There is one question that we at Elliott Wave International get over and over again:
"You were correct with your predictions of deflation. But now that it's here – isn't the government still in control? Why can't they do [fill in the blank] to stop it?"
It's not surprising that this remains such a popular question, even among some of Elliott Wave International's subscribers. There are lots of articles out there – well-written articles written by qualified authors – arguing how the government can do this or that to stop deflation.
In our opinion, they ALL miss one key point: social mood.
Conventional economists look at the deflationary problem in a very mechanistic and cause-and-effect kind of way: stocks fall, then goes the economy, then investors and consumers lose confidence, and so on. Now if only the Federal Reserve and the government restore confidence, they can reverse the process and save the day.
Here at Elliott Wave International, we have long argued that this is not how it works. Bob Prechter, EWI's founder and president, takes five chapters in his Conquer the Crash* – which predicted deflation long before it became mainstream news – to explain why; here's an excerpt. (My advice: Do read the book to understand this crucial point completely.)
In contrast to the assumptions of conventional macroeconomic models, people are not machines. They get emotional. People become depressed, fearful, cautious and angry during depressions; that’s essentially what causes them. A change in the population’s mental state from a desire to expand to a desire to conserve is key to understanding why central bank machinations cannot avert deflation.
When ebullience makes people expansive, they often act on impulse, without full regard to reason. That’s why, for example, consumers, corporations and governments can allow themselves to take on huge masses of debt, which they later regret. It is why creditors can be comfortable lending to weak borrowers, which they later regret. It is also why stocks can reach unprecedented valuations.
Conversely, when fear makes people defensive, they again often act on impulse, without full regard to reason. One example of action impelled by defensive psychology is the increasing conservatism of bankers during a credit contraction. When lending officers become afraid, they call in loans and slow or stop their lending no matter how good their clients’ credit may be in actuality. Instead of seeing opportunity, they see only danger. Ironically, much of the actual danger appears as a consequence of the reckless, impulsive decisions that they made in the preceding uptrend.
In an environment of pessimism, corporations likewise reduce borrowing for expansion and acquisition, fearing the burden more than they believe in the opportunity. Consumers adopt a defensive strategy at such times by opting to save and conserve rather than to borrow, invest and spend. Anything the Fed does in such a climate will be seen through the lens of cynicism and fear. In such a mental state, people will interpret Fed actions differently from the way that they did when they were inclined toward confidence and hope.
If people and corporations are unwilling to borrow or unable to finance debt, and if banks and investors are disinclined to lend, central banks cannot force them to do so. During deflation, they cannot even induce them to do so with a zero interest rate. That’s what has been happening in Japan for over a decade, where rates have fallen effectively to zero but the volume of credit is still contracting. Thus, regardless of assertions to the contrary, the Fed’s purported “control” of borrowing, lending and interest rates ultimately depends upon an accommodating market psychology and cannot be set by decree.
Doesn't this excerpt (from a book published in 2002!) describe absolutely perfectly the environment we find ourselves in now? And now, the mainstream observers are beginning to notice that, too (emphasis added):
"Governments in Europe and the U.S. have handed over billions to the ailing banks to try to prevent their collapse. Despite the cash, the biggest banks are not willing to lend at normal levels and the entire trade and credit economy has slowed way down. Consumers are not spending and prices of goods are beginning to drop, bringing fears of deflation." (IPS News, Jan. 29)
In other words, you can lead the horse to water, but you can't make him…err, borrow. Social mood is the driving force of inflation and deflation. Until it improves, we are unlikely to see any real changes in the stock market or the economy.