Deflation

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In economics, deflation is a decrease in the general price level of goods and services.[1] Deflation occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money – allowing one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow-down in the inflation rate (i.e. when inflation declines to lower levels).[2] As inflation reduces the real value of money over time, conversely, deflation increases the real value of money – the functional currency (and monetary unit of account) in a national or regional economy.

Currently, mainstream economists generally believe that deflation is a problem in a modern economy because of the danger of a deflationary spiral (explained below).[3] Deflation is correlated with recessions including the Great Depression, as banks defaulted on depositors. Additionally, deflation may cause the economy to enter the liquidity trap. However, historically not all episodes of deflation correspond with periods of poor economic growth.[4]

Contents

Effects of deflation

In the IS/LM model (that is, the Investment and Saving equilibrium/ Liquidity Preference and Money Supply equilibrium model), deflation is caused by a shift in the supply and demand curve for goods and services, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity.

Since this idles capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand, and to borrow at interest rates which are below those available to private entities.

In more recent economic thinking, deflation is related to risk: where the risk-adjusted return on assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. This can produce a liquidity trap. A central bank cannot, normally, charge negative interest for money, and even charging zero interest often produces less stimulative effect than slightly higher rates of interest. In a closed economy, this is because charging zero interest also means having zero return on government securities, or even negative return on short maturities. In an open economy it creates a carry trade, and devalues the currency producing higher prices for imports without necessarily stimulating exports to a like degree.

In monetarist theory, deflation must be associated with either a reduction in the money supply, a reduction in the velocity of money or an increase in the number of transactions. But any of these may occur separately without deflation. It may be attributed to a dramatic contraction of the money supply, or to adhere to a gold standard or other external monetary base requirement.

Deflation is generally regarded negatively, as it causes a transfer of wealth from borrowers and holders of illiquid assets, to the benefit of savers and of holders of liquid assets and currency. In this sense it is the opposite of inflation, which is similar to taxing currency holders and lenders (savers) and using the proceeds to subsidize borrowers. Thus inflation may encourage short term consumption. In modern economies, deflation is usually caused by a drop in aggregate demand, and is associated with recession and (more rarely) long term economic depressions.

In recent times, as loan terms have grown in length and loan financing (or leveraging) is common among many types of investments, the costs of deflation to borrowers have grown larger. Deflation discourages investment and spending, because there is no reason to risk on future profits when the expectation of profits may be negative and the expectation of future prices is lower. Consequently deflation generally leads to, or is associated with a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent just to hold on to money, and not to spend or invest it.

Deflation is, however, the natural condition of hard currency economies when the rate of increase in the supply of money is not maintained at a rate commensurate to positive population (and general economic) growth. When this happens, the available amount of hard currency per person falls, in effect making money more scarce; and consequently, the purchasing power of each unit of currency increases. Deflation occurs when improvements in production efficiency lower the overall price of goods. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.

Rising productivity and reduced transportation cost created structural deflation during the peak productivity era of the last quarter of the 19th century until the establishment of the Federal Reserve in 1913. There was inflation during World War I, but deflation returned again after that war and during the 1930s depression. Most nations abandoned the gold standard in the 1930s. There is less reason to expect deflation, aside from the collapse of speculative asset classes, under a fiat monetary system with low productivity growth.

While an increase in the purchasing power of one's money sounds beneficial, it amplifies the sting of debt, since—after some period of significant deflation—the payments one is making in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. Consequently, deflation can be thought of as a phantom amplification of a loan's interest rate. If, as during the Great Depression in the United States, deflation averages 10% per year, even a 0% loan is unattractive as it must be repaid with money worth 10% more each year. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate — the overnight federal funds rate in the United States — and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.

During severe deflation, targeting an interest rate (the usual method of determining how much money to create) may be ineffective, as even lowering the short-term interest rate to zero may result in a real interest rate which is too high to attract credit-worthy borrowers. Thus the central bank must directly set a target for the quantity of money (called "quantitative easing") and may use extraordinary methods to increase the supply of money, e.g. purchasing financial assets of a type not usually used by the central bank as reserves (such as mortgage backed securities). As the current Chairman of the United States Federal Reserve, Ben Bernanke, said in 2002, "...sufficient injections of money will ultimately always reverse a deflation."[5]

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.

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 the gold standard and onto a silver or bimetal standard because the supply of silver was increasing relatively faster than the supply of gold (making silver inflationary—or less deflationary—compared to gold).

Effects of deflation

  1. Decreasing nominal prices for goods and services.
  2. Cash money and all monetary items increase in real value over time.
  3. Discourages bank savings and decreases investment.
  4. Enriches creditors at the expenses of debtors.
  5. Benefits fixed income earners.
  6. Associated with recessions and unemployment.

Deflationary spiral

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.[6] Since reductions in general price level are called deflation, a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. The Great Depression was regarded by some as a deflationary spiral.[7] Whether deflationary spirals can actually occur is controversial.[8]

A deflationary spiral is the modern macroeconomic version of the general glut controversy of the 19th century. Another related idea is Irving Fisher's theory that excess debt can cause a continuing deflation.

Causes of deflation

In mainstream economics, deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply. Studies of the Great Depression by Ben Bernanke have indicated that, in response to decreased demand, the Federal Reserve of the time decreased the money supply, hence contributing to deflation.

Basic types of deflation

Some types of deflation can be distinguished.
On the demand side:

On the supply side:

Money supply side type deflation

From a monetarist perspective deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person.

Credit deflation

In modern credit-based economies, a deflationary spiral may be caused by the central bank initiating higher interest rates (i.e., to 'control' inflation), thereby possibly popping an asset bubble. In a credit-based economy, a fall in money supply leads to markedly less lending, with a further sharp fall in money supply, and a consequent sharp fall-off in demand for goods. 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 production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets which have fallen dramatically in value since their mortgage loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans (as in Japan, most recently). This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.

Effects of scarcity of 'official' money

In unstable currency economies, barter and other alternate currency arrangements such as dollarization are common, and therefore when the 'official' money becomes scarce (or unusually unreliable), commerce can still continue (e.g., most recently in Russia and Argentina). Since in such economies the central government is often unable, even if it were willing, to adequately control the internal economy, there is no pressing need for individuals to acquire official currency except to pay for imported goods. In effect, barter acts as protective tariff in such economies, encouraging local consumption of local production. It also acts as a spur to mining and exploration, since one easy way to make money in such an economy is to dig it out of the ground.

Special arrangements (?)

When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to (artificially) increase the money supply.

Examples of credit deflation

This cycle has been traced out on the broad scale during the Great Depression. International trade contracted sharply, severely reducing demand for goods, thereby idling a great deal of capacity, and setting off a string of bank failures. A similar situation in Japan, beginning with the stock and real estate market collapse in the early 1990s, was arrested by the Japanese government preventing the collapse of most banks and taking over direct control of several in the worst condition. These occurrences are the matter of intense debate.

Counteracting 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. Reserve requirements from the central bank were high compared to recent times. So were it not for redemption of currency for gold (in accordance with the gold standard), the central bank could have effectively increased money supply by simply reducing the reserve requirements and through open market operations (e.g., buying treasury bonds for cash) to offset the reduction of money supply in the private sectors due to the collapse of credit (credit is a form of money).

With the rise of monetarist ideas, the focus in fighting deflation was put on expanding demand by lowering interest rates (i.e., reducing the "cost" of money). This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000–2002, respectively. Economists now worry about the (inflationary) impact of monetary policies on asset prices. Sustained low real rates can be the direct cause of higher asset prices and excessive debt accumulation. Therefore lowering rates may prove only a temporary palliative, leading to the aggravation of an eventual future debt deflation crisis.

Examples of deflation

Deflation in Hong Kong

Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the 4th quarter of 2004 [2]. Many East Asian currencies devalued following the crisis. The Hong Kong dollar however, was pegged to the US Dollar, leading to an adjustment instead by a deflation of consumer prices. The situation was worsened by the increasingly cheap exports from Mainland China, and weak consumer confidence in Hong Kong. This deflation was accompanied by an economic slump that was more severe and prolonged than those of the surrounding countries that devalued their currencies in the wake of the Asian financial crisis.[9][10]

Deflation in Ireland

In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced deflation, with prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish economy since 1960. Overall consumer prices decreased by 1.7% in the month.[11]

Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account, "Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in child benefit, public sector pay and professional fees are being considered. Mr Lenihan said month-on-month there has been a 6.6% decline in the cost of living this year."

This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be.[12]

Deflation in Japan

Deflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates (part of their 'quantitative easing' policy), but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended.

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

In November 2009 Japan has returned to deflation, according to the Wall Street Journal. Bloomberg L.P. reports that consumer prices fell in October 2009 by a near record 2.2%.[13]

Deflation in the United States

Annual inflation (in blue) and deflation (in green) rates in the United States from 1666 to 2004.

Major deflations

There have been three significant periods of deflation in the United States.

The first was the recession of the late 1830s, following the Panic of 1837, when the currency in the United States contracted by about 30%, a contraction which is only matched by the Great Depression. This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money.

The second was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War.

"The Great Sag of 1873-96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to Milton Friedman, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year.[14]

The third was between 1930–1933 when the rate of deflation was approximately 10 percent/year, part of the United States' slide into the Great Depression, where banks failed and unemployment peaked at 25%.

The deflation of the Great Depression, as in 1836, did not begin because of any sudden rise or surplus in output. It occurred because there was an enormous contraction of credit (money), bankruptcies creating an environment where cash was in frantic demand, and the Federal Reserve did not adequately accommodate that demand, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash— see Fractional-reserve banking). From the standpoint of the Fisher equation (see above), there was a concomitant drop both in money supply (credit) and the velocity of money which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.

Minor deflations

Throughout the history of the United States, inflation has approached zero and dipped below for short periods of time (negative inflation is deflation). This was quite common in the 19th century and in the 20th century before World War II.

Some economists believe the United States may be currently experiencing deflation as part of the Financial crisis of 2007–2010; compare the theory of debt-deflation. Year-on-year, consumer prices dropped for six months in a row to end-August 2009, largely due to a steep decline in energy prices. Consumer prices dropped 1 percent in October, 2008. This was the largest one-month fall in prices in the US since at least 1947. That record was again broken in November, 2008 with a 1.7% decline. In response, the Federal Reserve decided to continue cutting interest rates, down to a near-zero range as of December 16, 2008.[15] In late 2008 and early 2009, some economists feared the US could enter a deflationary spiral. Economist Nouriel Roubini predicted that the United States would enter a deflationary recession, and coined the term "stag-deflation" to describe it.[16] It is the opposite of stagflation, which was the main fear during the spring and summer of 2008. The United States then began experiencing measurable deflation, steadily decreasing from the first measured deflation of -0.38% in March, to July's deflation rate of -2.10%. On the wage front, in October 2009 the state of Colorado announced that its state minimum wage, which is indexed to inflation, is set to be cut, which would be the first time a state has cut its minimum wage since 1938.[17]

United Kingdom

During World War I the British pound sterling was removed from the gold standard. The motivation for this policy change was to finance World War I; one of the results was 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.

The UK experienced deflation of approx 10% in 1921, 14% in 1922, and 3 to 5% in the early 1930s.[18]

See also

Notes

  1. ↑ Robert J. Barro and Vittorio Grilli (1994), European Macroeconomics, chap. 8, p. 142. ISBN 0333577647
  2. ↑ Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 343. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4. 
  3. ↑ Hummel, Jeffrey Rogers. "Death and Taxes, Including Inflation: the Public versus Economists" (Jan 2007). [1]
  4. ↑ Andrew Atkeson and Patrick J. Kehoe of the Federal Reserve Bank of Minneapolis Deflation and Depression: Is There an Empirical Link?
  5. ↑ Deflation: Making Sure "It" Doesn't Happen Here Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C. November 21, 2002
  6. ↑ Prof. Krugman on Deflationary Spirals
  7. ↑ The Economist on the dangers of a deflationary spiral
  8. ↑ "Nonsense about Deflation" by Robert Higgs
  9. ↑ Jao, Y C (2001). "Why Was Hong Kong a Laggard in Economic Recovery". The Asian Financial Crisis and the Ordeal of Hong Kong. Quorum Books. pp. 155–170. ISBN 978-1567204476. 
  10. ↑ Liu, Henry C K (2003-07-04). "Why Hong Kong is in crisis". Asia Times. http://www.atimes.com/atimes/China/EG04Ad04.html. Retrieved 27 April 2010. 
  11. ↑ RTÉ News - Deflation hits economy; 1st time in 49 years
  12. ↑ RTÉ News - Deflation a factor in Budget cuts - Lenihan
  13. ↑ Japan Releases Stimulus Package as Recovery Weakens (Update3)
  14. ↑ http://www.grantspub.com/articles/inflation/
  15. ↑ http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm FRB: Press Release
  16. ↑ http://www.forbes.com/2008/10/29/stagnation-recession-deflation-oped-cx_nr_1030roubini.html Get Ready for 'Stag-Deflation'
  17. ↑ Colorado minimum wage set to fall, by Aldo Svaldi, The Denver Post, 10/13/2009
  18. ↑ Bank of England Quarterly inflation report Feb 2009 p33 chart A

References

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