What Are the Causes of Deflation?

To understand the causes of deflation one must first clarify the definition of deflation. There is often misunderstanding around this. Many people define deflation as falling prices and inflation as rising prices. These definitions are wrong and describe effects of deflation and inflation, not the causes.

Deflation is a contraction in the amount of money and credit in an economy, where money is a socially accepted medium of exchange, value storage and final payment, and credit is the right to access money.

So, understanding what causes a contraction in money and credit is key to understanding the causes of deflation.

There are two main causes of deflation:

  1. A build-up of excess credit.
  2. A negatively trending social mood.

Pre-Condition for the Causes of Deflation

In order for there to be a contraction on money and credit in an economy, there has to have been a build-up of money and credit in the first place. This can be thought of as the primary pre-condition for the causes of deflation. Over the last couple of centuries, a minority of economists, particularly from the Austrian school such as Ludwig von Mises and Friedrich Hayek, and more recently from so-called post-Keynesians like Steve Keen, have written about the dangers of excessive credit expansion. The idea that credit expansion will lead to credit contraction is far from a mere theoretical, academic concept though. One just has to glance at history to see that deflationary periods are preceded by a build-up of excess credit. In fact, a 1957 letter by bank credit and Elliott wave expert Hamilton Bolton summarized a study he had undertaken of major U.S. depressions since 1830. He found that:

  • All (depressions) were set off by a deflation of excess credit. This was the one factor in common.
  • Sometimes the excess-of-credit situation seemed to last years before the bubble broke.
  • Some outside event, such as a major failure, brought the thing to a head, but the signs were visible many months, and in some cases years, in advance.
  • None was ever quite like the last, so that the public was always fooled thereby.
  • Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.
  • Credit is credit, whether non-self-liquidating or self-liquidating.
  • Deflation of non-self-liquidating credit usually produces the greater slumps.

On Bolton's latter two points, self-liquidating credit is a loan that is paid back, with interest, from a productive economic activity. For example, a company borrows money to buy a new machine to increase production. The increased production creates the added-value to pay back the loan, with interest. Non-self-liquidating credit is where, for example, someone borrows to purchase a television -- no economic value is being added to the economy.

The build-up in excess credit will go on for as long as a) there is a general willingness for people to borrow and lend, and b) borrowers have the ability to pay back their loans with interest. The most important factor is the willingness of people to engage in credit activity and, when this changes, it will have been caused by a move towards negative social mood.


A Negatively Trending Social Mood Causes Deflation

Trends in social mood are the cause of everything. The build-up of excess credit (inflation) that is a precursor to the subsequent deflation is, itself, driven by a positively trending social mood. People are optimistic about the future and so borrow and lend freely. The stock market goes up and companies' bonds are in great demand because social mood detects nothing but blue skies on the horizon.

At some point though, as the cycle matures, mood transitions from positive to negative. There is no "catalyst" for this mood change -- it happens subconsciously and naturally. But as the new negative mood sets in, society in general starts to become more cautious. This permeates into individual decisions regarding financial affairs. Lenders start to be less willing to lend, but borrowers also start to have a more cautious attitude. The process starts slowly, almost unnoticed, but gradually builds momentum until, as Bolton put it, "a major failure" brings the deflation to a head. The great credit crisis of 2008 did not just suddenly appear out of nowhere. Credit markets started to break down in 2007 when the willingness of lenders and borrowers began to wane.

The slowing in credit market and economic activity, caused by the negative trend in social mood, means that existing money is circulated less. Cash hoarding becomes prevalent as an increasingly cautious society sees the value in cash. As the prices of goods and services fall, a mind-set of delaying purchases emerges. This can lead to further cash hoarding, further price falls and a deflationary spiral.

As credit deflates, the money multiplier effect goes into reverse, causing the amount of bank deposits in the economy (money) to shrink as well.


An Example

Social mood in Japan was strongly positive in the 1980s and that fueled a build-up of private sector debt. As the chart below shows, private sector debt as a percentage of Gross Domestic Product (GDP) rose from around 150% in 1981 to over 200% by the end of the decade. The positive mood trend also drove a tremendous bubble in the stock market. The build up in excess credit was the pre-condition and the subsequent negative trend in social mood was the main cause of deflation in Japan. 

The Japanese stock market topped out in 1989 and started an 18-year decline with a precipitous fall in 1990. Notice that private sector debt as a percentage of GDP continued to rise until 1994. That was mainly due to GDP contracting but the level of debt remaining. Eventually, though, the forces of deflation lead to a contraction of debt as well, and the debt deflation in Japan picked up pace during the latter half of the 1990s and into the noughties as the negative trend in social mood intensified.

The Japan experience tells us that, although deflation can lead to short-term periods of acute stress, the overall process tends to be long and drawn out. It takes time for the excess credit to be deflated away and that is related to the negative social mood trend that drives it.

Japan Private Sector Debt as a Percentage of GDP