The deathly embrace of deflation

It seems that the US economy is slowly out of the woods with key economic indicators registering improved readings. Don't be easily swayed by these fickle numbers since up-and-down gyration around the mean is a natural short-term pattern. Look at the direction of the main pattern and you'll see deflation unfolding on an unprecedented scale. The indicators that matter - the labour force participation rate, the Case-Shiller house index and the total credit - are stalling, if not declining. What we need to understand are the factors that cause deflation and whether there is anyway to prevent it.

Deflation is basically the obverse of inflation. If you recall the picture of inflation in an earlier post, then deflation is just the opposite of it. It can either be the goods or services production growth outpacing the money supply growth (left panel of left picture) or the fall in money supply getting ahead of the fall in goods or services production (right panel above).

It's a deflation double whammy if a fall in money supply is accompanied by increases in goods or services production. As if that's not strong enough, we can add into the concoction, a slowing population growth, which by implication means a faltering consumption, to give us a treble whammy. Capitalism has been popularly likened to riding a bike; you must always move forward to avoid falling. With a treble whammy, it's like being in a plummeting stalled aeroplane, recovery is out of the question. You'd be lucky to survive.

We'll address only one cause of the oncoming deflation: the precipitous fall in money supply. The other two - increase in goods and services production, and the falling population growth - have been explained in several of my earlier posts. The continued growth of an economy has always required an increase in credit since higher economic activity entails more money or credit to facilitate economic exchange.

However most of this credit is expected to vanish, if not voluntarily, then through harsh means when businesses are shuttered, homes dispossessed, and banks folded. Credit is only as good as the income that sustains it. The income is now gone since in the maturing phase of a Kondratieff Wave, a few producers have cornered the market to themselves. When credit's gone, our financial savings will similarly vanish since savings are all supported by credit.

However in our modern day, the government has stepped in between the creditors and debtors as a backstop to halt the systemic transmission of credit defaults. The government would take up the debts of failed debtors thus safeguarding the creditors' assets. That's why the debt deflation crisis has been averted. No, the right word is deferred. Past governments, including those of ancient civilisations, confronted the debt crises head-on. If the leaders had brains, they annulled the debts, and if they hadn't, they literally lost their heads.

Our modern leaders are smart at seeing the small picture only, totally out of their depth in facing the enormity of the debt deflation crisis. Every problem that arises is tackled in a local manner, while the underlying debt keeps building up for the eventual explosive climax. Obama's major failure is his inability to discern the future economic pattern. The more he claims victory over the recession, the more he'll lose his credibility once the pattern starts moving against his premature declaration.

Technically the government can keep on taking over failed banks and corporations while continuing its major deficit spending. But all governments, no matter how great they are, have limits. And these limits are being reached in the fourth Kondratieff Wave. We only need to look at warfare's 4GW to see how governments will evolve during this crisis. Remember that developments in war presage changes in government. Even before this crisis has reached its extremes, governments all over the world are straining to prevent the fracturing of nation-states. As nations get smaller, their capacity to absorb debts becomes weaker.

With weak or no governments, how do communities get out of the debt deflation crisis? Since most modern leaders are nitwits, we have to look elsewhere for guidance, this time to the northern Thai village of Santi Suk, as reported in the Wall Street Journal, 7 January 2009. Following the 1998 Asian financial crisis, the villagers, facing a shortage of money, took it upon themselves to create their own money, on the advice of two young foreigners from international volunteer organisations.

They've been using that money for over 10 years and a result of that local money, the villagers have become more self reliant. Since the money has no value outside the village, there's no need to keep it for wealth accumulation. The money encourages local shopping and local production of goods. The money is also safe since it is not used elsewhere. So thieves have no incentives to steal the money. That actually is a foretaste of how the future economy would function. Every community would have to be self-sustaining. If you want to save, do it in precious metals. The money must be left to circulate in the local system.

Can our leaders and policymakers be creative in their thinking as these villagers? Fat chance. They're blinkered by the existing monetary systems that they can't see the forest for the trees. And we'll all be dragged along into this march towards self-destruction.