Price Effects of Inflation and Deflation
When the net volume of money and credit rises relative to the volume of goods available, the relative value of each unit of money falls, making prices for goods generally rise. When the net volume of money and credit falls relative to the volume of goods available, the relative value of each unit of money rises, making prices of goods generally fall. Though many people find it difficult to do, the proper way to conceive of these changes is that the value of units of money are rising and falling, not the values of goods.

The most common misunderstanding about inflation and deflation echoed even by some renowned economists – is the idea that inflation is rising prices and deflation is falling prices. General price changes, though, are simply effects.

The price effects of inflation can occur in goods, which most people recognize as relating to inflation, or in investment assets, which people do not generally recognize as relating to inflation. The inflation of the 1970s caused dramatic price rises in gold, silver and commodities. The inflation of the 1980s and 1990s caused dramatic price rises in stock certificates and real estate. This difference in effect is due to differences in the social psychology that accompanies inflation and disinflation.

The price effects of deflation are simpler. They tend to occur across the board, in goods and investment assets simultaneously.

The Primary Precondition of Deflation
Deflation requires a precondition: a major societal buildup in the extension of credit (and its flip side, the assumption of debt). Austrian economists Ludwig von Mises and Friedrich Hayek warned of the consequences of credit expansion, as have a handful of other economists, who today are mostly ignored. Bank credit and Elliott wave expert Hamilton Bolton summarized his observations this way:

In reading a history of major depressions in the U.S. from 1830 on, I was impressed with the following:

(a) All were set off by a deflation of excess credit. This was the one factor in common.

(b) Sometimes the excess-of-credit situation seemed to last years before the bubble broke.

(c) 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.

(d) None was ever quite like the last, so that the public was always fooled thereby.

(e) Some panics occurred under great government surpluses of revenue (1837, for instance) and some under great government deficits.

(f) Credit is credit, whether non-self-liquidating or self-liquidating.

(g) Deflation of non-self-liquidating credit usually produces the greater slumps.

Self-liquidating credit is credit that is paid back, with interest, in a moderately short time from production. Production facilitated by the loan generates the financial return that makes repayment possible. It adds value to the economy.

Non-self-liquidating credit is not tied to production and tends to stay in the system. When financial institutions lend for consumer purchases such as cars, boats or homes, or for speculations such as the purchase of stock certificates, no production effort is tied to the loan. Interest payments on such loans stress some other source of income. Contrary to nearly ubiquitous belief, such lending is almost always counter-productive; it adds costs to the economy, not value. If someone needs a cheap car to get to work, then a loan to buy it adds value to the economy; if someone wants a new SUV to consume, then a loan to buy it does not add value to the economy. Advocates claim that such loans "stimulate production," but they ignore the cost of debt service and its ultimate consequences. They also ignore the subtle deterioration in the quality of spending choices due to the shift of buying power from people who have demonstrated a superior ability to invest or produce (creditors) to those who have demonstrated primarily a superior ability to consume (debtors).

Near the end of the expansion, few creditors expect default, which is why they lend freely to weak borrowers. Few borrowers expect their fortunes to change, which is why they borrow freely. Deflation involves a substantial amount of involuntary debt liquidation because almost no one expects deflation before it starts.

What Triggers the Change to Deflation
A trend of credit expansion has two components: the general willingness to lend and borrow and the general ability of borrowers to pay interest and principal. These components depend respectively upon (1) the trend of people’s confidence, i.e., whether both creditors and debtors think that debtors will be able to pay, and (2) the trend of productivity, which makes it either easier or harder in actuality for debtors to pay.

As long as confidence and productivity remain steady or increase, then, the supply of credit tends to expand. The expansion of credit ends when the desire or ability to sustain the trend can no longer be maintained. As confidence and productivity decrease, the supply of credit contracts.

The psychological aspect of deflation and depression cannot be overstated. When the social mood trend changes from optimism to pessimism, creditors, debtors, producers and consumers change their primary orientation from expansion to conservation. As creditors become more conservative, they slow their lending. As debtors and potential debtors become more conservative, they borrow less or not at all. As producers become more conservative, they reduce expansion plans. As consumers become more conservative, they spend less money. These forces reverse the former trend. The wave position of the stock market today ensures that optimism has peaked and pessimism is on the rise.

The structural aspect of deflation and depression is also crucial. The ability of the financial system to sustain increasing levels of credit rests upon a vibrant economy. At some point, a rising debt level requires so much energy to sustain – in terms of meeting interest payments, monitoring credit ratings and chasing delinquent borrowers – that it slows overall economic performance. As the January issue of The Elliott Wave Theorist reiterated, just such a slowing has been evident for some time.

Because of reduced lending, spending and production, debtors earn less money with which to pay off their debts, so defaults rise. Default and the fears of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward self-reinforcing "spiral" begins, feeding on pessimism just as the previous boom fed on optimism. The cascading debt liquidation is a deflationary crash. In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities and real estate, causing their prices to plummet. Debts are retired by paying them off, "restructuring" or default. In the first case, no value is lost; in the second, some value; in the third, all value. The process ends only after it brings the supply of credit down to a level at which it is collateralized acceptably to the surviving creditors.

Why Deflationary Crashes and Depressions Go Together
A deflationary crash is characterized in part by a persistent, sustained, deep, general decline in people’s desire and ability to lend and borrow. A depression is characterized in part by a persistent, sustained, deep, general decline in productivity. Since productivity provides debtors the means to repay and service debt, a depression supports deflation. Since a decline in credit reduces new investment in economic activity, deflation supports depression. Because both credit and productivity support the prices for investment assets, their prices fall in a deflationary depression. As asset prices fall, people lose wealth, which reduces their ability to offer credit, service debt and support productive enterprise. This mix of forces is self-reinforcing.

The U.S. has experienced two major deflationary depressions, which lasted from 1835 to 1842 and from 1929 to 1932 respectively. Each one followed a period of substantial credit expansion. Credit expansion schemes have always ended in bust. The credit expansion scheme fostered by worldwide central banking is the greatest ever. The bust, however long it takes, will be commensurate. If my outlook is correct, the deflationary crash that lies ahead will be at least in the realm of the two previous major deflations and probably even bigger.

Financial Values Can Disappear
People seem to take for granted that financial values can be created endlessly seemingly out of nowhere and pile up to the moon. Turn the direction around and mention that financial values can disappear into nowhere, and they insist that it is not possible. "The money has to go somewhere–It just moves from stocks to bonds to money funds...It never goes away–For every buyer, there is a seller, so the money just changes hands." Sounds logical, doesn’t it? It isn’t.

Many people believe that when they hold someone’s IOUs (in the form of bills, notes and bonds), they still have money. "I have my money in Treasury bills" or "in municipal bonds" are common phrases. In truth, they own a value only as long as their debtors can and will pay them back. Let’s suppose that a lender starts with a million dollars and the borrower starts with zero. Upon extending the loan, the lender feels that he still owns the million dollars that he lent out, even though the borrower has actual possession of it. If anyone asks what he is worth, he says, "a million dollars," and shows the note to prove it. Actually, all he has is a financial asset. When the lender calls in the debt and the borrower pays it, he gets back his million dollars. If the borrower can’t pay it, though, the value of the note goes to zero. Its value disappears. If the original lender sold his note for cash, then someone else down the line loses. In an actively traded bond market, the result of a sudden default is like a game of "hot potato": whoever holds it last loses.

Financial values can also disappear through a decrease in prices for investment assets. For prices of assets to fall, it takes only one seller and one buyer who agree that the former value of an asset was too high. All that everyone else – including those who own some of that asset and those who do not – need do is nothing. If no other bids are competing with that buyer’s, then the value of the asset falls, and it falls for everyone who owns it. If a million other people own it, then their net worth goes down even though they did nothing. Two investors made it happen by transacting, and the rest of the investors made it happen by choosing not to disagree with their price.

Anyone who watches the stock market closely has seen this phenomenon on a small scale many times. Whenever a market "gaps" up or down on an opening, it simply registers a new value on the first trade, which can be conducted by as few as two people. It did not take everyone’s action to make it happen, just most people’s inaction on the other side. In financial market "explosions" and panics, there are prices at which assets do not trade at all as they cascade from one trade to the next in great leaps.

This is why a stock market can bankrupt millions of people when it falls. Most stock investors do not "move their money into a money market fund." Most investors do nothing. Only a very few early sellers of a collapsing stock get their money out at 90% of peak value and actually put it away in cash. Some others may get out at 80%, 50% or 30% of peak value. The vast, vast majority gets stuck holding certificates with low or non-existent valuations. The "million dollars" that a wealthy investor might have had at a stock’s peak value can quite rapidly become $50,000 or $5000 or $50. The rest of it just disappears. You see, he never really had a million dollars; all he had was a stock certificate. The idea that it had a certain financial value was in his head and the heads of others who agreed. When the point of agreement changed, so did the value. Poof! Gone in an aggregated flash of neurons. The same thing can happen with real estate holdings, bond investments and even commodities. In fact, that is exactly what does happen to most of them in a deflation.