24:27.819 --> 00:24:30.720 leads to asset bubbles and malinvestment. Both 00:24:30.720 --> 00:24:33.059 are destructive, but in fundamentally different 00:24:33.059 --> 00:24:35.799 ways. Correct. And that's why when we look back 00:24:35.799 --> 00:24:39.599 through history, prolonged severe deflation is 00:24:39.599 --> 00:24:42.259 almost always associated with major economic 00:24:42.259 --> 00:24:45.220 depressions like the Great Depression or the 00:24:45.220 --> 00:24:47.759 late 19th century long depression. OK, let's 00:24:47.759 --> 00:24:50.220 just zoom in on the spiral itself one final time 00:24:50.220 --> 00:24:52.700 to make sure we have fully grasped that positive 00:24:52.700 --> 00:24:55.109 feedback loop. Think of it as a chain reaction. 00:24:55.410 --> 00:24:57.670 It might begin with price drops, maybe due to 00:24:57.670 --> 00:25:00.349 a credit contraction. These price drops immediately 00:25:00.349 --> 00:25:03.349 cut into corporate profit margins, forcing companies 00:25:03.349 --> 00:25:06.190 to engage in lower production or even liquidation. 00:25:06.289 --> 00:25:09.089 Which means layoffs. Which means layoffs. Lower 00:25:09.089 --> 00:25:11.549 production and liquidation mean job losses, which 00:25:11.549 --> 00:25:14.190 translates directly into lower wages and lower 00:25:14.190 --> 00:25:17.430 consumer confidence. Lower wages and less demand 00:25:17.430 --> 00:25:19.869 than guarantee further price drops, which starts 00:25:19.869 --> 00:25:22.250 the entire cycle over again, but from a lower 00:25:22.250 --> 00:25:24.940 base. It is a runaway system where the economic 00:25:24.940 --> 00:25:27.519 depression itself becomes the fuel for an even 00:25:27.519 --> 00:25:30.259 deeper depression. And this is where Irving Fisher's 00:25:30.259 --> 00:25:33.220 theory really bites. Precisely. That feedback 00:25:33.220 --> 00:25:36.859 loop is exactly why his theory that a mass attempt 00:25:36.859 --> 00:25:39.500 to repay debt triggers a price collapse, which 00:25:39.500 --> 00:25:41.420 then increases the real burden of the remaining 00:25:41.420 --> 00:25:45.079 debt, is so terrifying. It means the very act 00:25:45.079 --> 00:25:47.380 of trying to fix your individual financial problem 00:25:47.380 --> 00:25:50.599 makes the collective disaster worse. If deflation 00:25:50.599 --> 00:25:52.920 is this structurally destructive, especially 00:25:52.920 --> 00:25:55.579 in a society as leveraged as ours, then fighting 00:25:55.579 --> 00:25:57.980 it becomes the absolute top priority for central. 00:25:58.059 --> 00:26:01.119 banks and governments. How did policymakers go 00:26:01.119 --> 00:26:02.819 from this old belief that the system would just 00:26:02.819 --> 00:26:06.019 fix itself to developing these modern, almost 00:26:06.019 --> 00:26:08.420 outlandish tools like QE? There was a dramatic 00:26:08.420 --> 00:26:10.519 intellectual shift, and it really started in 00:26:10.519 --> 00:26:13.579 the 1930s. Before that decade, the prevailing 00:26:13.579 --> 00:26:16.200 classical economic view was that deflation, while 00:26:16.200 --> 00:26:18.660 painful, was temporary and self -correcting. 00:26:18.700 --> 00:26:20.980 What was their logic? They believed falling prices 00:26:20.980 --> 00:26:22.799 would eventually increase the real wealth of 00:26:22.799 --> 00:26:24.819 savers, who would then feel richer and spend 00:26:24.819 --> 00:26:27.519 more. They also thought cheaper goods would naturally 00:26:27.519 --> 00:26:29.599 boost demand and the economy would stabilize 00:26:29.599 --> 00:26:32.099 without any external help. It was a very hands 00:26:32.099 --> 00:26:34.720 -off, weighted -out approach. But the sheer persistence 00:26:34.720 --> 00:26:37.940 and depth of the Great Depression clearly shattered 00:26:37.940 --> 00:26:40.779 that belief. It completely shattered it. John 00:26:40.779 --> 00:26:43.200 Maynard Keynes famously argued that the system 00:26:43.200 --> 00:26:45.420 is not self -correcting when you're in a liquidity 00:26:45.420 --> 00:26:48.309 trap. Therefore... Governments and central banks 00:26:48.309 --> 00:26:51.450 have an obligation to actively intervene to boost 00:26:51.450 --> 00:26:54.690 demand. So he was arguing for an active approach. 00:26:54.930 --> 00:26:57.269 Very active. The Keynesian prescription involved 00:26:57.269 --> 00:27:00.430 fiscal tools, aggressive tax cuts or massive 00:27:00.430 --> 00:27:02.869 increases in government spending, often through 00:27:02.869 --> 00:27:05.609 public works and infrastructure projects. At 00:27:05.609 --> 00:27:07.710 the same time, the emerging monetarist school, 00:27:07.970 --> 00:27:10.569 led later by Milton Friedman, focused on monetary 00:27:10.569 --> 00:27:13.930 tools, aggressively expanding demand by lowering 00:27:13.930 --> 00:27:16.049 interest rates to reduce the cost of money and 00:27:16.049 --> 00:27:19.210 force cash. Okay, so let's talk about the modern 00:27:19.210 --> 00:27:21.769 playbook. When nominal rates hit that zero lower 00:27:21.769 --> 00:27:24.549 bound or ZLB, conventional easing is impossible. 00:27:24.970 --> 00:27:27.069 What are the special arrangements that are required 00:27:27.069 --> 00:27:29.690 to overcome that ZLB and force the money supply 00:27:29.690 --> 00:27:32.390 to increase? This is where it gets really unconventional. 00:27:32.809 --> 00:27:35.490 The central bank finds itself unable to lower 00:27:35.490 --> 00:27:37.670 the price of money any further. So they have 00:27:37.670 --> 00:27:39.990 to switch tactics and focus on the quantity of 00:27:39.990 --> 00:27:42.809 money. They require these extraordinary policy 00:27:42.809 --> 00:27:45.269 measures to just flood the system with liquidity, 00:27:45.509 --> 00:27:48.470 even at a zero nominal rate, knowing that the 00:27:48.470 --> 00:27:50.710 real rate is still high because of the deflation. 00:27:51.130 --> 00:27:53.609 They are essentially trying to manufacture inflation 00:27:53.609 --> 00:27:56.890 expectations. And this is where the term quantitative 00:27:56.890 --> 00:28:01.009 easing or QE becomes the dominant phrase in finance. 00:28:01.309 --> 00:28:04.890 QE is the primary modern weapon against persistent 00:28:04.890 --> 00:28:07.930 deflation. It's fundamentally the central bank 00:28:07.930 --> 00:28:10.390 directly setting a target for the quantity of 00:28:10.390 --> 00:28:13.190 money and reserves in the banking system. And 00:28:13.190 --> 00:28:15.650 they achieve this by purchasing financial assets 00:28:15.650 --> 00:28:18.750 and crucially assets that are usually not used 00:28:18.750 --> 00:28:21.430 as bank reserves, like long term government bonds 00:28:21.430 --> 00:28:23.750 or even mortgage backed securities. So they're 00:28:23.750 --> 00:28:25.539 not just lending to banks. They're actively buying 00:28:25.539 --> 00:28:27.839 assets from them. Exactly. They're trying to 00:28:27.839 --> 00:28:29.960 inject massive amounts of liquidity directly 00:28:29.960 --> 00:28:32.460 into the financial system. Help us break down 00:28:32.460 --> 00:28:35.359 the mechanism of QE. I mean, it sounds complex, 00:28:35.519 --> 00:28:38.000 but if the goal is to create inflation, how does 00:28:38.000 --> 00:28:40.460 buying a bunch of mortgages from a bank achieve 00:28:40.460 --> 00:28:43.380 that? It's a massive asset swap. The central 00:28:43.380 --> 00:28:46.859 bank takes these slow, illiquid assets like mortgage 00:28:46.859 --> 00:28:49.220 backed securities off the commercial banks books 00:28:49.220 --> 00:28:52.380 and replaces them with pure cash in the form 00:28:52.380 --> 00:28:55.480 of bank reserves. The theory is twofold. First, 00:28:55.819 --> 00:28:58.480 by buying all these long term bonds, they force 00:28:58.480 --> 00:29:00.720 long term interest rates down across the entire 00:29:00.720 --> 00:29:03.619 economy, which should make investment marginally 00:29:03.619 --> 00:29:06.740 cheaper. Second, they pump the banks so full 00:29:06.740 --> 00:29:08.920 of cash that the hope is the banks will eventually 00:29:08.920 --> 00:29:11.259 be forced to lend that cash out into the real 00:29:11.259 --> 00:29:13.960 economy. That increases the money supply, increases 00:29:13.960 --> 00:29:17.220 velocity and thus creates inflation. The ultimate 00:29:17.220 --> 00:29:20.400 belief seems to be that money. or printing money, 00:29:20.519 --> 00:29:23.519 is powerful enough to overcome any economic hurdle. 00:29:23.720 --> 00:29:26.200 That view was definitively captured by the former 00:29:26.200 --> 00:29:29.259 Federal Reserve Chairman Ben Bernanke. Back in 00:29:29.259 --> 00:29:31.579 2002, he was referencing the Great Depression, 00:29:31.819 --> 00:29:34.539 and he stated unequivocally that, and I'm quoting 00:29:34.539 --> 00:29:37.079 here, sufficient injections of money will ultimately 00:29:37.079 --> 00:29:41.240 always reverse a deflation. The core idea is 00:29:41.240 --> 00:29:43.599 that the power of the printing press is limitless, 00:29:43.660 --> 00:29:46.000 and if you print enough, you can always spark 00:29:46.000 --> 00:29:49.599 demand and confidence. But the sources introduced 00:29:49.599 --> 00:29:52.180 some pretty significant and valid criticisms 00:29:52.180 --> 00:29:54.920 of this idea. This hasn't always been the silver 00:29:54.920 --> 00:29:57.279 bullet that was promised, has it? Not at all. 00:29:57.400 --> 00:29:59.339 And that's the nuance that the listener really 00:29:59.339 --> 00:30:02.019 needs to grasp. We saw that these accommodative 00:30:02.019 --> 00:30:04.519 policies largely failed to spur sufficient demand 00:30:04.519 --> 00:30:07.319 in Japan throughout the 1990s and early 2000s, 00:30:07.319 --> 00:30:09.420 and to some extent in the U .S. following the 00:30:09.420 --> 00:30:12.380 dot -com stock market shock. You can flood the 00:30:12.380 --> 00:30:14.279 banks with reserves, but that doesn't guarantee 00:30:14.279 --> 00:30:16.700 lending if the banks themselves remain risk -averse. 00:30:21.639 --> 00:30:25.420 But you can't make it drink. Precisely. Furthermore, 00:30:25.640 --> 00:30:27.940 we have to address the critique raised by Austrian 00:30:27.940 --> 00:30:30.599 school economists. They contend that sustained 00:30:30.599 --> 00:30:34.700 low real interest rates, even zero nominal rates, 00:30:34.980 --> 00:30:38.039 artificially stimulate asset speculation and 00:30:38.039 --> 00:30:40.259 excessive debt accumulation in the non -financial 00:30:40.259 --> 00:30:42.819 sector. So they'd argue QE isn't solving the 00:30:42.819 --> 00:30:45.339 problem. From their perspective, QE isn't fixing 00:30:45.339 --> 00:30:47.539 the underlying debt problem at all. It's merely 00:30:47.539 --> 00:30:50.579 papering over it and potentially aggravating 00:30:50.579 --> 00:30:53.180 a more severe debt deflation crisis that's waiting 00:30:53.180 --> 00:30:55.650 to happen when those new asset bubbles inevitably 00:30:55.650 --> 00:30:58.730 pop. So rather than fixing the fever, they're 00:30:58.730 --> 00:31:01.009 just delaying the inevitable systemic correction. 00:31:01.250 --> 00:31:03.650 That is the core of their critique. And finally, 00:31:03.710 --> 00:31:06.470 let's just mention the truly experimental tool 00:31:06.470 --> 00:31:09.190 that was deployed after 2008, negative interest 00:31:09.190 --> 00:31:10.869 rates. That sounds like something out of science 00:31:10.869 --> 00:31:13.750 fiction. How does a bank literally charge you 00:31:13.750 --> 00:31:15.950 to hold your money? The idea is to make holding 00:31:15.950 --> 00:31:18.970 cash in bank reserves actively punitive. The 00:31:18.970 --> 00:31:20.829 central bank charges commercial banks a small 00:31:20.829 --> 00:31:22.849 percentage for parking their reserves with them. 00:31:23.069 --> 00:31:25.470 This is meant to force those banks to lend the 00:31:25.470 --> 00:31:27.849 money out, to do something with it, to accelerate 00:31:27.849 --> 00:31:30.329 velocity. Is there a limit to that? There's a 00:31:30.329 --> 00:31:32.630 very firm limit. The rate cannot go too negative, 00:31:32.650 --> 00:31:34.769 maybe only a fraction of a percent, because if 00:31:34.769 --> 00:31:37.190 it does, people and corporations will simply 00:31:37.190 --> 00:31:39.329 withdraw their deposits as physical cash and 00:31:39.329 --> 00:31:41.769 hoard it in vaults. And that would completely 00:31:41.769 --> 00:31:44.089 nullify the central bank's efforts and trigger 00:31:44.089 --> 00:31:46.369 a whole new form of money supply contraction. 00:31:46.789 --> 00:31:48.869 We've established the theories and the tools. 00:31:49.069 --> 00:31:51.789 Now, let's ground all this knowledge in the great 00:31:51.789 --> 00:31:53.809 historical case studies provided in the sources, 00:31:53.930 --> 00:31:56.549 starting with the U .S. experience, where deflation 00:31:56.549 --> 00:31:59.089 was essentially a regular feature of economic 00:31:59.089 --> 00:32:01.170 life before the Federal Reserve was created. 00:32:01.410 --> 00:32:05.049 Indeed. The U .S. faced multiple severe deflationary 00:32:05.049 --> 00:32:08.910 episodes. The Depression of 1818 to 1821 is often 00:32:08.910 --> 00:32:10.880 considered one of the most severe. severe, at 00:32:10.880 --> 00:32:13.200 least in terms of the price collapse. Agricultural 00:32:13.200 --> 00:32:15.440 commodity prices, especially cotton, fell by 00:32:15.440 --> 00:32:17.920 nearly 50 percent in just a few years. 50 percent. 00:32:18.099 --> 00:32:20.619 What were the catalysts for such an extreme drop? 00:32:20.740 --> 00:32:23.359 It was a combination of global and local factors. 00:32:24.059 --> 00:32:26.500 Globally, a financial crisis in England caused 00:32:26.500 --> 00:32:29.299 a credit contraction that began draining hard 00:32:29.299 --> 00:32:31.759 currency species, you know, gold and silver out 00:32:31.759 --> 00:32:35.559 of the U .S. Locally. The newly operating Bank 00:32:35.559 --> 00:32:38.119 of the United States significantly reduced its 00:32:38.119 --> 00:32:41.420 lending. The result was a classic sharp credit 00:32:41.420 --> 00:32:43.420 contraction. And there was a food price element, 00:32:43.500 --> 00:32:46.039 too, wasn't there? There was. Prices for food 00:32:46.039 --> 00:32:48.079 crops had been artificially inflated because 00:32:48.079 --> 00:32:50.759 of the global famine caused by the 1816 year 00:32:50.759 --> 00:32:53.619 without a summer eruption of Mount Tambora. Once 00:32:53.619 --> 00:32:56.819 normal harvests returned in 1818, prices just 00:32:56.819 --> 00:32:59.440 crashed back to earth. And technology played 00:32:59.440 --> 00:33:02.230 a role even back then. It did. Crucially, improved 00:33:02.230 --> 00:33:04.769 transportation, early turnpikes, and steamboats 00:33:04.769 --> 00:33:08.250 played a deflationary role. By dramatically lowering 00:33:08.250 --> 00:33:10.789 the cost of moving goods to market, this introduced 00:33:10.789 --> 00:33:13.329 a structural, productivity -driven price decrease. 00:33:13.650 --> 00:33:16.130 So this episode was really a mix of credit deflation 00:33:16.130 --> 00:33:19.069 and a very early form of growth deflation. Okay, 00:33:19.109 --> 00:33:21.369 next up, the Depression of the late 1830s to 00:33:21.369 --> 00:33:24.210 1843. This one looks terrifying on paper. It 00:33:24.210 --> 00:33:26.829 was incredibly severe. Following the panic of 00:33:26.829 --> 00:33:29.529 1837, the currency in the United States contracted 00:33:29.529 --> 00:33:33.609 by about 34 % and prices fell by a matching 33%. 00:33:33.609 --> 00:33:35.970 That's a scale comparable only to what happened 00:33:35.970 --> 00:33:37.809 during the Great Depression decades later. The 00:33:37.809 --> 00:33:39.930 causes included a banking crisis, state bond 00:33:39.930 --> 00:33:42.250 defaults, and British banks cutting off the flow 00:33:42.250 --> 00:33:44.369 of specie after the collapse of the cotton market. 00:33:44.609 --> 00:33:46.650 A contraction of that magnitude sounds like a 00:33:46.650 --> 00:33:49.470 total societal collapse. Did output also collapse 00:33:49.470 --> 00:33:52.069 by a third? And this is the absolute key nuance 00:33:52.069 --> 00:33:54.750 that prevents us from equating all deflationary 00:33:54.750 --> 00:33:57.440 periods. Despite the severe monetary contraction 00:33:57.440 --> 00:34:00.019 and the price falls, U .S. GDP actually rose 00:34:00.019 --> 00:34:03.680 by 16 percent between 1839 and 1843. Wait, how 00:34:03.680 --> 00:34:06.259 is that possible? How can you have a severe depression 00:34:06.259 --> 00:34:09.239 and deflation and a massive 16 percent rise in 00:34:09.239 --> 00:34:11.340 output at the same time? It suggests that the 00:34:11.340 --> 00:34:14.199 productivity gains, the underlying economic machine, 00:34:14.440 --> 00:34:16.960 were just powerful enough to partially offset 00:34:16.960 --> 00:34:19.920 the financial contraction. So while borrowers 00:34:19.920 --> 00:34:22.719 and speculators were facing ruin, essential production, 00:34:23.000 --> 00:34:25.489 particularly in agriculture, with new cropland 00:34:25.489 --> 00:34:28.690 coming online, continued to grow. This made goods 00:34:28.690 --> 00:34:31.170 cheaper and more abundant, even as the money 00:34:31.170 --> 00:34:33.250 available to buy them was shrinking. So it was 00:34:33.250 --> 00:34:35.750 a financial depression, but not necessarily a 00:34:35.750 --> 00:34:38.090 production depression. That's a good way to put 00:34:38.090 --> 00:34:41.150 it. And it makes the 1830s depression fundamentally 00:34:41.150 --> 00:34:43.769 different from the Great Depression, where the 00:34:43.769 --> 00:34:45.869 financial and production collapses were very 00:34:45.869 --> 00:34:48.429 tightly coupled. That contrast is an incredible 00:34:48.429 --> 00:34:51.519 insight for our listener. Okay, let's move to 00:34:51.519 --> 00:34:55.360 the Great Deflation, spanning 1873 to 1896. This 00:34:55.360 --> 00:34:58.219 was a truly global event, known in some parts 00:34:58.219 --> 00:35:00.980 of Europe as the Long Depression. Structurally, 00:35:01.099 --> 00:35:03.179 it was rooted in the U .S. return to the gold 00:35:03.179 --> 00:35:04.800 standard and the retirement of all that Civil 00:35:04.800 --> 00:35:07.360 War paper money. But its defining feature was 00:35:07.360 --> 00:35:09.920 technological. It was a massive wave of cost 00:35:09.920 --> 00:35:12.000 -cutting and productivity -enhancing technologies. 00:35:12.340 --> 00:35:15.179 Bessemer steel, transcontinental railways, the 00:35:15.179 --> 00:35:17.760 telegraph. So this was slow and steady deflation. 00:35:18.090 --> 00:35:20.710 Very steady. According to Milton Friedman's analysis, 00:35:21.130 --> 00:35:24.889 prices in the U .S. fell by a steady 1 .7 percent 00:35:24.889 --> 00:35:28.610 per year during this entire 23 year period. It 00:35:28.610 --> 00:35:31.369 was slow. It was persistent and it was overwhelmingly 00:35:31.369 --> 00:35:34.250 technology driven. This sounds like the purest 00:35:34.250 --> 00:35:36.269 form of growth deflation we discussed earlier. 00:35:36.489 --> 00:35:39.269 Did that productivity impact all goods equally? 00:35:39.550 --> 00:35:42.050 No. And that's the nuance that David A. Wells 00:35:42.050 --> 00:35:44.969 provided back in 1890. He argued that the deflation 00:35:44.969 --> 00:35:47.519 only really impacted goods that benefited from 00:35:47.519 --> 00:35:49.179 these modern manufacturing and transportation 00:35:49.179 --> 00:35:52.800 methods. Goods produced by, say, local craftsmen 00:35:52.800 --> 00:35:55.420 or localized services did not see the same price 00:35:55.420 --> 00:35:57.320 decreases. What about wages? Even more telling. 00:35:57.519 --> 00:35:59.840 The cost of labor wages actually increased in 00:35:59.840 --> 00:36:01.679 real terms because of the overall prosperity 00:36:01.679 --> 00:36:04.659 and productivity gains. This reinforces the idea 00:36:04.659 --> 00:36:06.800 that it was technology and efficient scale driving 00:36:06.800 --> 00:36:09.579 prices down, not purely a crushing lack of demand. 00:36:09.880 --> 00:36:11.579 And finally, we have to touch on the Great Depression 00:36:11.579 --> 00:36:15.039 deflation of 1930 to 1933. It changed all the 00:36:15.039 --> 00:36:17.469 rules. This was catastrophic. with a deflation 00:36:17.469 --> 00:36:20.710 rate hitting approximately 10 % per year. The 00:36:20.710 --> 00:36:22.989 mechanisms were a brutal combination of every 00:36:22.989 --> 00:36:25.610 bad type of deflation we've discussed. There 00:36:25.610 --> 00:36:27.929 was an enormous contraction of credit, widespread 00:36:27.929 --> 00:36:30.849 bank failures, and a frantic psychological demand 00:36:30.849 --> 00:36:33.210 for cash. And the central bank made it worse. 00:36:33.409 --> 00:36:36.250 The Federal Reserve, operating under a mistaken 00:36:36.250 --> 00:36:39.050 doctrine, actually contracted the money supply 00:36:39.050 --> 00:36:41.809 by 30 % when it should have been massively expanding 00:36:41.809 --> 00:36:45.590 it. The simultaneous profound drop in both the 00:36:45.590 --> 00:36:48.230 money supply and its velocity created the perfect 00:36:48.230 --> 00:36:51.030 inescapable spiral. Before we move to the modern 00:36:51.030 --> 00:36:53.550 era, let's quickly acknowledge the brief recent 00:36:53.550 --> 00:36:56.070 dips into deflation in the U .S. Right. In the 00:36:56.070 --> 00:36:58.369 past 60 years, deflation has only occurred twice 00:36:58.369 --> 00:37:01.670 and very briefly. In 2009, during the Great Recession, 00:37:01.849 --> 00:37:04.590 the U .S. saw measurable deflation, hitting Nataco's 00:37:04.590 --> 00:37:07.849 2 .1 % year over year in July. This was driven 00:37:07.849 --> 00:37:09.789 by the collapse in energy prices and housing 00:37:09.789 --> 00:37:12.030 demand. And that led to that interesting policy 00:37:12.030 --> 00:37:15.059 footnote in Colorado. Yes. Where the state actually 00:37:15.059 --> 00:37:17.380 announced a cut in its minimum wage because it 00:37:17.380 --> 00:37:19.639 was indexed to inflation and inflation had gone 00:37:19.639 --> 00:37:21.099 negative. That was the first time a state had 00:37:21.099 --> 00:37:24.179 done that since 1938. And then we saw another 00:37:24.179 --> 00:37:26.460 minor short lived dip to manageable point one 00:37:26.460 --> 00:37:29.659 percent in 2015, which was mainly driven by global 00:37:29.659 --> 00:37:32.280 oil price crashes. OK, now let's turn to the 00:37:32.280 --> 00:37:34.739 ultimate modern laboratory for fighting deflation. 00:37:35.079 --> 00:37:38.139 Japan's lost decades. This is the cautionary 00:37:38.139 --> 00:37:40.829 tale for central bankers everywhere. Japan's 00:37:40.829 --> 00:37:43.469 experience, starting in the early 1990s, showed 00:37:43.469 --> 00:37:45.570 that monetary tools that worked perfectly in 00:37:45.570 --> 00:37:49.329 theory often fail completely in practice. Deflation 00:37:49.329 --> 00:37:51.550 persisted for decades despite the Bank of Japan 00:37:51.550 --> 00:37:53.909 implementing a zero interest rate policy, or 00:37:53.909 --> 00:37:56.949 ZRP, and conducting extensive rounds of quantitative 00:37:56.949 --> 00:37:59.429 easing. Their accommodative policies simply failed 00:37:59.429 --> 00:38:01.269 to generate a sustained increase in the broad 00:38:01.269 --> 00:38:03.710 money supply or its velocity. What were the specific 00:38:03.710 --> 00:38:06.289 systemic issues that made the deflation so utterly 00:38:06.289 --> 00:38:08.840 stubborn? Well, there were at least seven interlinked 00:38:08.840 --> 00:38:11.480 structural causes. First, believe it or not, 00:38:11.519 --> 00:38:14.559 tight monetary conditions. Ironically, the Bank 00:38:14.559 --> 00:38:17.460 of Japan frequently tightened policy, even just 00:38:17.460 --> 00:38:19.900 marginally whenever deflation seemed to be ending. 00:38:20.159 --> 00:38:23.099 They were so terrified of a return to the asset 00:38:23.099 --> 00:38:25.719 bubble of the 80s that they effectively short 00:38:25.719 --> 00:38:28.380 circuited every nascent recovery. And demographics 00:38:28.380 --> 00:38:31.880 played a role. A huge role. Second. unfavorable 00:38:31.880 --> 00:38:34.960 demographics. Japan has a rapidly aging and declining 00:38:34.960 --> 00:38:37.699 population, which inherently constrains long 00:38:37.699 --> 00:38:40.059 -term aggregate demand, regardless of what interest 00:38:40.059 --> 00:38:43.780 rates are. Third, fallen asset prices. The spectacular 00:38:43.780 --> 00:38:46.420 stock and real estate bubble of the 1980s burst, 00:38:46.679 --> 00:38:49.360 leading to a painful asset price deflation that 00:38:49.360 --> 00:38:51.940 required decades of mean reversion, which just 00:38:51.940 --> 00:38:54.340 depressed confidence for a generation. This leads 00:38:54.340 --> 00:38:56.360 to the famous issue of zombie companies and the 00:38:56.360 --> 00:38:58.360 paralysis in the banking system. That's a key 00:38:58.360 --> 00:39:00.460 piece of regulatory insight from the sources. 00:39:00.909 --> 00:39:04.090 Absolutely crucial. Fourth, insolvent or zombie 00:39:04.090 --> 00:39:07.230 companies. Instead of forcing immediate liquidation, 00:39:07.389 --> 00:39:10.150 Japanese banks, often with implicit regulatory 00:39:10.150 --> 00:39:12.969 approval, just delayed collecting on nonperforming 00:39:12.969 --> 00:39:15.670 loans. They were hoping that the assets would 00:39:15.670 --> 00:39:18.150 eventually recover. They kept these unrealized 00:39:18.150 --> 00:39:20.929 losses on their books. And what did that do to 00:39:20.929 --> 00:39:23.469 the broader economy? It allowed these non -productive 00:39:23.469 --> 00:39:26.409 insolvent firms, the zombies, to just keep existing. 00:39:26.710 --> 00:39:29.269 It prevented capital and labor from moving to 00:39:29.269 --> 00:39:31.630 more productive sectors, which just perpetuated 00:39:31.630 --> 00:39:34.309 the deflationary stagnation. And the banks themselves 00:39:34.309 --> 00:39:37.130 are in trouble. Yes. Fifth, the banks themselves 00:39:37.130 --> 00:39:40.690 became insolvent banks. With these huge portfolios 00:39:40.690 --> 00:39:42.489 of non -performing loans, they couldn't lend 00:39:42.489 --> 00:39:44.769 new money. They were forced to just build up 00:39:44.769 --> 00:39:47.150 their cash reserves to cover the bad loans, which 00:39:47.150 --> 00:39:49.389 further restricted the credit supply. And the 00:39:49.389 --> 00:39:51.429 public responded rationally to this bank for... 00:39:51.469 --> 00:39:53.849 agility, I assume. They did. That's the sixth 00:39:53.849 --> 00:39:58.010 point. Fear of bank collapse. The Japanese public, 00:39:58.090 --> 00:40:00.489 seeing the banking system struggle, preferred 00:40:00.489 --> 00:40:03.329 buying extremely safe Japanese treasury bonds 00:40:03.329 --> 00:40:05.210 instead of putting their money in bank accounts. 00:40:05.730 --> 00:40:08.369 This money was locked away from the lending system, 00:40:08.670 --> 00:40:11.090 depressing both consumption and new investment. 00:40:11.349 --> 00:40:13.929 The public was hoarding bonds, not cash, but 00:40:13.929 --> 00:40:16.250 the effect was basically the same. And the seventh 00:40:16.250 --> 00:40:19.210 factor. Seventh, Japan faced imported deflation. 00:40:19.710 --> 00:40:22.110 As countries like China industrialized rapidly, 00:40:22.409 --> 00:40:25.469 Japan was importing increasingly cheap consumable 00:40:25.469 --> 00:40:28.010 goods. Domestic producers were forced to cut 00:40:28.010 --> 00:40:29.949 their own prices to remain competitive, which 00:40:29.949 --> 00:40:32.730 created a powerful external deflationary force 00:40:32.730 --> 00:40:35.750 that monetary policy couldn't easily counteract. 00:40:35.929 --> 00:40:38.150 Finally, what about the massive fiscal response? 00:40:38.449 --> 00:40:40.429 I mean, Japan spent an enormous amount of money 00:40:40.429 --> 00:40:43.570 on stimulus packages. They did. But the sources 00:40:43.570 --> 00:40:45.710 mentioned the Austrian and monetarist critique 00:40:45.710 --> 00:40:48.769 that Japan's massive Keynesian stimulus packages 00:40:49.070 --> 00:40:52.710 totaling over 100 trillion yen over the years, 00:40:52.869 --> 00:40:55.429 may have actually suppressed private wealth creation. 00:40:56.190 --> 00:40:58.590 The argument is that the government, by spending 00:40:58.590 --> 00:41:01.750 so heavily on public works, was competing against 00:41:01.750 --> 00:41:03.849 and crowding out private investment dollars, 00:41:04.070 --> 00:41:06.969 thereby hindering the natural, productive reallocation 00:41:06.969 --> 00:41:09.389 of capital that the economy so desperately needed. 00:41:09.630 --> 00:41:11.849 And it remains a problem to this day. It does. 00:41:12.070 --> 00:41:14.610 Despite Prime Minister Shinzo Abe's policies 00:41:14.610 --> 00:41:17.730 finally achieving some inflation by 2014, the 00:41:17.730 --> 00:41:20.829 subsequent COVID -19 recession reignited deflation 00:41:20.829 --> 00:41:23.829 fears in 2020. This prompted heavy government 00:41:23.829 --> 00:41:27.030 stimulus worth over 20 % of GDP. Japan remains 00:41:27.030 --> 00:41:29.550 the classic example of how entrenched structural 00:41:29.550 --> 00:41:31.909 deflation can resist even the most aggressive 00:41:31.909 --> 00:41:34.309 monetary action. Let's briefly touch on those 00:41:34.309 --> 00:41:36.869 examples of deflation caused by currency rigidity, 00:41:36.969 --> 00:41:39.059 starting with Hong Kong. Hong Kong provides a 00:41:39.059 --> 00:41:41.280 perfect lesson on the constraints of fixed exchange 00:41:41.280 --> 00:41:45.039 rates. Following the 1997 Asian financial crisis, 00:41:45.340 --> 00:41:47.739 most of Hong Kong's neighbors devalued their 00:41:47.739 --> 00:41:50.320 currencies, which helped their recovery. But 00:41:50.320 --> 00:41:53.019 Hong Kong maintained its firm peg to the US dollar, 00:41:53.139 --> 00:41:55.579 which prevented devaluation. So they were forced 00:41:55.579 --> 00:41:59.119 to adjust internally. They had no choice to maintain 00:41:59.119 --> 00:42:01.579 competitiveness against their devaluing neighbors. 00:42:01.800 --> 00:42:03.920 Hong Kong had to go through a prolonged period 00:42:03.920 --> 00:42:06.559 of consumer price deflation that lasted until 00:42:06.559 --> 00:42:10.519 late 2004. This internal deflation was worsened 00:42:10.519 --> 00:42:12.960 by cheap mainland Chinese exports and actually 00:42:12.960 --> 00:42:15.119 created a slump that was more severe than in 00:42:15.119 --> 00:42:17.360 many surrounding countries. And we saw this same 00:42:17.360 --> 00:42:19.699 internal adjustment pressure inside the eurozone. 00:42:20.030 --> 00:42:23.949 Yes, specifically between 2013 and 2016, several 00:42:23.949 --> 00:42:27.429 eurozone members, Greece, Cyprus, Spain and Slovakia 00:42:27.429 --> 00:42:29.989 and countries pegged to the euro like Bulgaria, 00:42:30.170 --> 00:42:32.809 they all experienced periods of negative inflation 00:42:32.809 --> 00:42:35.550 because they shared a common currency or were 00:42:35.550 --> 00:42:37.929 pegged to it. They couldn't use devaluation to 00:42:37.929 --> 00:42:40.070 stimulate their trade. They were forced into 00:42:40.070 --> 00:42:42.710 that same painful process of internal adjustment, 00:42:42.889 --> 00:42:46.210 cutting wages and prices to try and restore competitiveness 00:42:46.210 --> 00:42:48.630 within the monetary union. They were essentially 00:42:48.630 --> 00:42:51.420 imported. deflation to align with the more productive 00:42:51.420 --> 00:42:54.260 members like Germany. And that intriguing outlier 00:42:54.260 --> 00:42:57.340 example from Ireland in 2009. That was a rare 00:42:57.340 --> 00:42:59.920 moment of political honesty. When Ireland announced 00:42:59.920 --> 00:43:02.699 its first annual negative inflation since 1960, 00:43:03.059 --> 00:43:05.320 the finance minister, Brian Linehan, actually 00:43:05.320 --> 00:43:07.340 mentioned deflation as a factor that supported 00:43:07.340 --> 00:43:09.340 the argument for budget cuts to public sector 00:43:09.340 --> 00:43:11.860 pay and child benefits. So he used it as a justification 00:43:11.860 --> 00:43:15.179 for austerity. He did. Instead of treating deflation 00:43:15.179 --> 00:43:17.880 as a sickness to be avoided at all costs, he 00:43:17.880 --> 00:43:20.079 treated it as data that justified the painful 00:43:20.079 --> 00:43:22.460 but necessary wage cuts needed for that internal 00:43:22.460 --> 00:43:26.280 adjustment. It's a pragmatic, if painful, response 00:43:26.280 --> 00:43:29.519 to fixed currency realities that you rarely hear 00:43:29.519 --> 00:43:32.420 voiced so explicitly by modern Western policymakers. 00:43:32.940 --> 00:43:35.519 This has truly been a comprehensive deep dive 00:43:35.519 --> 00:43:37.920 into deflation. It's absolutely clear that this 00:43:37.920 --> 00:43:40.579 concept is far more complex than just a simple 00:43:40.579 --> 00:43:43.400 sale sign in a shop window. Let's bring this 00:43:43.400 --> 00:43:45.500 all back to the essential takeaway for the listener. 00:43:45.789 --> 00:43:47.789 The essential takeaway is that deflation is not 00:43:47.789 --> 00:43:50.630 merely a sign of falling prices. It is a profound 00:43:50.630 --> 00:43:53.670 structural crisis. It's rooted in the corrosive 00:43:53.670 --> 00:43:56.250 relationship between massive debt loads and the 00:43:56.250 --> 00:43:58.510 financial system's inability to generate money 00:43:58.510 --> 00:44:01.989 velocity. In a modern leveraged economy, deflation 00:44:01.989 --> 00:44:04.190 dramatically increases the real cost of every 00:44:04.190 --> 00:44:06.829 single loan, and it completely destroys the psychological 00:44:06.829 --> 00:44:09.030 incentive to undertake productive investment. 00:44:09.349 --> 00:44:12.289 And that is why central bankers see low positive 00:44:12.289 --> 00:44:15.070 inflation as mandatory economic lubrication. 00:44:15.079 --> 00:44:17.239 We've established that the primary tools of the 00:44:17.239 --> 00:44:20.619 last 90 years, Keynesian fiscal stimulus, ZRRP, 00:44:20.820 --> 00:44:23.579 and quantitative easing, were engineered primarily 00:44:23.579 --> 00:44:26.440 to fight credit deflation, the kind that follows 00:44:26.440 --> 00:44:29.659 debt bubbles and monetary contraction. But let's 00:44:29.659 --> 00:44:31.480 look forward and maybe a little bit back to the 00:44:31.480 --> 00:44:34.340 19th century. We saw those periods of powerful 00:44:34.340 --> 00:44:36.960 growth deflation that were driven by unprecedented 00:44:36.960 --> 00:44:40.239 technological leaps. The question we face now 00:44:40.239 --> 00:44:43.360 is whether history is cyclical. If future technology, 00:44:43.539 --> 00:44:46.260 perhaps advanced automation, AI -driven efficiencies, 00:44:46.260 --> 00:44:49.420 or even breakthroughs in materials science, if 00:44:49.420 --> 00:44:51.739 that technology dramatically cuts the cost of 00:44:51.739 --> 00:44:54.619 production across all sectors, does that 19th 00:44:54.619 --> 00:44:56.679 century phenomenon of growth deflation become 00:44:56.679 --> 00:44:59.139 structurally inevitable once again? And that 00:44:59.139 --> 00:45:01.059 raises a really important question for you to 00:45:01.059 --> 00:45:03.780 mull over. If we enter a sustained era where 00:45:03.780 --> 00:45:06.280 technology drives prices down year after year, 00:45:06.699 --> 00:45:08.780 Are our current monetary policy tools, which 00:45:08.780 --> 00:45:11.260 all rely on increasing the money supply to counteract 00:45:11.260 --> 00:45:13.239 a failure of demand, are they even equipped to 00:45:13.239 --> 00:45:15.179 handle a future deflationary environment that's 00:45:15.179 --> 00:45:18.059 driven not by economic depression or debt, but 00:45:18.059 --> 00:45:20.239 purely by staggering, relentless productivity 00:45:20.239 --> 00:45:23.800 gains? Will we need entirely new tools to manage 00:45:23.800 --> 00:45:26.900 an economy of prosperity that costs less and 00:45:26.900 --> 00:45:29.840 less to achieve? Something to consider as you 00:45:29.840 --> 00:45:32.119 observe the price of your next durable good purchase. 00:45:32.380 --> 00:45:34.400 Thank you for joining us for this deep dive. 00:45:34.599 --> 00:45:35.260 We'll see you next time.