Deflation - definition and effect on the economy

Deflation is a decline in the prices of both goods and services. It often happens when there is a decreased supply of currencies and loans available within a nation.

When there is a deflation, one's purchasing power tends to go up as prices go down. So why is deflation considered to be a bad thing?

• Deflation is a phenomenon that happens when a nation's prices go down.
• When deflation happens, most people wisely opt to hold onto their savings rather than spend them on goods and services right now, as prices will be even lower in the near future, thereby ensuring that they will be able to buy much more.
• However, a deflationary period can often lead to a recession as the nation's economy slows down to a near stop.
• Deflation often occurs when fewer loans are made and when the supply of a nation's currency is reduced. However, the greater productivity of workers or machines can also lead to lower overall prices.

Causes of deflation and the resulting consequences

Most countries measure how much prices go up or down by sampling a "basket" of goods' prices over 2 different dates. In America, this indicator is called the CPI (or Consumer Price Index). On the rare occasion that prices have gone down, the CPI figure will be lower than the previous reported number.

Deflation results in lower prices for goods/services and labour, not to mention borrowing costs.

One's first reaction may be to believe that decreasing prices benefit everyone. Unfortunately, an ongoing decline in overall prices can have a negative impact on a nation's economic growth.

Although many consumers can end up as "winners" in a deflationary economy, those who owe money (bank loans) end up having to pay back money that is worth more than it initially was. Also, investors who expected prices to rise (on homes, stocks, precious metals, etc.) also face an unprofitable situation.

How does deflation happen?

Deflation only happens when the supply of financial assets or currencies decreases. As of 2020, currency supplies are mainly determined by a country's central bank, such as the UK's Bank of England. If their supply of British pounds and credit decrease, while production remains stable, the prices of UK goods and services would tend to fall. Deflation is especially likely to occur after a sustained period of monetary expansion (or quantitative easing, sucn as when a country simply prints more money, as the U.S. frequently does!). Deflation is rare, though. In the U.S., the last real deflation occured after the 1929 market crash; more recently only Japan had a deflation 30 years ago.

Economic specialist Milton Friedman suggested that an optimal economic policy would see a flat nominal interest rate with a price level falling steadily to this real rate. His view led to the self-named Friedman principle, which is a widely respected monetary policy.

Thus, and as mentioned above in the introduction, prices can go down due to a decreased demand for consumer goods and services, as well as increased productivity. Such a decline is demand will lead to gradual downward pressure on prices. As for the causes: decreased demand for stocks, a greater propensity to hold onto cash, less government spending and higher interest rates.

In addition, declining prices may appear when industrial production expands faster than the supply of loans or the local currency supply. This can happen due to industrial breakthroughs which improve worker output, which can lead to lower factory expenses - savings which are passed along to the consumer via cheaper goods/services. This is not the same as regular price deflation, where purchasing power goes up as prices go down.

Deflation via improved technologies and worker productivity is also possible. An example of this is the cost of information: in 1990 10GB of data had an overall cost of $1,000,000 whereas in 2020 that same quantity of data only costs $1,000! This helps explain why computer hardware and software have both been increasingly cheap.

Deflation and decreased sales

Deflations are often a direct result of a recession. As consumer demand sinks and corporate investment goes down, industrial production naturally slows down.

The consequence of such a situation is lower prices, as companies need to get rid of excess inventories. Meanwhile, investors and consumers increasingly hold onto whatever cash they have to offset any losses they may incur, and this increased savings rate in turn reinforces the overall decrease in demand.

A sort of vicious cycle occurs: as people expect prices to keep on dropping, they keep on saving, knowing that a given basket of goods will cost less next month than it does today.

Deflation also affects borrowing and the use of one's cash reserves

Deflation decourages people (as well as companies and public authorities) from borrowing money as payments will steadily increase in overall value. And the offshoot is that it steadily increases the value of their savings.

From the standpoint of the average trader, a company or group that is able to save lots of cash (such as Apple, which has always boasted billions of dollars in reserves) or owes little, becomes more enticing to own during a deflationary period. In addition, deflationary periods are marked by higher interest rates on bonds, and improved overall yields.

Deflation's vicious cycle

If factories slow down their pace of output due to lesser consumer demand, they will also fire employees, which will have a negative impact on the nation's employment figures. These victims will in turn eat up all the cash they've saved to pay bills, and may even default on their home loans, their car payments, Visa/Mastercard payments, etc.

As an increasing number of consumer and corporate loans go bad, banks have to carry them over as losses in their accounts. And as the banks appear to be in trouble, consumers will often rush to withdraw their savings to avoid losing them.

If too many people rush to recover their deposits from their banks, the latter may no longer be able to operate normally, leading to their collapse and reducing the amount of money in circulation (as well as loans that can be made to both consumers and companies).

As a result, a nation's central bank will likely modify its monetary policy:
An expansionary shift would for example inject new funds into society by purchasing government bond from the market with freshly printed/minted cash,
A contracting shift would for example lower interest rates to discourage people and companies from holding too much money in the form of savings.

If this doesn't help to generate both economic growth and demand for goods/services, the national banking system can simply print more money, buying assets on the stock market and/or issuing loans if commercial banks are unable to.

Tax policy can also stimulate an economy. Lowering tax rates leads to greater disposable income which leads to more goods and services being purchased. The downside is that the nation's lower income (via taxes) impedes its ability to hire workers and operate as it does when modest inflation is in effect.

The downward deflation spiral

When the above-explained vicious cycle gets out of hand a deflation spiral happens. This is often the direct result of a recession, as factories slow down their output and consumers/companies express lower demand for goods and services. And the result of this: lower prices of goods, as factories need to unload their unsold inventories to make room for newer output.

Not surprisingly, both companies and people hold onto their savings for the upcoming weeks and months - but this reinforces the lower demand we just described. In addition, people and companies also hold onto their savings and reserves as they rightfully believe that their cash will buy more goods and services in the future than it will right now.

The real impact of a deflationary period

After the big depression of 1929, when deflation went hand in hand with unemployment and soaring loan defaults, most people believed that deflations were a negative thing. After this dark period, many nations tweaked their national monetary policy, injecting more and more bills/coins into the economy, despite the fact that this leads to steadily increasing prices and greater personal debt levels.

The UK's John M. Keynes was against deflations, accusing them of leading to pessimistic behaviour such as abstaining from investing. As for Irving Fisher, he developed a debt-deflation theory that says that paying back loans after a bleak economic period can entail a decrease in the number of new loans, which can further fuel deflation, and turn up the heat on those who owe money, causing a chain of bankruptcies.

Lately, economic experts are rethinking how they view deflations. After a 2005 examination of 16 countries, economist Patrick Keho and Andy Atkinson identified 64 of 72 deflations that were not followed by a recession and 20 out of 30 depressions that experienced no deflation. The question is still up in the air and experts have yet to agree 100% on the subject.

Conclusion

Inflation can actually contribute positively to a nation's economic growth, as long as it's between 1.5% to 2.5% per year. However, the opposition situation (declining prices), often during or following a recession, can lead to a worse situation.

When prices are tumbling, factory output declines and inventories are sold at bargain prices. Unemployment starts to go up and demand is no longer rising. As a result of this, people and companies decide to save their money as they suspect prices will soon be far lower. People/companies are unable to pay back their loans, and people empty their bank accounts as they're afraid their bank may go bankrupt. In reaction to this, public authorities try to stimulate the economy using tax incentives and by putting new currency (freshly printed bills and newly minted coins) into circulation.

Most governments want to avoid deflations at all costs!