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Deflation (economics)

In economics, deflation is a decrease in the general price level, or a rise in the purchasing power of money with respect to a large class of goods or services. Inflation is the opposite of deflation.

Deflation should not be confused with disinflation which is a slowing 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 wages, 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 and producers who are in debt, such as home mortgage holders, also suffer because while their income drops, their payments remain constant. Central bankers worry about deflation, because many of the tools of monetary policy become ineffective as the inflation rate drops to zero or turns negative, and deflation can set off a deflationary spiral , where businesses refuse to invest, because the risk adjusted returns of investing are lower than holding currency.


Effects of deflation

In mainstream economic theory deflation is a general reduction in the level of prices, or of the prices of an entire kind of asset or commodity. Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices, or a sustained reduction in the velocity of money which increases the demand for money versus commodities.

Deflation is generally regarded negatively, as it is a tax on borrowers and on holders of illiquid assets, which accrues to the benefit of holders of liquid assets and currency. In this sense it is the opposite of hyperinflation, which is a tax on currency holders and lenders in favor of borrowers and short term consumption. In modern economies, deflation is caused by a collapse in demand, and is associated with recession and long term economic depressions.

In modern economies, as loan terms have grown in length and financing is integral to building and general business, the penalties associated with deflation have grown larger. Since deflation discourages investment, because there is no reason to risk on future profits when the expectation of profits is negative, it generally leads to, or is associated with a collapse in aggregate demand. Without the "hidden risk of inflation", it becomes more productive to hold stores of value.

Deflation is, however, the natural condition of hard currency economies where the supply of money is not kept in line with productivity growth. Improving production lowers the price of goods, and population growth faster than a slowly-growing money supply, from mining precious metals, means that there is less and less hard currency per person. In such economies, which include the late 19th century, hardship is caused, not by deflation per se, but by a reduction in money stock per person which is greater than the reduction in prices. This is why the long deflationary environment of the late 19th century could lead, simultaneously, to tremendous capital development, and tremendous deprivation for millions of people.

Hard money advocates argue that if there were no "rigidities" in an economy then deflation should be a welcome effect, as the lowering of prices would allow more of the economy's effort to be moved to other areas of activity, thus increasing the total output of the economy. However, there is no instance where this has actually happened, instead, deflation has, in every case, led to reduced investment demand - as holding currency becomes the most attractive and low risk investment, reduced consumer demand, as uncertainty about jobs and income grows, and ruptures to the financial system.

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 probability is much higher that he will default on the loan, which pushes up costs for the bank significantly.

Since deflationary periods favor those who hold currency over those who do not, they are often matched with periods of rising populist sentiment, as in the late 19th century, when populists in the United States wanted to move off of hard money standards and back to a money standard based on the more inflationary metal silver.

Most economists agree that the effects of long-term deflation are more damaging than inflation. Deflation raises real wages which are both difficult and costly for management to lower. This inevitably leads to layoffs and makes employers reluctant to hire new work, increasing unemployment.

Causes of deflation

From a monetary perspective deflation is caused by a reduction in the velocity of money, and the amount of money supply per person. In a hard money economy, deflation is the natural state of the economy - people multiply faster than hard money is created. Capitalism is also an engine of deflation: as capital stocks improve, and there are more competitors, the supply of goods goes up, which means prices must fall until they balance demand. Capitalism also drives efficiency and innovation which has a downward pull on prices.

A sharp distinction then, should be drawn between deflation in hard currency economies, such as those on the gold standard and economies which run on credit. In a credit based economy, a fall in money supply leads to less lending, and a sharper fall in demand. Moreover, in hard currency economies, barter and other alternate currency arrangements are common, and therefore when money becomes scarcer, commerce can continue without hard currency. Since in such economies the central government is often unable, even if it were willing, to tax or control the internal economy, there is no pressing need for individuals to acquire hard currency except to pay for imported goods. In effect, deflation acts as protective tariff in such economies, encouraging local consumption of local production. It also acts as a spur to mining and exploration, since the easiest way to make money in such an economy is to dig it out of the ground.

In modern credit based economies a deflationary spiral is caused by the popping of a bubble, either in equities, or the collapse of a command economy which had run at a higher level of production than it could actually support. Demand falls, and with the falling of demand, there is a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing. Business, unable to make enough profit no matter how low they set prices, are then liquidated. Banks then get assets which have fallen dramatically in value since the loan is made, and if they sell those assets, they further glut supply, which causes another round of price decreases, and more business to go bankrupt, which results in another round of foreclosures. To stop the deflationary spiral, banks will often simply not collect on non-performing loans. This stems deflation for only a short time, because they must then constrict credit, since they do not have money to lend, which reduces demand and so on.

When this point is reached, the central bank can no longer stimulate demand by lowering interest rates - "deflation is when the central bank cannot give money away". This is the famous liquidity trap. When deflation takes hold, it requires special arrangements to "lend" money at a negative rate of interest to increase the money supply.

This cycle has been traced out on the broad scale during the Great Depression, specifically when the collapse of the global trading system dramatically dropped demand, idling a great deal of capacity, and setting of a string of bank failures, and in Japan beginning with the market collapse in 1987. These two occurrences are the matter of intense debate. There are economists who argue that the post-2000 recession had a period where the US was at risk of deflation, and that therefore the central bank the Federal Reserve was right in holding interest rates at an "accommodative" stance from 2001-2004.

The Austrian school defines deflation and inflation solely in relation to the money supply. Deflation is therefore defined 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 there is a fixed money supply of 400 kg of gold in an economy that produces 200 widgets, then one widget will cost 2 kg of gold. However, next year if output is 400 widgets with the same money supply of 400 kg of gold the price of each widget will drop to 1 kg 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 there is a fixed money supply of 400 kg of gold in an economy that produces 200 widgets, then once again each widget will cost 2 a kg of gold. However, if next year the money supply is cut in half to 200 kg of gold with the same output of 200 widgets, the price of each widget will now only be 1 of kg of gold. The flaw in this view is that when capital profits are dropping rapidly, there is no reason to invest gold, which breaks the savings identity, and thus the automatic tendency of the economy to move back to equilibrium.

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.

Tools to fight deflation

Until the 1930s, 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 1930s during the Great Depression. Keynesian economists 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 fighting deflation was put on expanding demand by lowering interest rates. This view has received a tremendous setback in light of the failure of accommodative policies in both Japan and the US to spur general increases in wages and demand after stock market shocks in 1987 and 2000 respectively.

Examples of deflation

Examples of deflation include the Great Depression and the economy of Japan during the 1990s. 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 Sterling was removed from the gold standard. The reason for this was to finance the First World War, which resulted in inflation, and a rise in the gold price, along with the corresponding drop in international exchange rates for 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, which since it was higher than equivalent price in gold required prices to fall to realign with the higher target 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. The first was deliberate policy in retiring paper money printed during the Civil War, the second was part of America's slide into the Great Depression, where banks failed and unemployment peaked at 25%.

The deflation of the Great Depression did not occur because output fell. It occurred because bankruptcies created an environment where monetary base (cash) was in frantic demand, and the Federal Reserve did not adequately accommodate that demand, so banks toppled one-by-one like dominos. From the standpoint of the exchange equation, the drop in monetary velocity (money changing hands, sometimes calculated as GDP / money supply or constituents of money supply, like cash) was so profound that deflation took hold despite more money (increasing money supply or constituents of money supply) chasing fewer goods (falling GDP).

Minor deflations: Throughout the nation's history, inflation has approached zero and dipped below for a short time (negative inflation is deflation). This was very common in the late 1800s, and was seen in the 1920's periodically.

Deflation in Hong Kong

Following the Asian financial crisis in late 1997, Hong Kong has been experiencing a long period of deflation which has not been ended yet. Many East Asian currencies devalued following the crisis. The Hong Kong Dollar, however, was pegged to the US Dollar. The gap was filled by deflation of consumer prices. The situation is worsened with cheap commodity goods from Mainland China, and weak consumer confidence. According to Guinness World Records, Hong Kong was the economy with lowest inflation in 2003 [1].

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 1980s (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 a larger percentage of their loans which are "non-performing ", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans .
  • 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. This decreases the supply of money available for lending and economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.
  • 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 match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.

See also

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