Welcome to the Deep Dive, where we cut through
the noise and get straight to the impactful takeaways
from the detailed research you've shared with
us. Today's topic is one of the most counterintuitive
and frankly frightening concepts in all of macroeconomics.
I think so too. It's this idea that something
that sounds wonderful on a personal level, you
know, falling prices, is often a signal that
the entire financial system is Well, seizing
up. It is. We've analyzed your source material.
And our mission for this deep dive is to get
a really thorough understanding of deflation,
what some have called the economic phantom that
makes money too valuable. OK, so let's unpack
that right away, because if you walk into a store
and everything is 10 percent cheaper than it
was last year, my immediate gut instinct is great.
My money goes further. We're all hardwired to
love sales. Of course. So why is deflation, where
the general price level is actually decreasing
and the inflation rate falls below zero, why
is that considered such a huge red flag by central
bankers all over the world? That is the absolute
core paradox we have to confront here. Deflation
is a measurable increase in the real value of
the monetary unit. So while inflation is constantly
working to reduce the value of your currency.
Eating away at your savings. Right. It's eating
away at it. Deflation does the complete opposite.
You can literally buy more goods next month than
you can today with the same dollar. But, and
this is the big but. This is where the macroeconomic
nightmare begins. It means you have to sell more
goods or work more hours or cut more costs to
finance any payments that are fixed in nominal
terms. And the big one there is always debt.
OK, so let's make that concrete. If I'm a small
business owner, maybe I sell T -shirts and the
price of my shirts is falling, let's say, 5 %
a year. But the payment I owe on the bank loan
I took out last year, that dollar amount doesn't
change. It's fixed. It's fixed. So suddenly that
mortgage payment or that business loan represents
a much, much larger chunk of my actual revenue
that I have to generate. Exactly. You are paying
back dollars that are. for lack of a better term,
fatter or more valuable than the dollars you
originally borrowed. And before we go any further,
we really need to be crystal clear about the
terminology here, because the media, well, it
often gets this wrong. Oh, yeah. Let's clarify
deflation versus disinflation. Disinflation is
just a slowdown in the inflation rate. So if
inflation was, say, 10 % last year and this year
it's down to 3%, that's disinflation. Prices
are still going up, just not as fast. Still positive.
Still positive. Deflation means the rate is actually
negative. The price index is falling. And that
is the real danger zone. Got it. So negative
is the problem. This, I think, brings us to the
central idea in the sources about deflationary
shocks. I mean, is there any scenario where deflation
is actually OK? Well, the consensus among economists
is that sudden, unexpected deflationary shocks
are almost universally bad in a modern debt -fueled
economy. Why is that? Is it all about the debt?
It's primarily about the massive immediate increase
in the real burden of debt, which acts like a
profound break on the entire economy. It severely
aggravates recessions. It can lead to asset liquidation,
mass unemployment. It basically sets up the conditions
for what we call the deflationary spiral. The
spiral. We're going to be talking a lot about
that, I imagine. We are. And it is arguably one
of the most destructive forces a leveraged economy
can possibly face. We need to understand that
this isn't just theory. The entire economic policy
framework of the last, what, 90 years, from Keynesian
stimulus to modern quantitative easing, is a
direct result of trying to find ways to actively
prevent this spiral from ever taking hold. Because
history shows it doesn't just fix itself. It
doesn't fix itself quickly enough. And the damage
it does in the meantime can be catastrophic.
That sets the stage perfectly. So if the spiral
is the scary destination, let's look at how we
even get there. We're moving into the core mechanics
now. How does this entire massive economic machine
start tipping into a deflationary state in the
first place? Fundamentally, deflation happens
when there's a persistent imbalance. An imbalance
between the sheer volume of production and the
amount of money available to actually buy that
production. Or, just as importantly, how quickly
that money is moving through the system. The
velocity of money. Exactly. Your sources outline
the general causes, which you can really boil
down to three broad categories. Okay, walk us
through those fundamental drivers. So first,
you have high supply. This just means X. production
relative to what people are actually demanding.
If manufacturers flood the market with cars or
TVs, prices have to fall to clear that inventory.
Makes sense. Too much stuff. Second, you've got
low demand. This is the flip side. Consumption
just decreases. Maybe it's due to fear, uncertainty
about the future, a shock to household income
like mass layoffs. People just stop buying things
and businesses have no choice but to cut prices
to try and entice them back. And the third one,
you said it's often the most dangerous. It is.
The third is a decreased money supply. And this
is usually driven by a credit crunch. Banks just
stop lending or maybe careless investment leads
to a flight of capital out of the country. I
mean, if there's less money chasing the same
amount of goods, the price of those goods has
to fall. Right. And you also see it caused by
things like net capital outflow, some money leaving
a country or even just. Really intense competition
forcing price wars. All of those feed into it.
They all disrupt that core balance. I get the
supply and demand side, but this is where that
central paradox really hits me. The sources call
it the learner's dilemma. If prices are falling,
wouldn't the rational response for me as a consumer
be to rush out and grab those bargains? Why does
it cause consumption to stall? Because consumers,
when they're facing systemic deflation, are rational
at the individual level. But their collective
rationality leads to a completely irrational
economic outcome. Think about it this way. If
you're shopping for a new refrigerator today,
and you are absolutely convinced that that same
refrigerator will be 5 % cheaper six months from
now, what do you do? I wait. A hundred percent.
Why wouldn't I? You wait. And if millions of
people wait on buying new cars, new equipment,
real estate, durable goods, that simple rational
decision creates a massive collective problem.
It kills demand in the present. It completely
kills it. That waiting drastically reduces aggregate
demand right now. This idles productive capacity.
Factories slow down. It reduces corporate investment
because, well. Future profits look bleak. And
that reduction in demand then forces companies
to drop their prices even further to try and
sell anything at all. That's terrifying. It really
is a self -fulfilling prophecy. My totally rational
choice to save a few hundred dollars by waiting
becomes the very force that reduces my neighbor's
income, which forces him to wait, and so on and
so on. Precisely. That is the engine of the vicious
cycle. And this behavior, this waiting, leads
directly to the problem of hoarding and what
economists call the liquidity trap. Okay, explain
that connection for us. Why is deflation linked
so closely to risk aversion and hoarding cash?
Because when money itself is increasing in value
when the cash under your mattress is actually
yielding a positive real return just by sitting
there holding cash becomes an incredibly safe
and again highly rational investment strategy
for the individual. So doing nothing is the best
investment. It becomes the safest and best investment.
If you can get a guaranteed, say, 2 % or 3 %
real return just by holding cash and waiting
for prices to drop, why would you risk your money
on a new factory, a new business, or a volatile
stock market? The risk -reward calculation gets
completely warped. So the economy suffers a massive
loss of faith in any kind of productive investment.
Cash is king because cash itself is appreciating.
Correct. And this is what ties the central bank's
hands. Their main tool, their primary lever,
is lowering the short term interest rate to incentivize
borrowing and spending. But once that rate hits
zero, they enter the dreaded liquidity trap.
They've run out of road. They run out of road.
The central bank can't normally charge a significantly
negative interest rate on the cash that banks
hold in their reserves. Because people would
just pull it out. They just pull it out physically.
I mean, why keep your money in a bank that charges
you for it when you can just stick it in a vault?
It completely breaks them. model. So if the nominal
interest rate is zero, but deflation is running
at, say, 2%, the real interest rate, what borrowers
are actually paying back in real terms, is still
a positive 2%. That's it. The central bank has
run out of ammunition to make borrowing any cheaper.
Zero interest often fails to stimulate the economy
adequately because the real cost of debt remains
stubbornly high. And what about in a globalized
world? Does that add another wrinkle? It adds
a huge wrinkle. In an open economy, this zero
rate environment encourages what's known as a
carry trade. Investors borrow money at zero or
near zero rates in the deflating country, let's
say Japan, and then they invest it somewhere
else, somewhere with a higher, safer return.
So the money just leaves the country that needs
it most. It flees. Now, this does devalue the
deflating country's currency, which makes imports
more expensive and can help a little with inflation.
But it doesn't necessarily stimulate domestic
exports enough to compensate for the overwhelming
disincentive for people inside the country to
spend or invest. The hoarding continues and the
economy just remains stuck in that trap. Now
that we really understand the mechanics of the
spiral, let's explore how the sources categorize
deflation. It seems it's not just one simple
event, but there are, what, six distinct faces
based on its root cause. We should probably start
with the really strange one, the one that sounds
almost good, growth deflation. Yes, growth deflation
is the ultimate paradox. It's really the only
type that economists might not immediately panic
about, though, while they still fundamentally
prefer mild positive inflation. Why is it different?
This type is defined as an enduring decrease
in the real cost of goods and services. And it's
driven not by a collapse in demand, but by staggering
technological progress and hyper competition.
And the crucial difference here is the productivity
gains are so enormous that they actually offset
that impulse to delay purchases. Is that it?
That's the idea. People still buy because the
goods are so much cheaper and so much better
in quality than they were before. The supply
curve just shifts outward massively. Is there
a historical example of this actually happening?
Oh, yes. The key historical example is the structural
deflation that we saw from the 1870s right up
until the major economic upswing that began around
1895. What was going on then? What drove that
specific episode? It was the second industrial
revolution. You had phenomenal gains in productivity
from new mass manufacturing techniques, enormous
economies of scale. And this is critical, dramatically
reduced transportation costs with the global
expansion of railroads and steamships. So it
became cheaper to make things and cheaper to
move them. Massively cheaper. This led to oversupplied
markets and constant competitive price cuts.
An American economist, David A. Wells, writing
in 1890, he documented this process extensively.
He argued that the reduction in prices was directly
attributable to these massive technology driven
efficiency improvements. It was a complete structural
repricing of global commerce. That makes perfect
sense for that era, which was largely on a gold
standard. But your sources contrast this with
the post -World War II era. We had incredible
productivity gains in the 50s and 60s, but we
didn't see deflation. Why the difference? That's
a critical insight for understanding modern policy.
The 19th century economy was largely constrained
by the gold standard. This meant the money supply
was relatively rigid. It was tied to the physical
stock of gold that a country held. So when productivity
surged, those gains had nowhere to go but to
drive prices down. The amount of money was fixed,
but the amount of stuff was exploding. Exactly.
But after the 1930s and certainly after the world
moved to fiat currency systems, central banks
gained the flexibility to actively manage the
money supply. So when productivity surged after
WWII, central banks could and did expand the
money supply enough to keep inflation positive,
even if it was low. They prevented those cost
cuts from ever tipping the economy into outright
deflation. So they deliberately target something
like 2 percent inflation. to give themselves
a safety buffer. That's precisely why they do
it. It's a buffer against this deflationary risk.
So growth deflation is possible, but modern policy
is essentially designed to prevent it from becoming
negative deflation. OK, that makes sense. Let's
shift to the types that actively crash the system,
starting with bank credit deflation. This is
a classic supply side credit contraction. It
happens when the supply of bank credit suddenly
dries up. This can happen from a wave of mass
bank failures, which literally removes money
from circulation. Or more often today, it's caused
by a sudden, sharp increase in the perceived
risk of defaults. So banks just get scared to
lend. They get very scared. If banks believe
that corporate loans or consumer mortgages won't
be repaid, they immediately tighten their lending
standards. They restrict credit. And since new
credit is how the modern financial system generates
new money, when that pipeline stops, the money
supply contracts. And that leads us logically
to the most famous theory of all debt deflation,
which is I mean, it's impossible to talk about
without mentioning Irving Fisher. Absolutely.
The economist Irving Fisher developed this theory
in 1933 while he was trying to make sense of
the trauma of the Great Depression. His idea
of debt deflation is associated with the end
of massive long -term credit cycles. Think of
the huge asset bubbles of the 1920s. What's the
core mechanism? His theory states that when a
massive credit bubble bursts, individuals, companies,
attempt to pay down their debt at the same time
in a desperate bid for solvency. A mass deleveraging
event. Yes. And this mass effort to deleverage
crushes spending. It reduces the velocity of
money and it forces fire sales of assets. People
have to sell anything they can to get cash. These
asset sales drive prices down across the board
stocks, real estate commodities. The falling
prices then increase the real burden of whatever
debt is left, which forces more people to sell
assets and liquidate, reinforcing that downward
cycle. That's another one of those vicious feedback
loops. Fisher called it the paradox of thrift
taken to its absolute extreme. The more everyone
tries to save and pay down debt to fix their
own situation, the worse the entire system gets.
That sounds like a powerful multiplier effect.
Now let's look at this from the monetarist view
money supply side deflation. Right. From a strict
monetarist perspective, like Milton Friedman's,
deflation is caused by one of two things. Either
a reduction in the total quantity of money supply
per person. Or a drop in the velocity of money.
And velocity is just how fast money is changing
hands. It's the rate at which money is exchanged
from one transaction to another. If people get
scared and stop spending, if they just hold on
to their cash, velocity collapses. The sources
use the early U .S. experience before the Civil
War to really illustrate that scarcity of money
supply. The early U .S. provides a powerful,
tangible example of what an unstable money supply
can do. Before 1862, the U .S. had no single
national currency and suffered from a severe
lack of fiscal coinage. The vast majority of
commerce relied on bank notes issued by literally
thousands of individual private banks. And the
value of those notes, it depended entirely on
the solvency of the bank that issued it. A system
built entirely on trust. A very fragile trust.
During financial panic, like the ones in 1818
or 1837 banks would fail en masse. When a bank
failed, its notes became either completely worthless
or were heavily discounted by merchants relative
to gold or silver. So this wasn't just a drop
in velocity. It was a physical, measurable shrinking
of the usable money supply, sometimes overnight.
And that directly caused these steep deflationary
periods as money became incredibly scarce and
valuable. That's a system where if faith is lost,
the entire circulatory system just fails. It
does. And while modern central banking uses a
far more complex definition of the money base,
that historical inverse correlation is fascinating.
Historically, a decrease in the monetary base
sometimes led to an increase in money velocity
as people race to spend less valuable money.
But in modern crises, we usually see the absolute
worst case scenario, both the supply of money
and its velocity drop at the same time, which
just multiplies the deflationary force. This
brings us to credit deflation, which feels like
the drop. of most of the crises we've seen recently,
and it's usually tied to central bank policy.
This is often the initial trigger. It starts
when a central bank raises interest rates, maybe
aggressively, to fight high inflation or to try
and pop an asset bubble. In our modern high leverage
economy, that higher rate immediately slows down
lending. The cost of borrowing goes up. It goes
up. So less lending means less new money being
created. Confidence falls, velocity weakens,
and aggregate demand just plummets. Businesses
suddenly face a supply glut. as all their buyers
vanish, forcing them to slash prices. And where
does this become the true undeniable spiral?
The spiral connection is reached when falling
prices push businesses below their cost of production
or critically. below the amount they need to
service their debt. So they have to start liquidating
assets. And the banks, which suddenly own all
this foreclosed collateral homes, factories,
equipment, they receive these dramatically devalued
assets. And if the banks try to sell them all
at once. They flood the market, which makes the
deflation even worse. So the sources note that
to prevent this glut and to, frankly, keep up
appearances of solvency, banks in places like
Japan, America during the 2008 crisis and Spain,
they often just withhold these non -performing
assets from sale. But that has its own consequences.
It does. It means they can't clear their balance
sheets, which forces them to restrict new lending,
which further kills demand. It's a paralyzing
impasse. This sounds strikingly similar to those
U .S. 19th century financial cycles we talked
about. It is the exact same fundamental mechanism,
just in different clothes. The sources detail
how in the 19th century U .S., inflation and
deflation correlated with these capital flows.
Money was loaned heavily from the financial centers
in the Northeast out to the commodity regions
in the West and South. Prices would rise during
the lending boom. And then the crash would come.
When the panics hit, like in 1818 and 1839, the
banks in the Northeast would call in those loans
sharply. That sudden systemic credit contraction
caused commodity prices to crash, which directly
triggered deflation. And the Great Depression
amplified this by adding that layer of global
trade rigidity. Precisely. The deflation of the
Great Depression was caused by this massive overcapacity
hitting an immovable wall of severely contracted
demand. And it was amplified by huge global policy
errors like the Smoot -Hawley parafact in the
U .S., which just decimated international trade.
It removed a crucial source of external demand
and triggered the waves of bank failures and
credit contraction that followed. OK, finally,
we have a type of deflation that's externally
imposed. Currency pegs and monetary unions. This
one. is crucial for understanding global economics
today. If country A pegs its currency to country
B and country B has much higher productivity
growth, country A suddenly becomes uncompetitive.
Its prices are relatively too high. And since
they can't devalue their currency because of
the peg, they have to adjust internally. So if
they can't change the exchange rate. They're
forced to change their internal costs. Yes, they
must lower their factor prices. That means wages,
rent and other internal production costs have
to come down to maintain competitiveness. Cutting
wages and input costs fosters a deflationary
environment domestically. It's a very painful
process required to stay aligned with the foreign
currency. We saw this exact mechanism play out
across certain eurozone member states after 2008
and in Hong Kong after the Asian financial crisis.
They are in effect importing. deflation by fixing
their exchange rate to a stronger more productive
currency block now that we've locked down the
how of deflation let's pivot to the catastrophic
what happens next the actual economic consequences
the sources really stress that the pain of deflation
centers squarely on the borrower It does because
deflation is truly welcome only in a system with
very little debt. And since modern economies
are fundamentally debt driven, deflation amplifies
what the sources call the sting of debt. When
prices are falling, every future debt payment
represents a greater amount of real purchasing
power than it did when you originally took out
that debt. Let's use that specific example from
the sources to make this really tangible. If
deflation is averaging 10 % year, which it did
during the worst period of the Great Depression,
what does that actually do to an ordinary loan?
It makes that loan absolutely toxic. A 10 % annual
deflation rate meant that even if a bank offered
you a loan with 0 % interest. An interest -free
loan. An interest -free loan. You are still paying
back money that was effectively 10 % more valuable
each year. That is a 10 % real interest rate,
regardless of the nominal rate. rate written
on the paper. And that realization just freezes
lending. It kills all economic activity and it
pushes otherwise solvent businesses into insolvency.
Wow. That really changes the way I think about
credit. Even a zero nominal rate is incredibly
expensive in that environment. And this circles
us back perfectly to the zero bound problem.
It does. When central banks hit that zero lower
bound on short term nominal interest rates, they've
exhausted their conventional means of easing
policy. Deflation then guarantees that the real
interest rate, the rate that truly matters to
borrowers, remains significantly positive. It
keeps debt servicing difficult and it actively
restricts new investment. So monetary policy
just stops working. It stops working. And this
is why during severe deflation, political and
fiscal measures, particularly debt restructuring
or massive government spending, become the only
tools left in the toolbox. OK, let's look at
the flip side. Savings and investment. We talked
about hoarding cash. But how does deflation specifically
discourage productive investment, even if the
cost of capital is near zero? It's purely about
the expectation of future profit. Investment
is all about betting capital today on future
returns. So if I, as a factory owner, anticipate
that the widgets I produce next year will sell
for 3 % less than they do today, the incentive
to borrow money, buy new equipment and expand
my capacity just evaporates. Why bother? The
net return on my investment is being eroded by
guaranteed falling prices. And this results in
a pervasive discouragement of private investment
across the entire economy and a catastrophic
collapse in aggregate demand. And as you said,
holding money is actively rewarded. It is. This
is the behavior that mainstream economists find
so dangerous. While, you know, the Austrian school
might see some deflation as a necessary correction
of malinvestment, the vast majority of economists
agree with that. Quote, your sources provided
from Friedrich Hayek. He said it is agreed that
hoarding money is deflationary in its effects.
No one thinks that deflation is in itself desirable.
So even a libertarian champion of free markets
acknowledged that this psychological incentive
to hoard cash just destroys the economy's circulatory
system. He did. It paralyzes everything. The
sources make a very sharp distinction between
the effects of deflation and its opposite, inflation,
specifically on wealth transfer. This feels like
a crucial nugget of knowledge for our listeners.
This is the ultimate differentiator that determines
who wins and who loses. Deflation transfers wealth
from borrowers and holders of illiquid assets.
Think farmers with mortgage land or factory owners
with heavy equipment to savers and holders of
liquid assets or currency. The system rewards
holding cash. The inevitable consequence is generalized
underinvestment. And inflation just completely
flips that transfer on its head. Absolutely.
Inflation transfers wealth from currency holders
and lenders, the savers to borrowers, including
governments who borrow vast sums of money. The
system rewards spending immediately. The consequence
of prolonged high inflation is often overinvestment,
where capital floods into low -quality projects,
creating bubbles like the dot -com boom or the
housing crisis, because everyone is desperate
to buy something, anything, before their currency
loses more value. So, to put it simply... Deflation
leads to stagnation and underinvestment and inflation
leads to asset bubbles and malinvestment. Both
are destructive, but in fundamentally different
ways. Correct. And that's why when we look back
through history, prolonged severe deflation is
almost always associated with major economic
depressions like the Great Depression or the
late 19th century long depression. OK, let's
just zoom in on the spiral itself one final time
to make sure we have fully grasped that positive
feedback loop. Think of it as a chain reaction.
It might begin with price drops, maybe due to
a credit contraction. These price drops immediately
cut into corporate profit margins, forcing companies
to engage in lower production or even liquidation.
Which means layoffs. Which means layoffs. Lower
production and liquidation mean job losses, which
translates directly into lower wages and lower
consumer confidence. Lower wages and less demand
than guarantee further price drops, which starts
the entire cycle over again, but from a lower
base. It is a runaway system where the economic
depression itself becomes the fuel for an even
deeper depression. And this is where Irving Fisher's
theory really bites. Precisely. That feedback
loop is exactly why his theory that a mass attempt
to repay debt triggers a price collapse, which
then increases the real burden of the remaining
debt, is so terrifying. It means the very act
of trying to fix your individual financial problem
makes the collective disaster worse. If deflation
is this structurally destructive, especially
in a society as leveraged as ours, then fighting
it becomes the absolute top priority for central.
banks and governments. How did policymakers go
from this old belief that the system would just
fix itself to developing these modern, almost
outlandish tools like QE? There was a dramatic
intellectual shift, and it really started in
the 1930s. Before that decade, the prevailing
classical economic view was that deflation, while
painful, was temporary and self -correcting.
What was their logic? They believed falling prices
would eventually increase the real wealth of
savers, who would then feel richer and spend
more. They also thought cheaper goods would naturally
boost demand and the economy would stabilize
without any external help. It was a very hands
-off, weighted -out approach. But the sheer persistence
and depth of the Great Depression clearly shattered
that belief. It completely shattered it. John
Maynard Keynes famously argued that the system
is not self -correcting when you're in a liquidity
trap. Therefore... Governments and central banks
have an obligation to actively intervene to boost
demand. So he was arguing for an active approach.
Very active. The Keynesian prescription involved
fiscal tools, aggressive tax cuts or massive
increases in government spending, often through
public works and infrastructure projects. At
the same time, the emerging monetarist school,
led later by Milton Friedman, focused on monetary
tools, aggressively expanding demand by lowering
interest rates to reduce the cost of money and
force cash. Okay, so let's talk about the modern
playbook. When nominal rates hit that zero lower
bound or ZLB, conventional easing is impossible.
What are the special arrangements that are required
to overcome that ZLB and force the money supply
to increase? This is where it gets really unconventional.
The central bank finds itself unable to lower
the price of money any further. So they have
to switch tactics and focus on the quantity of
money. They require these extraordinary policy
measures to just flood the system with liquidity,
even at a zero nominal rate, knowing that the
real rate is still high because of the deflation.
They are essentially trying to manufacture inflation
expectations. And this is where the term quantitative
easing or QE becomes the dominant phrase in finance.
QE is the primary modern weapon against persistent
deflation. It's fundamentally the central bank
directly setting a target for the quantity of
money and reserves in the banking system. And
they achieve this by purchasing financial assets
and crucially assets that are usually not used
as bank reserves, like long term government bonds
or even mortgage backed securities. So they're
not just lending to banks. They're actively buying
assets from them. Exactly. They're trying to
inject massive amounts of liquidity directly
into the financial system. Help us break down
the mechanism of QE. I mean, it sounds complex,
but if the goal is to create inflation, how does
buying a bunch of mortgages from a bank achieve
that? It's a massive asset swap. The central
bank takes these slow, illiquid assets like mortgage
backed securities off the commercial banks books
and replaces them with pure cash in the form
of bank reserves. The theory is twofold. First,
by buying all these long term bonds, they force
long term interest rates down across the entire
economy, which should make investment marginally
cheaper. Second, they pump the banks so full
of cash that the hope is the banks will eventually
be forced to lend that cash out into the real
economy. That increases the money supply, increases
velocity and thus creates inflation. The ultimate
belief seems to be that money. or printing money,
is powerful enough to overcome any economic hurdle.
That view was definitively captured by the former
Federal Reserve Chairman Ben Bernanke. Back in
2002, he was referencing the Great Depression,
and he stated unequivocally that, and I'm quoting
here, sufficient injections of money will ultimately
always reverse a deflation. The core idea is
that the power of the printing press is limitless,
and if you print enough, you can always spark
demand and confidence. But the sources introduced
some pretty significant and valid criticisms
of this idea. This hasn't always been the silver
bullet that was promised, has it? Not at all.
And that's the nuance that the listener really
needs to grasp. We saw that these accommodative
policies largely failed to spur sufficient demand
in Japan throughout the 1990s and early 2000s,
and to some extent in the U .S. following the
dot -com stock market shock. You can flood the
banks with reserves, but that doesn't guarantee
lending if the banks themselves remain risk -averse.
But you can't make it drink. Precisely. Furthermore,
we have to address the critique raised by Austrian
school economists. They contend that sustained
low real interest rates, even zero nominal rates,
artificially stimulate asset speculation and
excessive debt accumulation in the non -financial
sector. So they'd argue QE isn't solving the
problem. From their perspective, QE isn't fixing
the underlying debt problem at all. It's merely
papering over it and potentially aggravating
a more severe debt deflation crisis that's waiting
to happen when those new asset bubbles inevitably
pop. So rather than fixing the fever, they're
just delaying the inevitable systemic correction.
That is the core of their critique. And finally,
let's just mention the truly experimental tool
that was deployed after 2008, negative interest
rates. That sounds like something out of science
fiction. How does a bank literally charge you
to hold your money? The idea is to make holding
cash in bank reserves actively punitive. The
central bank charges commercial banks a small
percentage for parking their reserves with them.
This is meant to force those banks to lend the
money out, to do something with it, to accelerate
velocity. Is there a limit to that? There's a
very firm limit. The rate cannot go too negative,
maybe only a fraction of a percent, because if
it does, people and corporations will simply
withdraw their deposits as physical cash and
hoard it in vaults. And that would completely
nullify the central bank's efforts and trigger
a whole new form of money supply contraction.
We've established the theories and the tools.
Now, let's ground all this knowledge in the great
historical case studies provided in the sources,
starting with the U .S. experience, where deflation
was essentially a regular feature of economic
life before the Federal Reserve was created.
Indeed. The U .S. faced multiple severe deflationary
episodes. The Depression of 1818 to 1821 is often
considered one of the most severe. severe, at
least in terms of the price collapse. Agricultural
commodity prices, especially cotton, fell by
nearly 50 percent in just a few years. 50 percent.
What were the catalysts for such an extreme drop?
It was a combination of global and local factors.
Globally, a financial crisis in England caused
a credit contraction that began draining hard
currency species, you know, gold and silver out
of the U .S. Locally. The newly operating Bank
of the United States significantly reduced its
lending. The result was a classic sharp credit
contraction. And there was a food price element,
too, wasn't there? There was. Prices for food
crops had been artificially inflated because
of the global famine caused by the 1816 year
without a summer eruption of Mount Tambora. Once
normal harvests returned in 1818, prices just
crashed back to earth. And technology played
a role even back then. It did. Crucially, improved
transportation, early turnpikes, and steamboats
played a deflationary role. By dramatically lowering
the cost of moving goods to market, this introduced
a structural, productivity -driven price decrease.
So this episode was really a mix of credit deflation
and a very early form of growth deflation. Okay,
next up, the Depression of the late 1830s to
1843. This one looks terrifying on paper. It
was incredibly severe. Following the panic of
1837, the currency in the United States contracted
by about 34 % and prices fell by a matching 33%.
That's a scale comparable only to what happened
during the Great Depression decades later. The
causes included a banking crisis, state bond
defaults, and British banks cutting off the flow
of specie after the collapse of the cotton market.
A contraction of that magnitude sounds like a
total societal collapse. Did output also collapse
by a third? And this is the absolute key nuance
that prevents us from equating all deflationary
periods. Despite the severe monetary contraction
and the price falls, U .S. GDP actually rose
by 16 percent between 1839 and 1843. Wait, how
is that possible? How can you have a severe depression
and deflation and a massive 16 percent rise in
output at the same time? It suggests that the
productivity gains, the underlying economic machine,
were just powerful enough to partially offset
the financial contraction. So while borrowers
and speculators were facing ruin, essential production,
particularly in agriculture, with new cropland
coming online, continued to grow. This made goods
cheaper and more abundant, even as the money
available to buy them was shrinking. So it was
a financial depression, but not necessarily a
production depression. That's a good way to put
it. And it makes the 1830s depression fundamentally
different from the Great Depression, where the
financial and production collapses were very
tightly coupled. That contrast is an incredible
insight for our listener. Okay, let's move to
the Great Deflation, spanning 1873 to 1896. This
was a truly global event, known in some parts
of Europe as the Long Depression. Structurally,
it was rooted in the U .S. return to the gold
standard and the retirement of all that Civil
War paper money. But its defining feature was
technological. It was a massive wave of cost
-cutting and productivity -enhancing technologies.
Bessemer steel, transcontinental railways, the
telegraph. So this was slow and steady deflation.
Very steady. According to Milton Friedman's analysis,
prices in the U .S. fell by a steady 1 .7 percent
per year during this entire 23 year period. It
was slow. It was persistent and it was overwhelmingly
technology driven. This sounds like the purest
form of growth deflation we discussed earlier.
Did that productivity impact all goods equally?
No. And that's the nuance that David A. Wells
provided back in 1890. He argued that the deflation
only really impacted goods that benefited from
these modern manufacturing and transportation
methods. Goods produced by, say, local craftsmen
or localized services did not see the same price
decreases. What about wages? Even more telling.
The cost of labor wages actually increased in
real terms because of the overall prosperity
and productivity gains. This reinforces the idea
that it was technology and efficient scale driving
prices down, not purely a crushing lack of demand.
And finally, we have to touch on the Great Depression
deflation of 1930 to 1933. It changed all the
rules. This was catastrophic. with a deflation
rate hitting approximately 10 % per year. The
mechanisms were a brutal combination of every
bad type of deflation we've discussed. There
was an enormous contraction of credit, widespread
bank failures, and a frantic psychological demand
for cash. And the central bank made it worse.
The Federal Reserve, operating under a mistaken
doctrine, actually contracted the money supply
by 30 % when it should have been massively expanding
it. The simultaneous profound drop in both the
money supply and its velocity created the perfect
inescapable spiral. Before we move to the modern
era, let's quickly acknowledge the brief recent
dips into deflation in the U .S. Right. In the
past 60 years, deflation has only occurred twice
and very briefly. In 2009, during the Great Recession,
the U .S. saw measurable deflation, hitting Nataco's
2 .1 % year over year in July. This was driven
by the collapse in energy prices and housing
demand. And that led to that interesting policy
footnote in Colorado. Yes. Where the state actually
announced a cut in its minimum wage because it
was indexed to inflation and inflation had gone
negative. That was the first time a state had
done that since 1938. And then we saw another
minor short lived dip to manageable point one
percent in 2015, which was mainly driven by global
oil price crashes. OK, now let's turn to the
ultimate modern laboratory for fighting deflation.
Japan's lost decades. This is the cautionary
tale for central bankers everywhere. Japan's
experience, starting in the early 1990s, showed
that monetary tools that worked perfectly in
theory often fail completely in practice. Deflation
persisted for decades despite the Bank of Japan
implementing a zero interest rate policy, or
ZRP, and conducting extensive rounds of quantitative
easing. Their accommodative policies simply failed
to generate a sustained increase in the broad
money supply or its velocity. What were the specific
systemic issues that made the deflation so utterly
stubborn? Well, there were at least seven interlinked
structural causes. First, believe it or not,
tight monetary conditions. Ironically, the Bank
of Japan frequently tightened policy, even just
marginally whenever deflation seemed to be ending.
They were so terrified of a return to the asset
bubble of the 80s that they effectively short
circuited every nascent recovery. And demographics
played a role. A huge role. Second. unfavorable
demographics. Japan has a rapidly aging and declining
population, which inherently constrains long
-term aggregate demand, regardless of what interest
rates are. Third, fallen asset prices. The spectacular
stock and real estate bubble of the 1980s burst,
leading to a painful asset price deflation that
required decades of mean reversion, which just
depressed confidence for a generation. This leads
to the famous issue of zombie companies and the
paralysis in the banking system. That's a key
piece of regulatory insight from the sources.
Absolutely crucial. Fourth, insolvent or zombie
companies. Instead of forcing immediate liquidation,
Japanese banks, often with implicit regulatory
approval, just delayed collecting on nonperforming
loans. They were hoping that the assets would
eventually recover. They kept these unrealized
losses on their books. And what did that do to
the broader economy? It allowed these non -productive
insolvent firms, the zombies, to just keep existing.
It prevented capital and labor from moving to
more productive sectors, which just perpetuated
the deflationary stagnation. And the banks themselves
are in trouble. Yes. Fifth, the banks themselves
became insolvent banks. With these huge portfolios
of non -performing loans, they couldn't lend
new money. They were forced to just build up
their cash reserves to cover the bad loans, which
further restricted the credit supply. And the
public responded rationally to this bank for...
agility, I assume. They did. That's the sixth
point. Fear of bank collapse. The Japanese public,
seeing the banking system struggle, preferred
buying extremely safe Japanese treasury bonds
instead of putting their money in bank accounts.
This money was locked away from the lending system,
depressing both consumption and new investment.
The public was hoarding bonds, not cash, but
the effect was basically the same. And the seventh
factor. Seventh, Japan faced imported deflation.
As countries like China industrialized rapidly,
Japan was importing increasingly cheap consumable
goods. Domestic producers were forced to cut
their own prices to remain competitive, which
created a powerful external deflationary force
that monetary policy couldn't easily counteract.
Finally, what about the massive fiscal response?
I mean, Japan spent an enormous amount of money
on stimulus packages. They did. But the sources
mentioned the Austrian and monetarist critique
that Japan's massive Keynesian stimulus packages
totaling over 100 trillion yen over the years,
may have actually suppressed private wealth creation.
The argument is that the government, by spending
so heavily on public works, was competing against
and crowding out private investment dollars,
thereby hindering the natural, productive reallocation
of capital that the economy so desperately needed.
And it remains a problem to this day. It does.
Despite Prime Minister Shinzo Abe's policies
finally achieving some inflation by 2014, the
subsequent COVID -19 recession reignited deflation
fears in 2020. This prompted heavy government
stimulus worth over 20 % of GDP. Japan remains
the classic example of how entrenched structural
deflation can resist even the most aggressive
monetary action. Let's briefly touch on those
examples of deflation caused by currency rigidity,
starting with Hong Kong. Hong Kong provides a
perfect lesson on the constraints of fixed exchange
rates. Following the 1997 Asian financial crisis,
most of Hong Kong's neighbors devalued their
currencies, which helped their recovery. But
Hong Kong maintained its firm peg to the US dollar,
which prevented devaluation. So they were forced
to adjust internally. They had no choice to maintain
competitiveness against their devaluing neighbors.
Hong Kong had to go through a prolonged period
of consumer price deflation that lasted until
late 2004. This internal deflation was worsened
by cheap mainland Chinese exports and actually
created a slump that was more severe than in
many surrounding countries. And we saw this same
internal adjustment pressure inside the eurozone.
Yes, specifically between 2013 and 2016, several
eurozone members, Greece, Cyprus, Spain and Slovakia
and countries pegged to the euro like Bulgaria,
they all experienced periods of negative inflation
because they shared a common currency or were
pegged to it. They couldn't use devaluation to
stimulate their trade. They were forced into
that same painful process of internal adjustment,
cutting wages and prices to try and restore competitiveness
within the monetary union. They were essentially
imported. deflation to align with the more productive
members like Germany. And that intriguing outlier
example from Ireland in 2009. That was a rare
moment of political honesty. When Ireland announced
its first annual negative inflation since 1960,
the finance minister, Brian Linehan, actually
mentioned deflation as a factor that supported
the argument for budget cuts to public sector
pay and child benefits. So he used it as a justification
for austerity. He did. Instead of treating deflation
as a sickness to be avoided at all costs, he
treated it as data that justified the painful
but necessary wage cuts needed for that internal
adjustment. It's a pragmatic, if painful, response
to fixed currency realities that you rarely hear
voiced so explicitly by modern Western policymakers.
This has truly been a comprehensive deep dive
into deflation. It's absolutely clear that this
concept is far more complex than just a simple
sale sign in a shop window. Let's bring this
all back to the essential takeaway for the listener.
The essential takeaway is that deflation is not
merely a sign of falling prices. It is a profound
structural crisis. It's rooted in the corrosive
relationship between massive debt loads and the
financial system's inability to generate money
velocity. In a modern leveraged economy, deflation
dramatically increases the real cost of every
single loan, and it completely destroys the psychological
incentive to undertake productive investment.
And that is why central bankers see low positive
inflation as mandatory economic lubrication.
We've established that the primary tools of the
last 90 years, Keynesian fiscal stimulus, ZRRP,
and quantitative easing, were engineered primarily
to fight credit deflation, the kind that follows
debt bubbles and monetary contraction. But let's
look forward and maybe a little bit back to the
19th century. We saw those periods of powerful
growth deflation that were driven by unprecedented
technological leaps. The question we face now
is whether history is cyclical. If future technology,
perhaps advanced automation, AI -driven efficiencies,
or even breakthroughs in materials science, if
that technology dramatically cuts the cost of
production across all sectors, does that 19th
century phenomenon of growth deflation become
structurally inevitable once again? And that
raises a really important question for you to
mull over. If we enter a sustained era where
technology drives prices down year after year,
Are our current monetary policy tools, which
all rely on increasing the money supply to counteract
a failure of demand, are they even equipped to
handle a future deflationary environment that's
driven not by economic depression or debt, but
purely by staggering, relentless productivity
gains? Will we need entirely new tools to manage
an economy of prosperity that costs less and
less to achieve? Something to consider as you
observe the price of your next durable good purchase.
Thank you for joining us for this deep dive.
We'll see you next time.