Deflation (economics)

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In economics, deflation is a rise in the market value or purchasing power of money. This is equivalent to a decrease in the general price level. Inflation is the opposite of deflation.

Basically, this means things appear to get cheaper (they cost less).

Deflation can be contrasted with disinflation which is a reduction in the rate of inflation (that is, the general level of prices are increasing at a decreasing rate).

Theoretically, the 'general price level' is comprised of the price of both wages and goods and services, so while consumers can buy more with the same amount of money, they also have less money coming in as wages. Consumers who are in debt (such as home mortgage holders) also suffer because while their income drops, their payments remain constant.

Table of contents

1 Effects of deflation
2 Groups Most Affected
3 Causes of deflation
4 An example of deflationary effects
5 Tools to fight deflation
6 Examples of deflation

6.1 Deflation in the United States
6.2 Deflation in Japan

7 A Different View of Deflation
8 Deflation: Bad, Tolerable, or Good?
9 See also

Effects of deflation

Deflation is widely regarded negatively, although this is a matter of some debate. When general price levels drop, consumers are typically assumed to delay their spending. This could be due to their reduced nominal incomes, insecurities about future economic prospects, or just waiting for prices to drop further. The soundness of this assumption rests on the common, but not always accurate, association of deflation with recession.

Most adverse effects of deflation are arguably due to rigidities in the economy: If wages, prices and interest rates adjusted seamlessly and predictably to deflationary expectations, they would have no real economic effects. However, workers are hesitant to accept wage cuts; a loan's interest rates cannot be negative and thus debtors suffer; and store owners cannot cut prices for too far below what they paid for their inventory.

Large amounts of deflation are destructive of economic health, just as are large amounts of inflation. Severe deflations have been associated with severe recessions or depressionss just as severe inflationary periods (or hyperinflations) have been associated with recessions or depressions. It is often noted that the best situation is one where overall prices are very predictable and nearly constant.

Groups Most Affected

Different people and organizations are hurt by inflation versus deflation. Large debtors like inflation because it reduces their effective debt. For example, if Joe pays $100k for a house at 8% interest with inflation at 3%, he's effectively paying 5% interest on the loan. If inflation jumps to 10%, he's happy, he's now making 2% on $100k instead of losing 5%. However, Joe's bank hates this; they were making 5% but are now losing 2% on the loan!

With deflation, the opposite occurs. Joe pays $100k at 8% with inflation of 3%. Inflation drops to 0 then goes negative to be 5% deflation. Joe finds that more than not making 3% because of inflation, he's losing 5%. Overall, his effective interest rate has shot up to 5%+8%=13%. Joe's bank loves this situation, though, since they're making 13% instead of 5%.

In truth, Joe's bank doesn't really like this situation, either. Since Joe is effectively paying more for the loan, the probablity is much higher that he will default on the loan, which pushes up costs for the bank significantly.

In deflationary times, consumers and businesses alike will benefit by paying down their debts and increasing their cash (or cash-equivalents like bank deposits) reserves. Economy-wide, this reduction in debt can be unhealthy when it prevents businesses from taking out loans to make sensible capital investments (good economic investments are unfunded).

Causes of deflation

Deflation may generally be caused by:

Rising currency (decreasing the cost of imports): Domestic currency increases in value - this means foreign raw materials fall in price, driving down overall production costs, lowering prices for goods.
Rising currency (decreasing the quantity of exports): Domestic currency increases in value - this causes foreigners to buy fewer exports (because they are now relatively more expensive), which drives down overall demand, and prices fall due to excess supply.
Decreasing consumer confidence: when consumers get gloomy about the future, they conserve money and buy less. This decreases demand and drives down prices.
Aging population: aging populations are less trendy than teenagers; they are stable and already have basic consumer goods (thus need to buy fewer of new ones), and they like to save more money for retirement as a portion of their income, leading to reduced demand (Japan is an example of this).
Technology: improvements in manufacturing and business processes lower the cost of producing a good, driving prices down (this is common in the computer industry). Another way to view this is advancements in technology increase productivity. If productivity increases, each unit of money will buy more, causing prices to fall.

Deflation is specifically caused by:

economic contraction: If the economy slows or reduces output, this is typically associated with a falling demand, and if supply remains unchanged, there will be excess supply, so prices will decrease, which is deflation. However, this is a temporary effect as firms will eventually cut production in order to efficiently meet the new demand.

decrease in the money supply (the M3). When the money supply falls prices fall as well as wages. In this case consumers will still be able to purchase the same amount of goods (after the economy has adjusted to the new money supply), holding productivity constant. Also, in this case prices will fall but consumer spending power will not increase.
Increase of productivity relative to money supply. Holdng the supply of money constant, if productivity in an economy increases due to advancements in technology or because of other factors (i.e. if the government relaxes regulations that hamper the market), each unit of money will buy more goods, causing prices to go down. In this case falling prices will reflect increased productivity and consumer spending power will increase.

An example of deflationary effects

Consider an automobile manufacturing plant that costs $1 billion to build, and is financed by issuing debt (loans or bonds). Assume it generates an annual net income (profit) of $200 million (20% return on investment). Suddenly, the economy slows, and no one buys cars. In spite of this reduced demand, the plant keeps producing cars, hoping things will improve, and an excess supply is created, dropping the price of cars. If cars are a significant component of the price index, then there will be a general decline in the overall price level (deflation).

Assume further that several months later the plant closes, the machines are sold creating cash flow for the car manufacturer that is used to pay back a portion of the $1 billion debt. Assume also that the increased supply of used machine tools available for sale reduces the price of these machines. After this adjustment, economic growth returns due to reallocated capital: more accurately adjusted supply/demand, and more accurately valued goods.

Tools to fight deflation

Until the 1930's, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention.

This view was challenged in the 1930's during the Great Depression. Keynesian economistss argued that the economic system was not self correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending. With the rise of monetarist ideas, the focus in fight deflation was put on expanding demand by lowering interest rates.

Examples of deflation

Examples of deflation include the Great Depression and the economy of Japan during the 1990s. There was also a slow decline of the general price level throughout all of human history, until the 20th century. During the 19th century the gold standard was in use and known gold stocks were growing less rapidly than production. As a result, gold became more expensive in terms of goods, that is, a drop in the price level. This phenomenon ended with the discovery of gold reserves in South Africa and Alaska.

During World War I the British Pound was removed from the gold standard. It subsequently resulted in inflation and a rise in the gold price (fall in the value of the pound). When the Pound was returned to the gold standard after the war it was done on the basis of the pre-war gold price (hence lifting the value of the Pound). This caused a period of deflation as consumer goods realigned with the new value of the pound.

Deflation in the United States

Major deflations: There have been two significant periods of deflation in the United States. The first was after the Civil War. The second was between 1930-1933 when the rate of deflation was approximately 10 per cent/year.

Minor deflations: Throughout the nations' history, inflation has approached zero and dipped below for a short time (negative inflation is deflation). This was very common in the late 1800's.

Deflation in Japan

Deflation started in the early 1990s. The Bank of Japan and the government have tried to eliminate it by reducing interest rates, but despite having them near zero for a long period of time, they have not succeeded.

Systemic reasons for deflation in Japan can be said to include:

Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980's (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.
Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks have delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks make even more loans to these companies, that are used to service the debt they already have. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by the Economist magazine) as methods to speed this process and thus end the deflation.
Insolvent banks: Banks with lots of bad loans cannot lend more money; they must increase their cash reserves to cover the bad loans. This decreases the supply of money available for lending and economic growth.
Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth.
Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products are decreasing. Domestic producers must either match these prices or become uncompetitive. This decreases prices for many things in the economy, and thus is deflationary.

A Different View of Deflation

A different view of deflation comes from the Austrian school of economics. The Austrian school defines deflation to be a contraction of the money supply. Under this definition, the Austrian school sees deflation as a cause of a general fall in prices, not a general fall in prices itself. They attribute the other main cause of a general fall in prices to be an increase of productivity relative to the money supply.

For instance if you have a fixed money supply of 100 ounces of gold in an economy that produces 200 widgets, then one widget will cost 1/2 of an ounce of gold. However, next year if output is 400 widgets with the same money supply of 100 ounces of gold the price of each widget will drop to 1/4 of an ounce of gold. In this case the general fall in price was caused by increased productivity.

The opposite of the above scenario has the same effect on prices, but a different cause. If you have a fixed money supply of 100 ounces of gold in an economy that produces 200 widgets, then once again each widget will cost 1/2 of an ounce of gold. However, if next year the money supply is cut in half to 50 ounces of gold with the same output of 200 widgets, the price of each widget will now only be 1/4 of an ounce of gold.

Austrians view increased productivity (the first scenario) to be a good cause of a general fall in prices, while deflation (the second scenario) as being a bad cause of a general fall in prices. Austrians contend that in the first scenario wages will remain the same because of the unchanged money supply but that a general increase in wealth will be reflected in lower prices. Austrians also take the position that there are no negative distortions in the economy due to a general fall in prices in the first scenario.

However, in the second scenario where a general fall in prices is caused by deflation, Austrians contend that this confers no benefit to society. For in this scenario wages will simply be cut in half and lower prices will not reflect a general increase in wealth. In addition, Austrians believe that deflation causes negative distortions in the economy with debtors and creditors as well as other areas.

Deflation: Bad, Tolerable, or Good?

Whether it is best for an economy to have periods of deflation as well as periods of inflation is an economics question that is still debated by some. Rather, it seems it is highly influenced by point-of-view. If someone is in debt, the debt shrinks in real terms during inflation. If someone owns bonds, their net worth shrinks in real terms during inflation. The situation is reversed during deflation. Since most people have large mortgage debt, inflation is their friend (and that's probably where the political power lies if politics influences central banking policy).