Deflation and its consequences

By George Atsalakis


Economical tightness commences upon the emergence of the reduction of the total demand of goods and services regarding their current total production. When such reduction appears, the prices of goods and services decrease. The fall in prices constitutes a sign for the producers to reduce their production resulting, therefore, in decreasing total production.
Historically speaking, (looking into the economy of the U.S.A) long-term economical recessions took place from 1720 until 1784, from 1835 until 1842 and from 1929 until 1932. The biggest recession in 1929 reached its lowest level in February 1933, seven months after the lowest level at the stock market. Stock markets do not start to collapse after long periods of economical worsening, but collapse all of a sudden after a long period that stock and shares rise as well as economy expansion. Recession starts with the reverse of the long lasting and insistent rise of stocks and shares. The abrupt change from increasing optimism to increasing pessimism creates economical tightness. In short, recession comes along with remarkable Stock Exchange drops.
1. When deflation appears
Inflation: it is the increase of the volume of money and credits compared to the goods available. Deflation: it is the decrease of the volume of money and credits compared to the goods available. Money: it is a socially-accepted means of transaction, accumulation of value and means of payment. Credit: it is the right to have access to the money. Credit can be given by the money-owner. In order the banks to attract money, they pay deposit interest to the money-owners (for simple or deferred deposits, for bonds, interest-bearing bills etc.) Thus, the banks owe money to their depositors and the depositors become creditors to the banks. Then, the banks lend money (provide credit) to their customers (business, housing loans etc) resulting in the banks being creditors and their customers to owe them money.
2. What are the consequences of inflation and deflation concerning prices?
When the  volume of money and credit increases  in relation to the volume of the goods available, the relative value of each money unit decreases making the prices of the goods to rise in general (inflation).
When the volume of money and credit decreases in relation to the volume of the goods available, the relative value of each money unit increases making the prices of the goods to reduce in general (deflation).
Therefore, it should be clear that the changes regarding the prices of the goods occur due to the fact that the value of the money unit is decreasing or increasing, and not the value of the goods itself.
Most people are aware that inflation affects the prices of goods; however, they rarely estimate the effect on the prices regarding investments (property, stocks, bonds, merchandise etc.). The inflation during the 1970s raised the prices of gold, silver and other merchandise. The inflation during the 1980s raised the prices of shares and property. Those changes in prices are due to the difference in the psychology of the society that comes along with inflation and deflation. The price effect due to deflation is simpler. Price decreases occur simultaneously to goods and investments.
A presumption is required for inflation to emerge: a general credit expansion in the society.
A credit (loan) is paid off with interest from the production (company). The production is being serviced by the loan (e.g. though the finance of new factories) and creates profits for the business that make possible the payment of the loan. This transaction adds value to the economy.
There are credits, however, which do not contribute to the production. When the banks give money for consumer goods such as vessels, mansions or for speculation such as loans for buying stocks, this kinds of loans do not contribute to the productive procedure.  The payment of these interests presses some other sources of income. This form of lending (for consumer goods, stocks etc.) is counter-productive since it adds cost to the economy and not value. If one borrows in order to buy a cheap car to commute, this kind of transaction gives value to the economy. If one wants to buy a luxury car, this type of loan does not add value to the economy. Additionally, the quality of the costs is worsening because the purchasing capacity is transferred from the investors or producers to those who borrow to consume.
Upon the end of a huge credit expansion very few creditors expect problems of non-loan payment, resulting in lending money to people with limited capacity of paying-off. Very few borrowers expect their luck to change and for this reason they borrow extensively so as to enjoy good life! Deflation entails a remarkable percentage of seizure for the pay-off of the loans that fall behind.
Credit expansion presupposes the existence of a general wish to provide and receiving loans and the general capability of the borrowers to pay interests.
This wish depends upon a) people’s trust e.g. if the creditors and the borrowers are sure that the debtors will have the ability to pay-off their loans and b) the tendency of the production that really enables the debtors to pay-off their loans.  Thus, the more trust and production increases, credit offer tends to increase, too. The expansion of credits finishes when the general wish of borrowing or the general ability to pay-off cannot be kept any more. As trust and production decrease, credit offers are getting difficult.
The psychological side of recession and deflation must be taken into account. When social disposition changes from optimism to pessimism, then the creditors, the debtors, the producers and the consumers, change their original orientation from expansionism to conservatism. Creditors become conservative and reduce loans. Debtors become more conservative and reduce their loans or they do not borrow at all. The producers become conservative and reduce their investment plans. Consumers become conservative and reduce their expenses saving more. This kind of behavior decreases the speed of money circulation (money becomes rare in the market) pressing the prices to lower.
The ability of the economical system to maintain the increasing levels of lending during a recession period is restricted. A situation of high debts becomes unbearable when the rate of development decreases under the rate of interest of the money owned and the creditors deny accepting to pay interest with more credit.
When these loads are so heavy and economy cannot support them anymore, then the reverse of the situation, the decrease in lending, the decrease in consumer expenses and the decrease in production result in debtors gaining less money that is not enough to pay-off their loans and at this point there is bankruptcy. The occurrence of bankruptcy and the fear on this issue deteriorate negative psychology and the creditors do not finance enough loans while they simultaneously  require paying-off or decreasing the already existing loans. In this way we have an increasing pessimism in the same way as previous development had led to over-optimism.
Loans are either paid-off or re-financed with other loans, or they cannot be paid and thus wasted.In the first case the value of the loans is not lost, in the second case there is a partial loss while in the third case there is complete loss.
The debtors try in despair to draw cash in order to pay-off their loans selling any part of their investments that can be liquidated (stocks, bonds, merchandise contacts, property etc). This policy results in constantly lowering the prices (in stocks, bonds, property etc.) due to over-demand and in this way the value of mortgages does not reassure paying-off the loans.  The above process continues until loans decrease in such a level that creditors accept that insecure loans can be covered by existing mortgages.
3. Deflation and recession
Deflation is partly characterized by a laborious, lasting and deep decrease of people’s wish and capability to lend and borrow.
Recession is partly characterized by a laborious, lasting and deep decrease of production. The time when reduction in production reduces the borrowers’ ability to pay-off their loans, then recession caters for deflation. The time when reduction in credits reduces new investments, deflation caters for recession. Since credit and production supply the values of the investments, the prices are reduced in an environment of deflationary recession. As the values of investments reduce, people lose money. This fact decreases the ability to lend, to serve their loans and support production.
The most important deflationary recessions took place from 1835 until 1842 and from 1929 until 1932. In both cases a continuous credit expansion was prior. Today the credit expansion is the biggest that the humanity has experienced.
Most people do not realize that the value of their investments can run through (mostly Stock Exchange investments). The majority believes that money should be invested somewhere and therefore they shift from stocks to bonds and then to property and so on. Money, however, is not lost because for every seller there is a buyer and so money just changes hands. This is true concerning money, but it is not true concerning the values of investments that constantly change.
The values of investments (e.g. the price of a stock) do not increase because for every seller there is a buyer but because the dealers agree that prices will increase even more. Therefore, no-one needs to do something for price rise. Reversely, investment rates are reduced because a seller and a buyer agree that the present rate of an investment (e.g. of a stock) is high. If there is no offer to buy in a higher price than the one the above seller offers, then the price –the value of the investment decreases not only for the above owner but for any other party that holds the same investment. Even if millions of investors have the same stock, the value decreases although they do nothing.
Two investors caused the reduction of the price through the transaction they realized and the other investors caused a further drop by choosing not to disagree with the price of the transaction in focus. The annihilation of the rates of the investments in stocks and merchandise can often be seen. Every time the rate of a stock decreases or increases in an «opening»,  a new price is simply registered during the first transaction which is agreed by two people (the buyer and the seller). No other activity is required on behalf of any investor for this to happen, it just happens because the rest of the investors did not activate on the other part. (E.g. the rate of a stock reduces because the buyer offers lower price and there is not a third party to offer a higher price in the market). In periods of panic there are certain price levels that transactions do not occur as  prices are reduced with big gaps; however from one transaction to another.
Same sort of dynamics are developed in credit, as well. Let us assume that the creditor lends 100.000Euros. The borrower receives the money. The creditor feels that he sill owns the 100.000 Euros. If the creditor is asked about his assets, he will estimate the 100.000 Euros he has lent, as well. According to this belief there is 200.000 Euros in the minds of lender and borrower while it was only 100.000 before. If the lender asks his money back and receives it, then he becomes the owner of the 100.000 again. If the borrower cannot pay the loan then its value is annihilated.  If the original creditor had sold his loan to an investment company then this company would register the damage caused by the inability to pay-off the loan.
When the volume of credit is vast, the investors can see huge amounts of money and values which in fact is only paper. This corresponds to paying-off contracts, the luck of which depends on common agreement regarding their value and the ability to pay-off.
The dynamics of the increase and decrease of the value of investments can explain why in a declining Stock Exchange market, millions of people become poor. At the peak of the expansion of the faith or the Stock Exchange market, the value of investments has highly increased. Not only the sellers but also those, who continue to keep their shares, feel the wealth. The investors, who keep their shares, constitute the biggest majority and enjoy more wealth because the total money offer is relatively stable and the price of the stocks continues to dramatically increase. When the tendency of the market reverses and declines, the dynamics function in a reverse mode. Only very few stock-holders sell their shares at the 90% of their peak price. Some others sell at the 80% of the top, others at the 50%, and others at the 30% and so on. In any case the sellers transfer the rest of future damage to someone else.
In a declining market the vast majority of investors does not activate and is trapped in low-rate shares or even shares of trifling value. The value that an investor believes to have in his portfolio diminishes terribly or is scattered to the winds. The idea that the shares he owned had significant value was only in his mind and in the mind of other investors who agreed on the issue.  When this agreement changed, values changed, as well. This is exactly what happened in most investments (property, stocks, merchandise, bonds etc.) during deflation period.

Source of publication  6th issue In-On

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