Deflation Explained: Causes and Examples

What Is Deflation?

Deflation is the decrease of asset prices or the prices of goods and services. Also known as a negative inflation rate, deflation occurs when prices fall. During deflation, the purchasing power of currency rises over time, meaning consumers can use the same amount of money to purchase a larger amount of goods or services.

The Consumer Price Index (CPI) is the instrument used to evaluate deflation. This index records the prices over long periods but publishes their findings each month. Continually low prices mean that the economy is suffering from deflation. 

Causes of Deflation

The causes of deflation are tied to supply and demand.

1. Aggregate demand decrease: One of the main causes of deflation is a drop-in demand within an economy, due to for example: tight monetary policy – higher interest rates, credit crunch/stock market fall, debt deleveraging etc.
2. Aggregate supply increase: When there is an excess in the supply of goods, businesses must lower prices. This boost in aggregate supply may stem from a drop-in production costs: If it costs less to produce goods, businesses can make more of them for the same price. This can result in more supply than demand and lower prices.
3. Decrease in the supply of money: Another cause for deflation is a decrease in the amount of money circulating in an economy. This can be triggered by for example raising the banks' reserve requirements.

Consequences/Effects of Deflation

Although it may seem helpful for the price of goods and services to fall, it can have very negative effects on the economy:

1. High unemployment rates: Companies attempting to cut production costs and falling prices may lower wages and lay off employees.
2. Debt: Deflation causes an increase in the real value of debt. Interest rates tend to go up in periods of deflation, which makes debt more expensive. Consumers and businesses often decrease spending as a result.
3. Slower economic activity: As more people lose their jobs during deflation, consumer spending drops and causes a slowdown in economic growth.
4. Stock market drop: During deflationary periods, stock markets often crash as investors pull out because of increased volatility and a lack of returns.
5. Deflationary spiral: This is a domino effect caused by each overlapping piece of deflation. Falling prices may result in less production. Less production may lead to lower pay. Lower pay may result in a drop-in demand. And a drop-in demand may cause increasingly lower prices. And on and on. This chain reaction can result in a catastrophic financial crisis and ultimately the country's currency to collapse.

Is Deflation More Harmful Than Inflation?

In period of inflation, prices go up and the power of the currency goes down. But, it also reduces the value of debt, so borrowers keep borrowing and debtors keep paying their bills. The economy typically experiences inflation of 1% to 3% per year—and a small amount is generally viewed as a sign of healthy economic growth.

While it may seem worse for prices to rise than to fall, deflation is generally less favorable and is associated with economic contractions and recessions . A deflationary spiral may turn hard economic times into recessions and then depressions .

Protecting yourself against deflation is also a little trickier than safeguarding against inflation. Unlike with inflation, debt becomes more expensive with deflation, leading people and businesses to avoid taking it on as they try to pay off the increasingly pricy debts they already owe.

Also, deflation is more harmful than inflation because interest rates can only be lowered to zero.

Once rates have hit zero, central banks must use other tools. But as long as businesses and people feel less wealthy, they spend less, reducing demand further. They don't care if interest rates are zero because they aren't borrowing anyway. There's too much liquidity, but it does no good. It's like pushing a string. That deadly situation is called a liquidity trap . It is an economic situation where everyone hoards money instead of investing or spending it. People are too afraid to spend so they just hold onto the cash.

Historic Deflations

To learn more about how deflation works in the real world, consider some of these historical examples:

1. The recession of 1920–1921: Following World War I and the 1918 influenza pandemic (Spanish flu), the US economy experienced deflation as the prices dropped for over a year.
2. The Great Depression: Deflation was an accelerator of one of the toughest US economic periods. Although it began as a recession in 1929, rapidly decreasing demand for goods and services caused prices to drop significantly, which led to the collapse of many companies and rising rates of unemployment. Between the summer of 1929 and early 1933, the wholesale price index fell 33%, and unemployment peaked at above 20%. During this period, the US Federal Reserve (FED), raised interest rates in an attempt to counteract the crashing stock market. Unfortunately, this strategy failed and consumer spending dropped, continuing a deflationary spiral. Price deflation due to the Great Depression happened in virtually every other industrialized country in the world.
3. The Lost Decade: Commonly used to describe the decade of the 1990s in Japan, a period of economic stagnation which became one of the longest-running economic crises in recorded history. The primary causes of this downturn were skyrocketing interest rates and falling equity rates. As a result, a "liquidity trap" occurred.
4. The Great Recession: There was much concern about deflation in the US recession spanning late 2007 to mid-2009. Commodity prices fell, and debtors found it harder to repay loans. The stock market was down, unemployment was up, and home prices dropped precipitously. Economists were concerned that deflation would lead to a deep downward economic spiral, but that didn’t happen.

Above mentioned deflation experiences in western countries were devastating. However, it is also possible to have good deflation. From 1870 through 1890, the UK and US economies greatly benefited from a global decline in prices resulting from the second industrial revolution. This was due to the major increase in productivity levels due to better and more efficient steam engines, increased steel production, cheaper cost of transport by railway, and improved communication systems. These factors helped these economies to transition from a traditional agrarian economy towards an industrial one. The US economy experienced rapid growth during this time as the new technology significantly lowered their costs of production.

How to control Deflation?

The government has a few strategies and tools to rein in deflation.

Monetary Policy Tools:

1. Boost the money supply: The FED (in US) or central banks and governments in other countries can buy back treasury securities to increase the supply of money. With a greater supply, each dollar or other currency is less valuable, encouraging people to spend money and raising prices.
2. Make borrowing easier: The FED might ask banks to boost the amount of credit available or lower interest rates so people can borrow more. If the FED lowers the reserve rate, which is the amount of cash commercial banks must have on hand, banks can loan out more money. This encourages spending and helps raise prices.
3. Quantitative easing: When nominal interest rates are lowered all the way to zero, central banks must resort to emergency monetary tools. Quantitative easing (QE) is when private securities are purchased on the open market, beyond just treasuries. Not only does this pump more money into the financial system, but it also bids up the price of financial assets, keeping them from declining further.
4. Negative interest rates: A negative interest rate policy (NIRP) effectively means that depositors must pay, rather than receive interest on deposits. If it becomes costly to hold on to money, it should encourage spending of that money on consumption, or investment in assets or projects that earn a positive return.

Fiscal Policy Tools:

1. Increasing government spending: If individuals and businesses stop spending, there is no incentive for companies to produce and employ people. The government can step in as a spender of last resort with hopes of keeping production going along with employment. The government can even borrow money to spend by incurring a fiscal deficit. Businesses and their employees will use that government money to spend and invest until prices begin to rise again with demand.
2. Cutting tax rates: If governments cut taxes, more income will stay in the pockets of businesses and their employees, who will feel a wealth effect and spend money that was previously earmarked for taxes. One risk of lowering taxes during a recessionary period is that overall tax revenues will drop, which may force the government to curtail spending and even cease operations of basic services.

Conclusion:

Deflation is, unfortunately, an economic phenomenon that occurs from time to time. It is very difficult to control, and that is why it is usually considered to be much worse than inflation. In the worst-case scenario, deflation can cause a deflationary spiral that can lead to a cascade of negative outcomes that hurt everyone. While fighting deflation is a bit more difficult than containing inflation, governments and central banks have an array of tools they can use to stimulate demand and economic growth.

However, the right kind of deflation from improved efficiency, advancements in technology, new sources of innovation and low production costs will substantially improve consumers' purchasing power provided that their income remains unaffected. This is beneficial for the overall growth of the economy and its industries. The people also become better off as their buying power gets improved and can improve their living standards. But the main problem is how quickly deflation can occur and overturn all the positives into negatives.