Expert Commentary

Deflation: The Excess-of-Credit Situation

Let's talk about deflation.

Back in the 1940's, Hamilton Bolton had read R.N. Elliott's articles in financial world magazine, and they struck a chord. In 1946, he and his partner formed the Bolton-Tremblay Bank Credit Analyst in Montreal, Canada, and Bolton went on to publish his own Elliott wave supplements to that publication. BCA research still exists to this day and still uses the language of cycles and super cycles.

Bolton studied the history of depressions since 1830 and summarized his conclusions in 1957. 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.

So, a build-up of excess credit is the main precondition for deflation.

This is what happened in Japan, as this chart shows. Japanese private debt as a percentage of GDP ballooned higher in the 1980's as positive social mood also propelled the stock market higher. The Japanese stock market topped at the very end of 1989 and crashed during 1990.

200407 - MG1

Notice, though, that, after that, private sector debt in Japan initially increased as a percentage of GDP. this was due to the decline in GDP, and it highlights the fact that debt inititally becomes even more of a burden in a deflation. Then, as the deflationary mood took hold in Japan, private sector debt deflated relentlessly. At the same time in Japan, public sector debt ballooned in an effort to offset what was happening. But it couldn't. The public sector merely crowded out the private. A similar process could now be underway in western developed economies.

This next chart shows U.S. private sector debt as a percentage of GDP. Notice the similarity in numbers between the U.S. and Japan, each over 210% at their peak.

200407 - MG2

The U.S. chart reveals that the private sector debt deflation process may have already started in 2009. However, the drop is due to the fact that, even though the nominal level of private debt has continued to expand, the economy has been in a boom, even though that may have been artificially fuelled by QE. Indeed, private sector debt to GDP is still hovering around 200%.

Now that the nominal value of the stock market has topped out and the economy is going into freefall, do not be surprised if the level of private debt to GDP actually rises initially. This will be due to GDP cratering. Only after that, will we see debt deflation in all its power, as the negative trend in social mood results in lenders not wanting to lend and borrowers not wanting to borrow.

Stay tuned to Elliott Wave International and also to keep one step ahead.