Deflation Myths

Three Myths of Deflation and Recession

February 4, 2009

This article is part of a syndicated series about deflation from market analyst Robert Prechter, the world’s foremost expert on and proponent of the deflationary scenario. For more on deflation and how you can survive it, download Prechter’s FREE 60-page Deflation Survival eBook, part of Prechter’s NEW Deflation Survival Guide.

The following article was adapted from Robert Prechter’s NEW Deflation Survival eBook, a free 60-page compilation of Prechter’s most important teachings and warnings about deflation.

By Robert Prechter, CMT

Myth 1: “War Will Bail Out the Economy”

Many people argue that war will bring both inflation and economic boom. Wars have not been fought in order to inflate money supplies. You might recall that Germany went utterly broke in 1923 via hyperinflation yet managed to start a world war 16 years later, which was surely not engaged in order to inflate the country’s money supply. Nor are wars and inflated money supplies guarantors of economic boom. The American colonies and the Confederate states each hyperinflated their currencies during wartime, but doing so did not help their economies; quite the opposite. With respect to war, the standard procedure today would be for the government to borrow to finance a war, which would not necessarily guarantee inflation. If new credit at current prices were unavailable, either the new debt could not be sold or it would “crowd out” other new debt. The U.S. could decide to inflate its currency as opposed to the credit supply. As explained in Conquer the Crash, doing so would be seen today as a highly imprudent course, so it is unlikely, to say the least. If it were to occur anyway, the collapse of bond prices in response would neutralize the currency inflation until the credit markets were wiped out. Despite these arguments, I concede that war can be so disruptive, involving the destruction of goods and the curtailment of commercial services, that the environment from the standpoint of prices could end up appearing inflationary. To summarize my view, the monetary result may not be certain, but an inflationary result is hardly inevitable.

There is in fact a reliable relationship between monetary trends and war. A downturn in social mood towards defensiveness, anger and fear causes people to (1) withdraw credit from the marketplace, which reduces the credit supply and (2) get angry with one another, which eventually leads to a fight. That’s why The Elliott Wave Theorist has been predicting both deflation and war. You cannot cure one with the other; they are results of the same cause.

Myth 2: “Deflation Will Cause a Run on the Dollar, Which Will Make Prices Rise”

This is an argument that deflation will cause inflation, which is untenable. In terms of domestic purchasing power, the dollar’s value should rise in deflation. You will then be able to buy more of most goods and services.

It is unknown how the dollar will fare against other currencies, and there is no way to answer that question other than following Elliott wave patterns as they develop. From the standpoint of predicting deflation, the dollar’s convertibility ratios are irrelevant. There may well be a “run on the dollar” against foreign currencies, but it would not be because of deflation. I think the impulse to predict a run on the dollar comes from people who own a lot of gold, silver or Swiss francs. They feel the ’70s returning, and so they envision the dollar falling against all of these alternatives. If deflation occurs, a concurrent drop in the dollar relative to other currencies would be for other reasons. Perhaps the dollar is overvalued because it has enjoyed reserve status for so long, which might make it fall relative to other currencies. If this is what you expect, what are you going to buy in the currency arena? The yen? Japan has been leading the way into the abyss. The Euro? Depression will wrack the European Union. Maybe the Swiss franc or the Singapore dollar. But these are technical questions, not challenges to deflation or domestic price behavior.

Myth 3: “Consumers Remain the Engine Driving the U.S. Economy”

Only producers can afford to buy things. A consumer qua consumer has no economic value or power.

The only way that consumers who are not (adequate) producers can buy things is to borrow the money. So when economists tell you that the consumer is holding up the economy, they mean that expanding credit is holding up the economy. This is a description of the problem, not the solution! The more the consumer goes into hock, the worse the problem gets, which is precisely the opposite of what economists are telling us. The more you hear that the consumer is propping up the economy, the more you know that the debt bubble is growing, and with it the risk of deflation.

Robert Prechter, Chartered Market Technician, is the world's foremost expert on and proponent of the deflationary scenario. Prechter 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.