Deflation and You: A Guide to Understanding this Peculiar Economic Model


I just wanted to share a little bit about deflation. Deflation is when the combined amount of money and credit in an economic system is shrinking, and the velocity of money is stagnant or drops.

Once deflation begins, it is self reinforcing. To see how this works, first think of your own recent spending decisions.

If you are like me, your spending behavior and patterns have probably changed quite a bit since the housing bubble started to bust, and especially since the Dow Jones Industrial Average hit its all time high on October 11, 2007 and then started its wild ride down.

Before you begin to think about your spending behavior, though, one thing must be understood: Money is created by people when they take out loans. People offer up an asset or a promise, which the bank takes and files, and then the bank simply increases the number in their account. That is all there is to it. This might be hard to accept at first, but this is simply how it works in this economic model.

The amount of coins and dollar bills in the economy are a very, very small fraction of the total amount of money out there. Most of what we see as “money” is actually bank credit, which is created when people go to banks, are approved for a loan, and then spend that “money”. If you imagine all those loans, all of them in the country, all at once, that is basically the money supply.

Behind each “dollar” (or bank credit) in a bank account, there is a loan document somewhere that was used to bring that “dollar” (or bank credit) into existence. If the size of all of those loans, let’s just call this the “public debt” for simplicity, if that starts to shrink, for whatever reason, then that means there is less money in the economy. Less money to spend. Less money to earn.

At the moment, the money supply is shrinking because people are behaving perfectly sensibly. They see what is going on with the rising unemployment rate, the falling housing prices, the unstable stock market, the inability of the government to fix it, and the bad economic news that comes out on the TV, the radio, the internet, and in print.

What does a reasonable person do?

How have your thoughts for the future changed since October 2007? Think about that for a moment or two. Then, allow me to examine the top ten ways that I have changed my spending, and my thinking about what things constitute “money”.

1. I don’t think my house is a source of money anymore.

I used to think my house would increase in value, and that I was getting rich by just sitting on it, and that I could take out a huge home equity loan, and buy whatever I wanted.

Today, I think that if I’d take out the “Home Equity Line Of Credit” I’ve been approved for, I would not be able to sell my house for that amount, which is to say, I’d be stuck in my house, unable to sell, with no money. In fact, I don’t want to take any money, not even a penny, out on this “HELOC”.

True story: We were looking to buy a little summer cottage, and so we got this HELOC all set up, and we could have bought the place twice over using that HELOC, but I thought to myself, no way, I’m not doing it, I’m not going to put myself in debt, especially if the job market gets worse, and my wife, or I, or both of us, could lose our jobs. No, I’m not using that HELOC, and I convinced my wife that we shouldn’t use it.

We weren’t willing to bid much on the house, since we were only willing to buy it with money out of our current savings, and so it sold for even LESS than we would have bid, less than if we had been confident about the future.

2. I don’t think that buying a house is a good idea.

I used to think that I could buy a second house, fix it up, use it, and then sell it for a tidy profit. Hey, yo, let’s “flip that house”.

Since 2006, I’ve seen that home prices were going down. And they just keep going down, relentlessly. Why would I buy until I was confident that prices were moving up? How many months of rising home prices would that take? Six months? A year? Why would I buy when there was a good chance that it would be worth less in the future? Why not wait?

And wait we did. We were looking for a second house, that summer home, for two years now, but the housing prices keep going down. Why would we buy?

In looking over the place we were going to buy this summer, we figured up the various monthly and yearly expenses, including taxes, and realized that we were going to be paying $4,000 per year, every year, at a minimum, just to have it.

Why not just rent some place for the week or two that my wife can take off in the summer, and stay at the parents’ house for the few weekends that we might visit?

Why saddle ourselves with another $4,000 annual obligation when the job market is looking worse and worse? We have enough bills as it is, plus two preschoolers to take care of.

No, buying a house is not a good idea, and buying a second house is really not a good idea.

3. I don’t think I’ll be getting any raises in the future.

It used to be that I’d get a 3%, or a 2%, or even a 1% raise to the top step of the salary schedule at the school where I teach.

This year, in negotiating a “master agreement” with the Board of Education, it took us over a year just to get our wages figured out for the year. That was a year beyond the end of our previous agreement. Our negotiating team had to fight tooth-and-nail to get a compensation package that wasn’t all that much worse than previous years.

Then the state came and decided that since our state pension fund had lost billions since October 2007, and since the state was broke, that we needed to contribute more towards the pension that we had already been guaranteed, in a special teacher tax. The government showed that it could, in the swipe of a pen, decrease my salary, and our local negotiations really meant nothing.

I will be bringing home less this year, and the state is likely to try to cut salaries again, as it becomes clear that the budget is getting worse.

If I don’t think I’ll be getting any raises in the future, I’m certainly not going to spend like I’m expecting a raise, in fact, I started saving up, because we will need a cushion in hard times.

4. I don’t see my pension fund, or my social security, as money.

A number of years ago, I was so excited about my state pension, that I “bought” five additional years of service credit, and sent the State thousands of dollars, so that I could either retire earlier, or have a bigger monthly retirement check. This was on top of the thousands that my school district already was sending back each month into “my” pension account.

Now, with all the news coming out about how all of the states are broke, and the pensions are underfunded, I don’t think that any of “my” pension money will be there when I’m old enough to retire.

It’s not “my” money anymore. I gave it to the State. It is gone. And I will probably never get it back.

So, I’m going to have to save for retirement myself, and not in a pension fund.

By the same token, with all the news about the national debt, and social security no longer paying for itself, I don’t think that money will be there either.

The reports showing that most young people don’t expect it to be there, well, that just confirms to me that it probably won’t.

So, I’ll need to start saving up more, on my own.

5. I don’t see my 403(b), mutual funds, or stocks as money anymore.

At one time, we went to a “financial advisor” and agreed to set up a 403(b) investing in mutual funds. We believed that this was basically a sure thing, and sure, there might be dips and bumps, but it was definitely, DEFINITELY, better than keeping our money in a credit union savings account.

But, with the stock markets crashing over 50% from October 2007 to March 2008, I don’t have any faith that my 403(b), or my wife’s large 401(k), which she automatically contributes to each pay period, will be worth anything.

I don’t even know how, or if, she could get out. Can she sell? I don’t know.

If the market crashes, it may never recover, and most or all of that “value” will be gone.

So, we do not have that money for retirement either. Here, we have yet another incentive to save.

6. I don’t think the banks are safe anymore.

I used to think that they were great places to put money, to save up, and at one point we had over a year’s salary in our bank account. I suppose I thought that because I’d opened a passbook savings account when I was about 5 years old, and was always taught to save up for a rainy day.

Now, I see that the banks are being bailed out left and right, and that they are paying their employees huge salaries for doing nothing but draining money from the person on the street.

Lehman’s failed. AIG failed. Northern Rock failed. Fannie and Freddie failed. And -most of- the rest are dead-men walking, “zombie” banks.

If any bank tried to sell all of its assets today, or even over the next month, or even the next year, (in the open market, that is), it would get far less cash back than what it owes to its depositors.

The banks are “insolvent”. They are bank-rupt. But the government keeps on trying to “help them”. Plus, more banks fail every single week. Here is the list.

When a local bank failed a few weeks ago, a bank which was flagged as “in trouble” on, and one that I had used as an example of a bank that would fail, well, when it failed, I FELT the failure.

Add to that the fact that the FDIC has used all of its money and is itself broke and is now relying on the government so that it can prevent a bank run.

And still more: I’ve learned that most banks only have as much actual cash as what is in the ATM machines and in the cash drawers. There are no piles of cash in the vaults.

Maybe, MAYBE, there is enough for a week or so of typical withdrawals, based on what they know people tend to take out in cash each week. But that amount is a tiny fraction, well less than 10%, of what the depositors believe to be in their accounts.

Finally, I’ve learned that depositors like us can only take out a certain amount of cash in a given day. At my credit union, the limit is $10,000 cash a day. At a smaller local credit union, the limit is $600 per day. If I had a lot of money “in the bank”, I would not be able to get it out all at once.

All of these facts about banks combine to make me think that my deposits are not safe, and are not money in the same way as I used to think of them.

Obviously, I still think it is slightly safer, or more convenient, to have “money” in the bank, but only barely so. If I could figure out a way to save that money myself, and keep it safe from theft or fire, then I would only have as much in the bank as was necessary for paying bills.

7. I don’t think of my gold coins as money anymore.

I used to think, when their prices were going up, that gold coins were so great, and a great investment. In fact, I bought in 2005, and now in 2010, those few coins have more than doubled in “value”. There are websites galore that say “Buy Gold”, and signs in shop windows that say “We Buy Gold”, and everyone seems to think that “gold is REAL money”.

But I’ve very recently realized that if there were a banking system failure, and people only had cash and gold coins to use as money, that the value of those coins would drop like a stone, because all the people that end up running out of cash would then be pulling out their coins to use as money, and this would happen all at once. The value of the coins would fall rapidly as they flooded the market, and my “doubling of value” would end up being “took a bath”.

Interestingly, the American Gold Eagle 1-ounce coins do have a $50 mark on them. Perhaps they will not fall in value below that. That is some cold comfort with gold selling for over $1,200 per ounce right now.

The fact that I have them in the bank, and the bank could close at any minute, makes me less and less confident that I could use them as money. Also, the last time there was a major crash in the markets, back in 1929, the President of USA ordered all the safe-deposit boxes sealed, and all the gold coins confiscated and sold for a rate that the Government selected (See Executive Order 6102).

8. I don’t think of our personal possessions as money.

I used to count the cars, the appliances, the electronics, the furnishings, the lawn tractor, even my clothes, as money. I could put them up for sale, and get a decent price, especially for the cars. In fact, I vaguely remember making a spreadsheet on the computer, listing all these sorts of things as part of my “net worth”.

Now, everyone is starting to look broke.

There are tons of used cars on the market.

People only want things for free off FreeCycle or Craigslist.

My DVD collection isn’t work $20 per DVD, like I used to figure. The video store chain in my area went out of business, and those same DVD’s wouldn’t even sell for $5.

I’ve been to some garage sales this year, and second hand stores, and arts and craft shows, and flee markets, and I start to recognize that most of this stuff is literally value-less, despite what it might have sold for in the past.

My personal possessions are no longer money.

9. I don’t think I’ll get any inheritance anymore.

For a couple of years, I received an “inheritance” check from my grandmother. Her stocks were doing well. Her house was increasing in value. She was healthy and happy. And this could have continued; I expected that, and I think my family did as well.

Now, my grandmother is in the medical care facility which costs thousands of dollars per month. The stocks had to be sold, and they had lost lots of value before that.

My grandmother’s house has now been vacant for years, and the most recent attempt to sell it, for a new lower price, fell through.

I won’t be getting any more checks. In fact, my wife and I have talked about saving up some money for my grandmother, in the case that she completely runs out, because her diminishing cash reserves are going fast.

And while I know that my parents are healthy and will live for another twenty or more years, I no longer see their house as increasing in value until then.

No, the values of homes are falling everywhere, and unlikely to even return to those 2006 levels. Historically, some housing bubbles have been so big that it has taken hundreds of years to return to the same level.

So, no “inheritance”, which means even less money in the future.

10. I’m not spending money.

A while back, my wife and I made a nice long list of home improvements, trips we’d like to take, things we’d like to buy, and painted some pictures in the air of a fancy-dancy future: a new barn, a new carpet, a new hardwood floor, a new addition, a new fireplace, etc.

We aren’t spending on those things because we think we need to have some extra money saved up, in the event that one or both of us lose our jobs, as we would need if for food, health care, taxes, and all those other bills.

We are saving. We are not spending, not really.

Everyone Is Doing It

If this story resonates with you, it is because parts of it resonate with all of us. We are the ones who have the capacity to spend, and yet, we save instead. We could increase the money supply by signing up for loans, and buying things, but we are not.

We are doing what anyone would do. The prudent thing. The logical thing. The responsible thing. The sensible thing.

But we are all doing this at the same time, including all of the businesses, and that is causing the money supply to shrink, day after day, and each new day makes us want to save more, and each new day we feel more that we need to get out, or stay out, or debt.

All of that money we are saving, those of us lucky enough to be able to save, that money goes into the banks, the same banks that are insolvent, and they can’t get rid of it, because no one who is sensible will borrow it. They won’t touch it with a 10-foot pole.

The banks -which are insolvent, with less in assets than they owe in deposits-, when they get in money, they have to find something to do with it, so they buy Treasury bonds, which “earn” the banks interest, and which are very safe bets. Contrast this with the choice of offering up subprime loans, or alt-A loans, or jumbo loans, or any of those. They aren’t stupid. They know that they might not be able to sell those things anymore. They know those mortgages would be risky at best. They do the prudent thing and raise lending standards, and look elsewhere for profits.

“Go Out and Spend”

Savings in a bank, just like savings under the bed, are not being used to buy things, so it is as if that money did not exist. It has the potential to be money, but if it is not spent, then it can not be earned by someone else.

This lack of spending is slowing down the speed (velocity) at which money moves in the economy. It is the same as if there were actually less money.

Right now, both things are happening at once. The money supply, or credit supply, is shrinking because few loans are being created, and consequently, that money is not being used to purchase things AND the “velocity of money” is slowing because people are not spending at the rate that they once did.

Now, these two are really the same thing, what we’re talking about is how much you are buying this year, as compared to, say, 2006. And not just you, of course, but everyone. And we’re not just looking at “net income” paycheck money here, no, we’re also looking at how much you, and me, and other people, are spending out of credit sources… whether they are increasing their debt load to buy things, like in 2006, or decreasing their debt load by paying off that debt, and not spending, like now.

Most important to this is that so many people continue to pay down the principle on their mortgages, while very few new mortgages are being created to make up the difference. The money goes into the banks, and never comes out.

As mortgages are paid down, the mortgage documents, also known as promissory notes, become worth less; their value as an asset is less.

An example: image that a person pays off $500 in principal on their mortgage. Now, that mortgage document is worth $500 less than the day before. If no one takes out a loan of at least $500 to replace that, then this $500 is gone from the money supply.

Remember that it is the total value of all the mortgages, the public debt, that determines the money supply.

As everyone is “getting out of debt”, the money supply is shrinking.

Money is literally debt, in this peculiar economic model at least.

And as we all engage in this very, very, sensible, reasonable, logical paying down of debt, preparing for tough times, so too does everyone else, which means that people are spending less, so businesses are earning less, and then they have less to pay employees, and then those employees are either laid off, or their hours or wages are cut, so they can spend less, and then we see the unemployment report on the TV, and we all tighten our belt one more notch, and then we save a bit more, and we spend a bit less, and the businesses…

This is a vicious cycle which is self reinforcing. It is a positive feedback mechanism.

There is not a single thing that the political candidates, or the bank presidents, or the Federal Reserve chairman, or the Treasury secretary, or the President of the USA can do to make us stop acting sensibly.

What is deflation?

It is being sensible, all at once.