Intro to Deflation | StreetFins®

Deflation’s Causes and Explanations

Deflation is a decrease in the price of goods and services. It’s the opposite of inflation, where the price of goods and services increases. By definition, deflation increases purchasing power, so that a dollar is worth more. Deflation sounds great but it can be both good and bad: in a time of productivity and technological advancement for a certain industry, prices fall due to the effectiveness of a product. Bad deflation is when the general demand or amount of money circulating decreases, which is usually the start of a recession.

Deflation is caused by a shortage of money, a growth in the supply of products, or a stagnant or slowly increasing amount of currency. Another reason is lessened demand for a certain product, which limits the amount of money going into that industry. Deflation can happen naturally in a highly productive society as well. It’s important to note that deflation isn’t always bad.

What Happens in Deflation

During deflation, a certain set of phenomena occurs regarding consumer psychology, bank rates, and more. Customers will often jump at the opportunity to buy goods for cheaper prices, but if the prices rapidly and steadily decrease, it’s possible to see consumers withholding their money in hopes of better prices for desired items. The value of certain goods and the status of industries can greatly influence investment decisions. These factors often create a recession. Lower spending results in less investment in business and lower wages. Such an event will allow unemployment to run rampant.

Businesses will keep trying to lower prices to attract customers. The government tries to combat this by lowering tax rates. People start to take on debts due to the perceived cheapness of goods, thus accumulating debt. This poses a problem to the banks as well, as they are getting stretched financially as well. Some may decide to withdraw their money in case the bank fails, causing the bank to not have enough reserves, leading to financial institutions crashing (it’s important to note that it is highly unlikely in the U.S. since deposits in banks are insured by the FDIC which prevents bank failures, but it can still happen, both domestically and internationally). This makes everyone lose liquidity of currency, only worsening the situation and going in a downward spiral. Deflation can be more dangerous than inflation because interest rates can go to 0%.

The Winners and Losers of Deflation

Some of us stand to gain from deflation, while others may lose from it. Consumers would initially benefit from deflation because the aggregate (overall/combination of all products) cost of products would decline, spurring them to spend more. On the other hand, savers also reap a significant benefit, as the money they keep in the bank continues to increase in purchasing power as deflation continues. Retirees are also affected because depending on their financial plan, can see their funds last them for much longer, while others that are inflation-linked can see their streams of money diminish.

The losers are banks (especially the central bank), debtors, and retailers. Debtors can find it difficult to pay off what they owe when the amount of cash they receive dwindles, yet the debt accrued doesn’t fall with the markets. Instead, it only compounds which can result in them defaulting on their loan payments. Banks are also affected because as many people could file for bankruptcy, thus canceling their debts and creating losses for the banks. People now don’t want to take on more debt, so banks lose one of their main sources of revenue.

Retailers are at loss as well, because people keep wanting to save money, in hopes of getting a better deal for an item. This forces stores to lower prices even further which only exacerbates the problem and furthering the cycle. In the end, everyone loses in deflation, due to the collapse of key factors in the supply chain and economy.

Historical Examples of Deflation

The Great Depression is one of the most famous examples of deflation comes from the Great Depression of the 1930s. This period of economic difficulty followed the Roaring 1920s. It is widely debated why the Depression started. Theories include a drop in aggregate demand, a fall in the amount of money being circulated, the Federal Reserve’s policies, or a mix of the three. Regardless, all of these are signs of deflation. With the technological advancement of the 1920s, Americans increased their spending and bought items like cars on credit. As a result, the avg. American consumer debt increased every year during the 1920s. When the economy collapsed, banks and the financial sector crumbled. The stock market crashed after the prices of stocks didn’t reflect the profits and production of companies. Unemployment rose and the industrial and agricultural sectors’ production fell.

Japan’s Deflationary Spiral is another example. Japan has been fighting an economic downturn and deflation on and off for the past 20+ years. Japan’s population growth has slowed dramatically since 1950.he yearly deaths in Japan have outweighed the yearly births, devaluing much of the land in the process, due to the low demand for new property. The Bank of Japan increased interest rates for fear of inflation. However, the opposite occurred. Japanese consumers weren’t willing to spend and invest their money. This created a liquidity trap where investors and consumers hold off on spending their money. Banks stopped lending money after serious investment losses in real estate and other industries. Japan also imported many products from countries like China, where production costs are low Because of the low production costs, these products can be sold in Japan for low prices. Japanese manufacturers had to match this by lowering their prices as well.

Conclusion

Deflation is a profound economic phenomenon that has the potential to boost or crush a country. Learning from the situations of other countries and our own history can help us avoid these mistakes in the future.