Deflation is a Long-Term Process
by James Davidson and Lord William Rees-Mogg

Posted September 1999

(The following was published in 1993.  Events that occurred before this list was posted on September 1999 are shown in blue and events predicted to occur after this list was posted on are shown in red.)
By studying past booms and collapses, we have identified at least a few of the regularities that seem to be at work from one episode to another. The process works something like this:

The Inflationary Stage

1. Some shock often a war, sets the process in motion by disturbing the system. It alters property rights, encourages monetary instability, and raises real asset prices.  (1970s)

2. This leads to extraordinarily high rates of return in real assets, especially for debtors, who gain disproportionately. The high rates of return seem to justify massive new investment. (1970s)

3. A credit binge ensues, as people borrow at accelerated rates to capture the extraordinary profits. Real estate, in particular, rises in value. (1970s)

4. Institutions and contracts are adjusted to reflect the inflation.  Debt maturities shorten. Nominal and real interest rates rise.  (1970s)

5. Nonetheless, a credit binge continues, as investors now accustomed to high rates of return calculate that they can continue to earn supernormal profits.  (1980s)

6. Financial as well as real assets are purchased on a basis of increasing leverage, and a bull market in stocks follows, though not yet a drooling frenzy.  (1980s - 1995)

Then Comes the Deflationary Stage

7. Profitability declines toward more normal levels as investment matures and new output is brought onto the market. (1996)

8. Commodity prices decline. (1997)

9. The farm economy goes into recession. (1998)

10. Interest rates fall, and as they do, hot money moves into financial assets, further stimulating the stock market.  (1999)

----->  This list was posted here in Q3 1999

11. As opportunities in the real economy subside, investment is concentrated on financial assets, leading to a stock market blow-off. (Q4 1999 - Q1 2000)

12. The boom is self-limiting because debt contracted at high interest rates compounds faster than income, eventually requiring that owners of leveraged assets liquefy their holdings, thus driving asset prices down. (Q2 - 2000)

13. Real estate sags.  (Q3 2000)

14. Some trigger such as credit squeeze, a major bankruptcy, fraud, or simply the slowing of the real economy reveals the overvaluation of assets.  (Q3/Q4 2000)

15. The stock market crashes, credit contraction intensifies, the money supply implodes, and depression ensues, with returns on previous investment falling to subnormal rates.  (Q3/Q4 2000)

16. Real interest rates skyrocket, even as nominal interest rates fall, further reducing economic activity.  (2001)

17. Unemployment skyrockets because real wage rates rise. (2001)

18. Wages and prices are cut as the system winds down. (2001)

19. Bingo. You have been in deflation for some time.

Copyright © 1993 James Dale Davidson and Lord William Rees-Mogg
The Great Reckoning