The Case For Deflation

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

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.