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Generational Dynamics Web Log for 8-Nov-2008
The spectre of deflation forces a historic change in economic theory

Web Log - November, 2008

The spectre of deflation forces a historic change in economic theory

Economists are shocked that the fight against inflation is over.

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On Friday, I listened to a lengthy BBC segment on deflation, and how shocked economists are that the fear of inflation has changed into a fear of deflation in just a couple of months.

There was also a major NY Times article last weekend, and a Time Magazine article on "The rising threat of deflation." If you do an internet news search for the word "deflation," you'll now find dozens of examples in the last few days.

It's been quite a surprise to me to see this. I've been writing about deflation for years, and I've discussed how hyperinflation is completely impossible in today's deflationary spiral environment. But now, all of a sudden, economists are talking about deflation.

This is actually a major change in attitudes of economists. For years, economists have considered inflation the only major challenge. In fact, Bernanke is known to have believed (and perhaps still believes) that deflation of a "fiat currency" is impossible. Incredibly, he continued to believe this even after several years of deflation in Japan.

It's really astonishing to see this. When I was growing up in the 1950s, no one ever worried much about inflation, but they were very worried about a new Great Depression. That's because those people grew up during the Great Depression of the 1930s, and that's what they knew.

My mother's family had run a successful candy shop in Chicago in the 1920s, but in the 1930s the store went bankrupt. My mother managed to go out and lie about knowing how to operate accounting equipment and got a job as a bookkeeper. The $8 a week she earned allowed the family to survive. Throughout my life, my mother was always worried about a new Great Depression, well into the 1990s.

But today's economists believe that deflation is impossible, and that the only thing to worry about is inflation. That's because those people grew up during the ironically named Great Inflation of the 1970s.

As I've pointed out many times, mainstream economists and macroeconomists are totally clueless as to why any of this happened. They can't explain why inflation occurred in the 1970s, they can't explain why, having occurred, it didn't cause a major asset bubble, they can't explain why the panic of 1987 occurred, or why it happened at exactly that time, they can't explain why the dot-com bubble began in 1995, and why it began at exactly that time, they can't explain why real estate or credit bubbles occurred (and some are even still denying that there even was a bubble), and they have ABSOLUTELY NO IDEA AT ALL how we got to where we are today. All they can do is throw money at the problem, and they have ABSOLUTELY NO IDEA whether that's going to work.

Long-time readers of this web site know what I'm going to say next -- that generational theory explains all of these things, as I've written many, many times. (See "System Dynamics and the Failure of Macroeconomics Theory," and "What's coming next: Understanding the deflationary spiral," for example.)

In brief, the explanation is as follows: The real estate and credit bubbles created hundreds of trillions of dollars of money that was used for investments. Now, thanks to the leaking of these bubbles, there are a few trillion fewer dollars in the world each week than there were the previous week. As money becomes scarcer, it becomes more valuable, causing deflation. This deflationary spiral will continue for years, as the bubbles continue to collapse.

That's why the current change in attitudes of economists is so significant: Because it represents the repudiation of decades of mainstream economic "theory."

Accepting the fact that deflation is occurring is no trivial decision, like picking out the color of your clothing for the day. It's a major change in direction for mainstream economics, and it's a complete refutation of much of economic theory as developed by Fed Chairman Ben Bernanke and others.

They will literally have to change all their computer models, and rewrite all their research papers and textbooks. This change in economic thinking is truly historic.

As I said, I heard a lengthy segment on this subject on the BBC on Friday. Below is my transcription from business editor Louise Cooper.

I want to get into to this because it provides several examples of faulty reasoning about what's going on today.

"What's interesting about this is the very rapid change in expectations, from inflation to now deflation. And one of the reasons has been commodity prices. We've seen truly extraordinary falls in commodity prices. And I thought it would be quite useful just to run through some of them.

So, first of all food, wheat. The price of wheat peaked in February of this year at $470 a ton. It's now about halved to $259 a ton. Oil, even more extraordinary. Peaked in July at $147 a barrel, we're now below $60 a barrel. A truly extraordinary selloff. And steel, even more extraordinary -- this is looking at construction grade steel. A ton of it would have cost you $1,125 in August of this year. Now it's costing you $330 a ton. What about that -- just a third of the price, just a couple of months ago.

It's that dramatic fall in commodity prices that is now leading economists to say, "I think inflation is over." I don't know if it's true, but that's what they're thinking."

So we have step 1 in the logic: "We know that we're in a deflationary period because commodities prices are falling sharply."

This is the mirror logic to what we've been hearing for years -- that we've been in an inflationary period because commodities prices were high.

This has always been fairly shallow logic. In 2003-2004, I was pointing out that we were obviously in a basically deflationary period because interest rates were effectively close to zero. With interest rates that low, we should expect to see massive inflation, but instead we were seeing little inflation, and occasional deflation.

Still, it's good that economists are finally beginning to recognize that it's a deflationary environment, even if they arrived at that conclusion through faulty logic.

Cooper was asked what caused the fall in commodities prices:

"I think what's happened is that the credit crunch has been with us a bit over a year now, but I think in the last few months we've seen an intensification -- and I won't list how many banks have gone bankrupt or asked for money or been sold, but there's a whole load of them, really peaking in the bankruptcy of the American investment bank Lehman Brothers. And it seems that all of that news is now feeding through quite dramatically in terms of the economic effects, and all the data we're getting from the economy is very bad, and that says that demand is going to be bad in the future, recession is coming to the world, and that has caused some of the big decreases in the price of commodities."

Here's step 2 in the logic: "The credit crunch has caused bank failures, bank failures are causing bad economic data, bad economic data is causing a recession, and a recession is causing decreases in the price of commodities."

This is nothing but a laundry list of troubles. What caused the credit crunch? As I've said so many times, mainstream economics has NO IDEA how we got where we are. Others say we got here because of George Bush, even though that's not even possible.

Cooper was then asked what we can learn from Japan's experience with deflation in the 1990s. She didn't answer the question, and said something that makes no sense at all:

"Deflation is a very bad thing, and once you get it, it's very difficult to get rid of it. The policy tools, once you have deflation, are quite limited.

The problem is with deflation is that consumers, individuals and businesses postpone buying things. Because why would you buy something now, when you could buy it in six months or a year's time for cheaper. Bearing in mind consumption makes up about 70% of the economy in the UK and the US, that can have devastating effects.

Now the latest IMF report says that deflation in Europe and the States is just a little threat, but even a little threat of something as bad as deflation can cause those in power many sleepless nights."

Step 3 in the logic is total nonsense. "People will stop buying, in anticipation of falling prices, and that will hurt consumption."

People have to eat, and so they don't stop buying food. Furthermore, consumers, individuals and businesses have no way of being certain that deflation will continue.

Ever since the personal computer came out in the early 1980s, it's been a standing joke that whatever computer you buy today will be obsolete within six months, because something cheaper and more powerful will be available at that time.

And yet, consumers, individuals and businesses have bought huge numbers of personal computers, because it's something they needed. So this whole discussion of deflation reducing consumption is nonsense. If anything, reduced prices should increase consumption.

So it isn't deflation that causes decreased consumption. What causes decreased consumption is the lack of credit and liquidity.

Now I'd like to turn to a different segment in that same BBC broadcast. In this segment, the economist David Parker at Stanford University used Chaos Theory to explain why the current crisis was not predicted:

"Economics based principally on the principles of the Enlightenment, that if you study something long enough, you'll get the answer. But very small events can trigger huge changes in the economy.

We know that a bank problem can trigger a crisis, but usually bank problems just trigger small crises. This time out, they've triggered a whole hurricane. We didn't predict it and, in my view, we couldn't have predicted it, because the world out there is too complex."

This is such nonsense that it gives me a headache.

The standard example of chaotic events that everyone uses is the butterfly flapping its wings in China, triggering a hurricane in North America. Since most butterflies do NOT trigger hurricanes, Parker's point would be that you can't predict which butterfly will trigger a hurricane.

But that's not the issue.

When hurricane season approaches, you CAN in fact predict that there will be hurricanes, with a very high probability. Whether you can relate any hurricane to a particular butterfly is irrelevant.

Similarly, the current deflationary spiral could be predicted, and WAS predicted repeatedly on this web site, based on the huge real estate and credit bubbles. Every bubble has to burst, and that's VERY predictable, even if there's no way to relate the bursting to some particular banking problem.

Parker's claim is really very funny. If you believe him, then NOTHING would be predictable, because it would all fall prey to chaotic events. In fact, mainstream economics hasn't predicted or explained any of the major economic events for decades, so if you're a mainstream economist, then Parker's claim is a good excuse for why you're always wrong.

The sinking boat is actually a sculpture, in the Thames river in front of London's business center. <font size=-2>(Source:</font>
The sinking boat is actually a sculpture, in the Thames river in front of London's business center. (Source:

From the point of view of Generational Dynamics, all of this economics chatter represents a historic passage, where economists are realizing that mainstream theory is completely wrong. The theories are wrong, the models are wrong, the results are wrong.

It'll be interesting to see where economists land. If they move in the direction that I described in "System Dynamics and the Failure of Macroeconomics Theory," then they'll finally start to get some things right.

Unfortunately, that's not what's most likely to happen. What's most likely to happen is that they'll update their models and theory to take into account what happened in 2008. They'll finally start considering deflation as a possibility, but they'll model it incorrectly, so they'll be wrong again in 2009. As I always like to say, economists are among the people who "believe that history always begins this morning."

(Comments: For reader comments, questions and discussion, as well as more frequent updates on this subject, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (8-Nov-2008) Permanent Link
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