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Now is the Best Time to Argue the Case For Deflation

Case For Deflation
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EDITOR NOTE: There are many different theoretical interpretations of inflation--from the factors that may cause it to the very definition of what it is (believe or not). The same can be said of hyperinflation and, going in the opposite direction, of deflation. What you’re about to read is exceedingly technical and may take a break or two to finish and fully digest it. But it does pose a valid theoretical argument for the case of deflation. What matters to you, the investor or retiree, is not mastering the theoretical perspectives of a given inflationary/deflationary debate, but getting a grip on the “pragmatics” of either scenario. Put simply, it’s a question of “to hedge or not to hedge.” Or perhaps, how much to hedge should either scenario materialize. But it’s tricky. Remember that the Weimar Republic also experienced a period of deflation, just months before its hyperinflationary spiral leading to the death of its currency.

With so much focus being placed on the inflation versus deflation debate of late and many financial pundits declaring a new inflation paradigm is upon us, what better a time to argue the case for deflation.

Back in March, I laid out the case for inflation in comprehensive fashion, now, as all good investors ought to do, I will present my case why the disinflationary and deflationary trends that have engulfed markets over the past 40 or so years may continue.

We all know the major deflationary forces of today; debt, demographics, globalization and technology. I will endeavor to address these throughout this article. However, there are also a number of lesser known deflationary forces that perhaps do not get as much attention as they deserve. These too I will endeavor to explain below, along with where we stand with the current inflationary pressures, transitory or not.


For listeners of Erik Townsend’s excellent MacroVoices podcast, you will be aware of Erik’s proclamations of how many of the best and brightest minds in finance and macro have shifted from the deflation to inflation camps; with Vincent Deluard, Russell Napier and Louis-Vincent Gave being some such examples. However, there does remain a few “deflationists” out there, the most prominent being Lacy Hunt, and it is from Lacy’s arguments for debt and economic growth driving deflation where I will begin.

The chief problem facing most of the worlds developed economies today is the level of outstanding debt, both private and public. Whilst the creation of debt can represent an expansion in the broad money supply, the destruction of debt conversely equates to a contraction in the money supply. As all debts must eventually be repaid, debt by nature is deflationary over time.

This is not so much a problem if the marginal return on debt exceeds the cost of debt. We have however long past that point whereby the creation of new debt lead to a greater increase in productivity. The marginal productivity of debt, or simply the return on debt, is at its lowest levels in over 70 years. As the below chart illustrates, we are now at the point whereby each new dollar of debt created is only able to increase GDP by less than 40 cents.

Source: Hoisington Investment Management

An increase in debt is an increase in current spending at the expense of future spending unless the income generated on the debt is sufficient to repay principal and interest. Stimulus hardly meets this criteria. Additionally, given central bankers and policy makers have never allowed the over indebtedness to resolve itself (rightfully or wrongfully) via the process of austerity and creative destruction, what has resulted is the dynamic of this ever falling return on debt being subjugated by the creation of even more debt in a negatively convex manner.

As much as the “MMTers” will argue this is solvable, what we know for sure is this has never worked in history. Folk love to harken how the tale of Japan will not be the fate of the US and how Japan was different (to which Lyn Alden has previously presented an excellent case for, and one in which I largely agree), though we are yet to see any evidence the United States’ spiral down this deflationary debt dynamic is actually different.

This is the greatest flaw in the argument fiscal dominance and MMT will create growth and inflation: we are searching for an easy solution to economic growth, one that has never worked in history. Yes, fiscal dominance may be the catalyst for inflation, but the debt overhang simply does not allow this to be accompanied by sustained growth. Instead, at best we may see stagflation accompanied by financial repression, as I discussed in my previous musing on inflation.

Debt & Money Velocity

To get inflation, we need a pickup in the velocity of money. Money velocity is largely a function of the level of debt relative to GDP. In the chart below, you can see how the year-over-year change in the velocity of money (red line, inverted) has a significant inverse relationship with government debt/GDP (blue line).


As debt is a constraint on money velocity, for velocity to increase, the economic growth needs to exceed the growth in debt, meaning the debt must be put to productive uses such that it spurs growth greater than its cost. A bet on inflation is a bet on an increase in the velocity of money, which is a bet on the increase in the marginal productivity of debt.

long as the MMT-style stimulus is debt financed, this dynamic will struggle to reverse. As a result, the historic increases in money supply could be somewhat irrelevant unless the velocity of money increases. You simply cannot look at the growth in money supply without also looking at the velocity of money. Debt financed stimulus ultimately leads to the same conclusion; more debt and less growth. History tells us this has never been more than a temporary solution.

In the long-run, debt is simply a constraint on aggregate demand, and, for prices to rise demand must exceed supply. Whilst certainly possible, unless we go through a period of creative destruction and austerity (unlikely), the debt constraints on the US economy create a significant headwind for sustained inflation moving forward.


Demographics remain one of the most powerful drivers of long-term economic growth. I have written extensively on the topic of demographics in the past, as it is a force whose impact on all facets of economics should not be underestimated or overlooked.

The developed world has a demographics problem that is not going away. The largest generation in history is retiring and as a result the number of retirees relative to workers is rising and is likely to continue to do so over the coming decades. Empirical evidence shows productivity, consumption and economic output peaks for workers roughly in their 20s-50s. Conversely, the contribution to GDP growth for the average worker falls negative as people enter their mid-to-late 50s and thus are no longer a contributor to economic growth.

The below chart from the work of Research Affiliates illustrates this relationship between age and economic output.

Source: Rob Arnott, Denis Chaves, Research Affiliates

A falling support ratio (working age population relative to children and retirees) for countries with an aging population is a powerful constraint on economic growth. This makes sense, as consumption (being the largest input for GDP) is largely based on age. The older we get, the less we consume and contribute to the economy. This dynamic is a deflationary force over the long-term.

As we can see below, the labor force in the US has long since peaked.


The relationship between the labor force and economic growth is better comprehended when comparing the two in rate-of-change terms.


Clearly, we can see above how the two are related. Whilst there has been a significant jump in the labor force compared to 12 months ago, it is important to consider the base effects of year-over-year data. This time last year, the worlds economies were on stand-still. On an absolute basis, we remain near the lowest level of labor force participation in about 40 years.

What’s more, similar to how debt is a constraint on the velocity of money, so too is the labor force participation rate.

The labor force is highly correlated to the velocity of money. To get a pick-up in velocity, what is really needed is a growth in the level of the population who are more willing to spend and consume, which, as we know from the previous chart comparing age groups and growth in GDP, is an increase in those aged between 20 and 50.

However, as we look forward, we can see the level of retirees relative to those working (support ratio) is only going to continue its downward trend for at least the next decade or two as the average age of the population increases. There is a stark contrast between the median age of today relative to that of the structural inflationary 1970s and 1980s.


The immediate future will continue to see more people leaving the economy and retiring compared to those entering the economy. The demographic headwinds facing not just the US, but most of the developed economies worldwide undoubtedly continues to provide a significant headwind to any form of sustained inflation.

Other Deflationary Forces

Whilst debt and demographics have been two of the most significant deflationary forces at play, along with technology and globalization, there remain a number of lesser known but meaningful dynamics working to reinforce deflation.

Technology & Productivity

Technological advancement and increasing productivity are inherently deflationary. Technology creates efficiency, which increases productivity which reduce costs. Technological innovation is not a trend that will plateau or reverse, technology is exponential.

The trend of investment in information technology hardware and software continues to rise.

Case For Deflation

Likewise, productivity on a year over year basis is at its highest point in a decade. Growth in productivity is an inflation killer (core-CPI inverted below).

Case For Deflation

Technology will only further allow for the transformation of labor to capital through automation and efficiency. Going forward, the continued shift to a digitalized economy and growth in decentralized finance should only exacerbate this trend. Technology is an inflationary headwind unlikely to subside any time soon.

Money Creation, Quantitative Easing, Banking Lending & Interest Rates

There are two ways broad money supply is created; commercial banking lending and directly monetized government spending. I discussed the dynamics of money creation within my article on inflation in detail, and have again detailed this process as follows.

Historically, it has been the commercial banks that have been able to claim sole responsibility for the growth in the broad money supply. The notion that quantitative easing (QE) conducted by itself is money creation is false. The Federal Reserve and other central banks have the ability to influence the base money supply (M0), but not the broad money supply (M2). They can lend, but they cannot spend. Commercial banks create money via fractional reserve banking when lending occurs between said banks and consumers and businesses. QE is a means of capitalizing the banks, allowing them further scope to be able to lend against these freshly printed reserves with the central banks, whilst also pushing down interest rates in the hope this will spur an increase in lending. QE is effectively just a swap of government bonds for central bank reserves; unless lent against the two are negligible. Getting banks to lend is what increases the broad money supply.

Unlike the Fed, the Federal government does have the power to spend. If the central banks and governments work together, they are able to rapidly increase the base money supply and the broad money supply. If the central banks are directly funding government spending and outright guaranteeing loans made by banks, then this is money creation and has no doubt played a role in the expansion of the broad money supply we have seen of late.

Indeed, the shift of using monetary policy in isolation to monetary stimulus combined with fiscal stimulus will likely lead to a continued increase in the broad money supply. However, the misunderstood aspect of this dynamic is that ultra low interest rates and QE are in fact more likely to be deflationary, not inflationary. What’s more, whilst the government is spending central bank financed money, the traditional means of broad money creation in the form of commercial bank lending is still non-existent.

Focusing in on QE and interest rates, the primary goal of quantitative easing has been to lower interest rates to spur lending, create economic growth, increase asset prices and create a wealth effect. QE has succeeded in only two of these aspects; increasing asset prices and lowering interest rates. It is no secret QE has been by and large a failure.

The first problem associated with QE is suppressing interest rates to artificially low levels. Artificially low interest rates are not stimulative. In fact, there is evidence to suggest artificially low interest rates are only stimulative to a certain level, once they reach the ultra-low levels of today, these positive effects disappear to the point whereby they could be argued as being entirely deflationary. The below chart illustrates this dynamic well.

Case For Deflation

Source: Visual Capitalist

By artificially suppressing interest rates, this works to reduce the interest costs associated with existing debt. Reducing interest costs allow debtors more flexibility to repay the associated principal in addition to the interest payments, and, if these low interest rates are not spurring additional lending and creation of money to offset the repayment of principal, then this process is in fact the outright destruction of money. Likewise, those who live off fixed-income interest payments receive less interest, which leads to less income and thus less consumption.

To solve this problem, banks need to lend. The problem here is demand for credit is still largely contracting. Outside of fiscal stimulus, there is little growth in the broad money supply from commercial bank lending.

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