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Editor’s Note: On Nov. 19, 2008, the U.S. Labor Department reported a 1 percent drop in the consumer price index for October 2008. The drop marked the largest decline in 61 years, and it was the first decline in that measure in nearly a quarter of a century. The 1 percent drop was twice as large as many mainstream analysts had forecast. Such a large decline in consumer prices is forcing U.S. policymakers to rethink the possibility of deflation in America. For more on deflation, we turn to Robert Prechter, the man who literally wrote a book on how to survive it. The following article, adapted from Prechter’s book Conquer the Crash – You Can Survive and Prosper in a Deflationary Depression, will help you understand exactly what to expect from deflation.

In addition to this article, visit Elliott Wave International to download the free 8-page report, Inflation vs. Deflation. It contains details on which threat you should prepare for and steps you can take to protect your money.

By Robert Prechter, CMT

Before explaining the price effects of inflation and deflation, we must define the terms inflation, deflation, money, credit and debt.

Webster’s says, “Inflation is an increase in the volume of money and credit relative to available goods,” and “Deflation is a contraction in the volume of money and credit relative to available goods.”

Money is a socially accepted medium of exchange, value storage and final payment. A specified amount of that medium also serves as a unit of account.

According to its two financial definitions, credit may be summarized as a right to access money. Credit can be held by the owner of the money, in the form of a warehouse receipt for a money deposit, which today is a checking account at a bank. Credit can also be transferred by the owner or by the owner’s custodial institution to a borrower in exchange for a fee or fees – called interest – as specified in a repayment contract called a bond, note, bill or just plain IOU, which is debt. In today’s economy, most credit is lent, so people often use the terms “credit” and “debt” interchangeably, as money lent by one entity is simultaneously money borrowed by another.

When the volume of money and credit rises relative to the volume of goods available, the relative value of each unit of money falls, making prices for goods generally rise. When the volume of money and credit falls relative to the volume of goods available, the relative value of each unit of money rises, making prices of goods generally fall. Though many people find it difficult to do, the proper way to conceive of these changes is that the value of units of money are rising and falling, not the values of goods.

The most common misunderstanding about inflation and deflation – echoed even by some renowned economists – is the idea that inflation is rising prices and deflation is falling prices. General price changes, though, are simply effects of inflation and deflation.

The price effects of inflation can occur in goods, which most people recognize as relating to inflation, or in investment assets, which people do not generally recognize as relating to inflation. The inflation of the 1970s induced dramatic price rises in gold, silver and commodities. The inflation of the 1980s and 1990s induced dramatic price rises in stock certificates and real estate. This difference in effect is due to differences in the social psychology that accompanies inflation and disinflation, respectively.

The price effects of deflation are simpler. They tend to occur across the board, in goods and investment assets simultaneously.

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For more information on deflation and inflation, including money-saving steps for protecting your wealth, download Elliott Wave International’s free 8-page report, Inflation vs. Deflation.

Robert Prechter, Certified Market Technician, is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

Why Your FDIC-Backed Bank Could Fail
November 11, 2008

With big bank bailouts dominating the news, there’s no better time to get the truth about bank safety.

This informative article has been excerpted from Bob Prechter’s New York Times bestseller Conquer the Crash. Unlike recent news articles that are responding to the banking crisis, it was published in 2002 before anyone was even talking about bank safety. However, you may find the information even more valuable today than ever before.

For even more information on bank safety, visit Elliott Wave International to download the free 10-page report, Discover the Top 100 Safest U.S. Banks. It contains details on how you can protect your money from the current financial crisis, updated for 2008.

Risks in Banking

Between 1929 and 1933, 9000 banks in the United States closed their doors. President Roosevelt shut down all banks for a short time after his inauguration. In December 2001, the government of Argentina froze virtually all bank deposits, barring customers from withdrawing the money they thought they had. Sometimes such restrictions happen naturally, when banks fail; sometimes they are imposed. Sometimes the restrictions are temporary; sometimes they remain for a long time.

Why do banks fail? For nearly 200 years, the courts have sanctioned an interpretation of the term ‘deposits’ to mean not funds that you deliver for safekeeping but a loan to your bank. Your bank balance, then, is an IOU from the bank to you, even though there is no loan contract and no required interest payment. Thus, legally speaking, you have a claim on your money deposited in a bank, but practically speaking, you have a claim only on the loans that the bank makes with your money.

If a large portion of those loans is tied up or becomes worthless, your money claim is compromised. A bank failure simply means that the bank has reneged on its promise to pay you back. The bottom line is that your money is only as safe as the bank’s loans. In boom times, banks become imprudent and lend to almost anyone. In busts, they can’t get much of that money back due to widespread defaults. If the bank’s portfolio collapses in value, say, like those of the Savings & Loan institutions in the U.S. in the late 1980s and early 1990s, the bank is broke, and its depositors’ savings are gone.

Because U.S. banks are no longer required to hold any of their deposits in reserve, many banks keep on hand just the bare minimum amount of cash needed for everyday transactions. Others keep a bit more. According to the latest Fed figures, the net loan-to-deposit ratio at U.S. commercial banks is 90 percent. This figure omits loans considered securities such as corporate, municipal and mortgage-backed bonds, which from my point of view are just as dangerous as everyday bank loans. The true loan-to-deposit ratio, then, is 125 percent and rising. Banks are not just lent to the hilt; they’re past it.

Some bank loans, at least in the current benign environment, could be liquidated quickly, but in a fearful market, liquidity even on these so-called securitieswill dry up. If just a few more depositors than normal were to withdraw money, banks would have to sell some of these assets, depressing prices and depleting the value of the securities remaining in their portfolios. If enough depositors were to attempt simultaneous withdrawals, banks would have to refuse. Banks with the lowest liquidity ratios will be particularly susceptible to runs in a depression. They may not be technically broke, but you still couldn’t get your money, at least until the banks’loans were paid off.

You would think that banks would learn to behave differently with centuries of history to guide them, but for the most part, they don’t. The pressure to show good earnings to stockholders and to offer competitive interest rates to depositors induces them to make risky loans. The Federal Reserve’s monopoly powers have allowed U.S. banks to lend aggressively, so far without repercussion. For bankers to educate depositors about safety would be to disturb their main source of profits. The U.S. government’s Federal Deposit Insurance Corporation guarantees to refund depositors’ losses up to $100,000, which seems to make safety a moot point. Actually, this guarantee just makes things far worse, for two reasons. First, it removes a major motivation for banks to be conservative with your money. Depositors feel safe, so who cares what’s going on behind closed doors? Second, did you know that most of the FDIC’s money comes from other banks? This funding scheme makes prudent banks pay to save the imprudent ones, imparting weak banks’ frailty to the strong ones. When the FDIC rescues weak banks by charging healthier ones higher premiums, overall bank deposits are depleted, causing the net loan-to-deposit ratio to rise.

This result, in turn, means that in times of bank stress, it will take a progressively smaller percentage of depositors to cause unmanageable bank runs. If banks collapse in great enough quantity, the FDIC will be unable to rescue them all, and the more it charges surviving banks in premiums,the more banks it will endanger. Thus, this form of insurance compromises the entire system. Ultimately, the federal government guarantees the FDIC’s deposit insurance, which sounds like a sure thing. But if tax receipts fall, the government will be hard pressed to save a large number of banks with its own diminishing supply of capital. The FDIC calls its sticker a symbol of confidence, and that’s exactly what it is.

For more information on bank safety, including how to choose a safe bank during the current financial crisis, download EWI’s free 10-page report, Discover the Top 100 Safest U.S. Banks.