We found an article this morning written by an anonymous risk manager which explains deflation in easy to understand terms. Given the ongoing battle between deflationary forces and inflationary forces, we thought this would be a great article to post.
"Deflation is the contraction (reduction) of money and credit. It occurs when the economic system is carrying too much debt to be supported by the level of income generated by economic activity. It occurs because too much debt has been incurred to create unproductive assets that don’t generate income. Deflation is a corrective process, it’s simply the market not being able to service debt, so we must forfeit.
Since central banks and accepted economic theory are all about creating debt to grow (artificially) economies, periods of inflation (creating money-debt and credit) last a long time: Debt is accumulated incrementally until there is too much of it. So people don’t really understand the tells of deflation.
For example, the things that drive currency movements are quite different. If we’re in an inflationary period (expanding credit) and we get a good economic number, people expect the value of the dollar to rise: A growing economy will attract investment so foreigners buy dollars to invest in US stocks. If you get a bad economic number on the margin, you’d expect the dollar to fall as the opposite is true.
We just this morning saw a disappointing durable goods number. If we were in an inflationary period, you would see the dollar fall. The number actually made the dollar rise by 30 basis points. Why?
In deflation, there’s too much debt. If the economy is slowing down, it makes it more difficult to pay back that debt and you would expect more to default. The more debt that forfeits, the more dollars are destroyed. The more dollars destroyed, the more they’re worth.
Central banks of countries with massive external debt (the US) are desperate to create inflation (keep credit from contracting), but the mechanism to do that is broken (because there’s too much debt in the system).
It is important to always ask the question why something is happening rather than just observe patterns because patterns can change depending on the environment."
