We have studied past deflation in an attempt to understand the dynamic process involves. Blood in the Streets spelled out some of our conclusions as of 1986. We believe that deflation is much more likely at some times than others. Just as tornadoes or hurricanes occur only under certain atmospheric conditions, so spontaneous deflation and depression are not everyday dangers.

They are only likely as delayed reactions to a significant discontinuity, such as a change in political barriers, technological revolution, or a geopolitical shock. Deflation is a delayed compensation for inflation.

The world economy was buffeted in the early 1970s. The collapse of the international monetary system of fixed exchange rates based on gold disrupted price signals. And a dramatic geopolitical event (the oil shock of 1973) transfer trillions in wealth. At the same time, the economy began to experience a profound mega political transformation based upon the microchip. These developments present many parallels with the conditions that led to the deflation in the 1930s, as we argued in other posts on this website and others. There are also a number of more technical warning signs of impending deflation.

The first danger sign of deflation on the horizon is a rising percentage of debt compared to nominal GNP. In the United States in 1992, the ratio was approaching 195%, as compared to about 140% in 1929.

The second danger sign of debt deflation is a record of extraordinarily high returns in many forms of investment a decade or more ago. An unweighted average for all 15 investments listed in the frequently quoted Salomon Brothers study showed an average compound rate of return of 16.6% over the decade June 1970 to June 1980. The average compound growth rate of corporate profits since 1872 has been only 4%. And there have been many periods when the rate was much lower. Hyper normal returns like those of the 1970s, following decades of stable growth, are a danger sign that a period of some normal growth is likely to ensue.

Extraordinarily high profits during World War I were followed by lower than ordinary profits during the 20s and a massive fall off of profits in the 1930s. For the first five years of the 1980s, the unweighted average compound rate of growth for all 15 investments tracked by Salomon was just .8%.

The third danger sign of a massive deflation in the near future is the occurrence of debt compounding faster than income. As the end approaches, it is difficult for everyone to borrow with abandon. The trillions in debt added in the United States and other economies in the 1980s, however, have no parallel in their magnitude in any previous credit bubble. In the mid-80s, that debt issuance in the United States reached an astonishing 10 times the personal savings rate. For the decade as a whole, total debt grew by 11%, while nominal GNP grew by just 8%. A growing ratio of debt to income is inevitable if the real rate of interest exceeds the rate of growth of the economy. This was the case in the United States throughout the 1980s. There is clearly a limit to the percentage of income that can be devoted to debt service. It can jump from 20% to 40%. A further jump to 80% is highly unlikely. But still another doubling to 160% is mathematically impossible.

We will be discussing more of the different danger signs for debt deflation in more posts which you can find in our Articles category. We will see you then.

• The Worries of Debt Deflation

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