When it seems like everyone wants to talk about inflation, it can be a good idea to clear your head and listen to some simple language about how deflation gets started. Bob Prechter's most recent Elliott Wave Theorist is an excellent source for this kind of information, which is why we have excerpted it below.
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Excerpted from The Elliott Wave Theorist by Robert Prechter, September 2007
A Deflationary Spiral
It is beginning to dawn upon people how a deflationary spiral works. As explained in Conquer the Crash, to satisfy creditors, debtors will sell all they can, even their best assets, to raise cash. That’s one reason why gold and silver are not going up. When the sub-prime mortgage market crashed, guess what: other bonds, including supposedly safe municipal and corporate bonds, also fell. Most commentators believe that forced liquidation is the only reason that perfectly good investments fell in price. As one report dated August 24 said, “There’s really no credit-related reason behind the decline.”
But Conquer the Crash is on record predicting that a large portion of currently outstanding corporate and municipal debt will become worthless. Every trend has to begin somewhere, and its ultimate outcomes are never evident at the start of a move. By the end of the price decline in these bonds, when a bit of glue on the back of them will aid their use as wallpaper, observers will finally postulate why the bear market started in the first place. Even if most of the recent price declines are due to forced sales, those sales in turn are decreasing the total value of investments, which in turn will curtail individuals’ and companies’ economic activity, which will lead to an economic contraction, which will stress the issuers of such bonds to the point that they will be unable to make interest payments or return principal. In other words, whether investors understand it now or not, the forced sale of bonds is itself enough reason to sell them also on the basis of default risk.
Despite my description, this process is not linear. Every step of the way seems to have an immediate causal precursor, but like credit inflation, credit deflation is in fact an intricate, interwoven process, whose initial impetus is a change in social mood from optimism toward pessimism. If you are still on the fence about this idea, ask yourself: What changed in the so-called “fundamentals” between June and August? The answer is: absolutely nothing. Interest rates did not budge; there were no indications of recession; there were no changes in bank lending policies; there were no chilling government edicts. The only thing that changed was people’s minds. One day sub-prime mortgages were a fine investment, and the next day they were toxic waste....
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