Contrary to the popular myth, Hitler was voted into power in Germany because of deflation, not inflation. Hitler was elected in 1932, following three years of deflation – the consequence of restrictive polices after the great crash in 1929.

In contrast, inflation – often quoted as being responsible for Hitler’s victory – peaked in Germany in 1923. This was a full decade before the Nazis democratically entered the Reichstag.

The reason the European elite is now panicked about deflation in the Eurozone is because the political implications of deflation are impossible to predict. In the next two years, every major European country, with the exception of Germany, has an election.

The Hitler example is not meant to be in any way portentous or analogous to today’s Europe, it is simply a way of reinforcing to you how dangerous deflation is and why Europe’s politicians are taking enormous risks in allowing deflation to take hold, particularly as Europe’s economy is mired in debt both public and private.

Of all the financial pathologies to afflict an economy, too much debt combined with simultaneously falling prices, can tip an economy from recession into depression, from which it is extremely difficult to escape.

The ECB is just now beginning to realise that the gravitational pull of falling prices is so strong that it cannot be counteracted using monetary policy alone.

There is a real danger that the debt deflation dynamics that afflicted the world in the 1930s become embedded with catastrophic consequences.

Here’s why. In a normal economy, people and companies buy and sell stuff to each other. In the Eurozone, we all buy and sell to each other. As the Eurozone is a pretty closed economy, each country’s spending is another country’s income. France buys from Italy and vice versa. France’s spending is Italy’s income. The same equation holds at a personal level: your spending is also my income and vice versa.

If there is a shock to demand, such as a massive Eurozone financial crisis, people and companies get worried about the future and they start saving for the rainy day. But if everyone is saving, who is spending? And if no one is spending what happens to income?

Typically, if the private sector is saving, governments will take up the slack, but if they don’t, overall spending falls and so too does, by definition, income.

As debts are expressed in terms of income, if income is falling, debt ratios are rising without any new debt being incurred.

Out on the street, retailers experience a sharp fall in demand for their products. So what do they do? They cut prices to coax people into the shops. But because our incomes are falling, something strange happens deep inside our heads. We don’t see the new lower price as a bargain, but as a harbinger for further price falls. So rather than encouraging people to come out and spend, the very fall in prices repels demand.

When prices are falling and companies and workers can’t pass their costs on via higher prices or wages, their debts get worse, not better. Therefore, good debt goes bad, performing loans become delinquent.

This is when interest rates don’t work. Because the private sector and/or the public sector has too much outstanding debt, it doesn’t want to borrow new credit and because the banks have too much bad debt, they don’t want to lend, irrespective of how low the interest rates go.

As bad debts mount on both the balance sheets of the private sector and the banks, demand and income contracts further. This means that debt ratios actually rise because income is falling faster than debt is being paid off. In turn, debt to income ratios rise, not despite but because of efforts to pay off debt. To introduce aggressive debt repayment schedules while in a liquidity trap is like putting an anorexic on a diet.

This is a liquidity trap and this is when the economy gets stuck.

When the economy is caught in the twin embrace of falling prices and too much debt, the paradox of aggregation comes into play, whereby what is good for the individual may not always be good for the collective.

The banks in Europe, now worried about their own balance sheets, urge the debtors to sell their assets to repay outstanding loans. For the individual debtor this sounds good. They will sell the asset, get some cash, pay off what they can and clean up their balance sheet. They will de-lever and become solvent.

But what happens if everyone tries to de-lever and sell at the same time?

The paradox of de-leveraging tells us that the price of assets will collapse because the markets will be flooded by distressed sellers, who de-lever their way to bankruptcy by crystallizing losses, leaving the economy with asset price deflation. The debtor risks the paradoxical conclusion where the more he repays, the more he owes!

Traditional economics says that the economy will adjust via falling wages and, in time, we will rebalance and see a lower standard of living and start again.

But in reality wages don’t fall, particularly in the Eurozone.

Trade unions and public sector interests – the Insiders – move to protect their own workers. Wages in the protected sector change little. The adjustment doesn’t come through lower wages; it comes through higher unemployment for those on the outside – the Outsiders.

These Outsiders eventually listen to the politician who seems to understand their plight. This is when deflation tips over into democracy and we see the evisceration of the political mainstream and its replacement with something entirely different.

Is it any wonder that Europe’s political centre-ground are worried about deflation? The solution to deflation is inflation, yet up to now Germany refuses to allow the ECB to print money to alleviate the situation. Are we all to be put at risk because Germany doesn’t understand the lessons of its own history?

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