Why Can’t Central Banks Prevent Deflation?

It would be hard to overstate the degree to which psychology drives an economy’s shift to deflation.  When the prevailing economic mood in a nation changes from optimism to pessimism, creditors, debtors, investors, producers, and consumers all change their primary orientation from expansion to conservation.  As creditors become more conservative, they slow their lending.  As potential debtors become more conservative, they borrow less or not at all.  As investors become more conservative, they commit less money to debt investments.  As producers become more conservative, they reduce expansion plans.  And as consumers become more conservative, they save more and spend less.

These behaviors reduce the velocity of money, which puts downward pressure on prices.  Money velocity has already been slowing for years, a classic warning sign that deflation is impending.  Now, thanks to the virus-related lockdowns, money velocity has begun to collapse.  As widespread pessimism takes hold, expect it to fall even further.

In addition to the psychological drivers, there are structural underpinnings of deflation as well.  A financial system’s ability to sustain increasing levels of credit rests upon a vibrant economy.  A high-debt situation becomes unsustainable when the rate of economic growth falls beneath the prevailing rate of interest owed.  As the slowing economy reduces borrowers’ ability to pay what they owe, creditors may refuse to underwrite interest payments on existing debt by extending even more credit.  When the burden becomes too great for the economy to support, defaults rise.  Moreover, fear of defaults prompts creditors to reduce lending even further.

The resulting cascade of debt liquidation leads to a deflationary crash/spiral.  In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities, and real estate, causing the prices of these assets to plummet.  The cycle ends only after the supply of credit falls to a level at which the surviving creditors are satisfied with the collateralization borrowers have to offer.  Recognizing the role of psychology in this cycle is vital to understanding why no amount of intervention by governments and central banks can prevent deflation.

Unfortunately, because society at large thinks of deflation as an economic condition we should fear, central banks borrow and print money to avoid it. That’s what some are doing right now, through programs ranging from quantitative easing to sending citizens checks in the mail.  As they do so, they are increasing the volume of base money in their economies.  However, the deflation that we see coming will result from a swift contraction in credit, not base money.  And even the trillions of dollars central banks are injecting into the money supply are insignificant compared with the total amount of credit in the global economy.

Consider the situation in the United States.  In 2008, the U.S. monetary base was less than $900 billion.  Then, in response to the Great Recession, the Fed started printing vast amounts of money.  Today, the U.S. monetary base is around $3.8 trillion.  This fourfold increase is remarkable—but compare it with total U.S. debt, which statista.com pegged at $72 trillion at the end of 2018.  Add in derivatives, which are just another form of credit (I owe you $X if Y happens), and the number is much higher.  While we have found no reliable source of U.S.-only derivatives exposure, at a global level, total credit can be estimated to be in the range of $1.1 quadrillion to $1.8 quadrillion.  Quadrillion—in other words, a thousand trillion.

The deflation of such a stupendous amount of debt will overwhelm everything in its path.  The U.S. Federal Reserve and other central banks are so desperate to avoid deflation that they are buying up toxic loans and junk bonds. In the long term, these debts must be repaid with tax revenues.  And in a deflationary depression, tax revenues also plummet.

Central banks cannot prevent deflation.  The Bank of Japan and the Japanese government have spent decades injecting money into that nation’s economy, even buying huge amounts of stocks directly—in effect, nationalizing the stock market—to no avail.  Private debt as a percentage of GDP in Japan is still declining from its peak nearly three decades ago, and consumer prices remain stagnant.  When the massive credit bubble we’re currently riding deflates, the size of government debt will only exacerbate economic problems in the U.S. and beyond.