Deflation Is a Disaster – Part 2 — Faith and Finances Ministry
Part 1 of this series on deflation discussed why it is unthinkable. Although sustained deflation is rare, we must be prepared for it. But is deflation really a disaster? Wouldn’t it be a good thing if prices fell? Wouldn’t it be preferable if the median house price fell to $100,000? How about a $10,000 new car?
Who wouldn’t want affordable health care, education, energy, or insurance? If technology is making things better and cheaper, then why aren’t we seeing lower costs? No doubt, we are benefiting from advancing technology, but this isn’t the kind of deflation that is disastrous. Technology-based deflation counterintuitively increases demand and causes economic growth (i.e., it is the good kind of deflation, see Jevons paradox).
Our Unstable, Debt-Based Monetary System
No one (except for centenarians) can remember the Roaring 20s and the 1929-1939 Great Depression that followed. We have lost generational memory.
What has been will be again,
what has been done will be done again;
there is nothing new under the sun. …
It was here already, long ago;
it was here before our time.
— Ecclesiastes 1:9-10
The risk of a deflationary collapse stems from our unstable, debt-based monetary system. In our system, money is debt. Dollars are “Federal Reserve Notes”, which are physically printed debt obligations (of course, dollars are also created out of thin air in digital form). Banks, corporations, and even individuals can also create debt by making loans (banks create the great majority of money in the system). Increasing the money supply (and the speed in which it flows through the system, i.e. money velocity) devalues money (inflation).
However, every time a debt is paid off, the total money supply shrinks, increasing the value of money. Every time a company or person goes bankrupt, the same thing occurs. Just as it is with goods, money’s value is subject to the laws of supply and demand. When the value of money (or debt) increases, it drives more debt defaults, further perpetuating the downward cycle. If hyperinflation is the engine running too hot and eventually blowing up, uncontrolled deflation is the engine shutting down.
The system is inherently unstable, because debt can be rapidly created or destroyed. Central banks’ power to manage deflation and inflation is limited and fraught with political restraints. Even in the 1930s, when there was a gold standard, deflation took hold because banks had created too much currency. Inevitably, banks and governments make more promises to pay more gold than there is gold (e.g., ten promises to pay a unit of gold, but there’s only one unit of gold). This is called fractional-reserve banking, which has been used for thousands of years.
When economic confidence is severely shaken, people instinctively redeem their currency for gold (a bank run); but if there isn’t enough gold in a bank, the bank fails, potentially leaving its depositors with nothing. This can cause those depositors to go bankrupt, also potentially causing their creditors to go bankrupt. This viscous cycle perpetuates itself until debt leverage is brought low enough to restore confidence. This happened in the gold-backed system of the 1930s. In our current fiat-based system, where currency is not redeemable for anything, this type of disaster could be much worse.
The Downward Spiral: How Deflation Perpetuates Itself
Imagine a world where everyone’s pay gets cut in half (e.g., AI crashes the labor market), but everyone’s mortgage loan values and payments stay the same. Many people wouldn’t be able to keep up with their payments, and their properties would eventually go into foreclosure. The flood of foreclosures would then cause property values to fall dramatically, further exacerbating the decline. Many wouldn’t be able to sell their properties, because their home values would fall below their home equity. We saw some of this in the 2008 Great Financial Crisis.
If people didn’t have money to pay debts, creditors like banks and other financial institutions would eventually go bankrupt. People wouldn’t have money to buy goods and services, eventually causing corporations to go bankrupt. The banks and companies that survive would have to lay off workers and decrease wages. This downward spiral would feed on itself. At some point, the whole system would seize up, causing mass poverty and social unrest.
Governments would still owe the many trillions in debt obligations but would have difficulty making payments, because of falling tax revenues. Government deficits would balloon, because they would be still obligated to pay entitlements like Social Security and Medicare in appreciating dollars. Eventually, governments would not be able to continue to finance these types of entitlements and would be forced to reduce or eliminate the benefits.
Those who could pay down their debts would be strongly incentivized to do so (because debt would be increasing in value), putting further downside pressure on the money supply (paying down loans reduces the money supply by sending debt to “money heaven”). Many would file bankruptcy or simply not pay their debts. I won’t even bother discussing the massive deflationary risks associated with private equity and derivatives. With each default there would be fewer total dollars in the system, making dollars increasingly valuable.
A protracted deflationary unwind would leave most people completely broke and without a job. See my book review for The Great Depression: A Diary by Benjamin Roth for a vivid historical picture. Industry and society would be severely damaged. The townsfolk would eventually come out en masse with their torches and pitchforks. I think you can see why a deflationary spiral is a central banker’s worst nightmare and why the central banks work so hard to avoid deflation, even at the risk of creating too much inflation.
Some of you may be thinking that the government would never let this happen, because it can just print money to fix the problem. I tend to believe that too, but we’ll begin to address that likelihood in the next article on why governments can’t fully control deflation.
For further study, here is a list of Scriptures on investing. For a broader spiritual view on investing, inflation, deflation, and other topics, read Faith and Finances or do the Building Faith and Finances course.
