The following was adapted from Bob Prechter’s
2002 New York Times and Amazon best seller,
Conquer the Crash – You Can Survive and Prosper in a Deflationary Depression.
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, in a 1957 letter,
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
(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
(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.
Deflation of non-self-liquidating credit usually produces the greater
Self-liquidating credit is a loan that is
paid back, with interest, in a moderately short time from production. Production
facilitated by the loan – for business start-up or expansion, for example –
generates the financial return that makes repayment possible. The full
transaction adds value to the economy.
Non-self-liquidating credit is a loan that 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 the required debt service, which
burdens production. 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 a major 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.
For more on
deflation, including the following topics, see Elliott Wave International’s
free guide to
deflation, inflation, money, credit and debt. There, you can also download
two free chapters from Conquer the Crash.
Learn more about these six important topics:
What is Deflation and When Does it Occur?
Price Effects of Inflation and Deflation
The Primary Precondition of Deflation
What Triggers the Change to Deflation?
Why Deflationary Crashes and Depressions Go Together
Financial Values Can Disappear in Deflation
Robert Prechter, Certified Market
Technician, is the founder and CEO of Elliott Wave International, author of Wall
Street best sellers
Conquer the Crash and
Elliott Wave Principle and editor of
The Elliott Wave Theorist monthly market letter since 1979.