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Deflation is a decrease in the general price level, over a period of time. Deflation is the opposite of inflation. The terms is also used to refer to a decrease in the size of the money supply. During deflation the demand for liquidity goes up, in preference to goods or interest. During deflation the purchasing power of money increases.

Definition

The 'general price level' comprises the price of wages, consumption goods and services.

In the recent years, economists have also started to advocate including asset prices such as stocks and housing and other production goods into the general price level. They then speak of inflation or deflation in asset prices. Indeed, policies designed to fight inflation in goods, services and wages, have seemed to spur stock and housing price inflation, or asset bubbles.

As with inflation, there are economists who regard deflation as a purely monetary effect, when the monetary authority constricts the money supply, and there are those who believe that price deflation is also caused by real factors as for instances a fall in business confidence, which reduces the velocity of money, i.e. the speed with which money is circulating.

During deflation, while consumers can buy more with the same amount of money, they also have less access to money (e.g., as wages, debt, or the return realized on sales of their products). Consumers and producers who are in debt, such as mortgagors, suffer because as their nominal income drops, while their payments remain constant. Central bankers worry about deflation, because many of the tools of monetary policy become ineffective as the real cost of money, the interest rate minus the inflation rate, begins to turn higher again once the inflation rate drops below zero. While nominal interest rates do not fall below zero there are ways by which central banks can create an effective rate of interest below zero for favored customers, macroeconomic theory holds that reductions of the central bank interest rate become less effective as the nominal interest rate drops below 1%. Deflation may set off a deflationary spiral, where businesses slow or stop investing, because the investment risk is perceived as higher than just letting the money appreciate due to deflation. The deflationary spiral is the opposite of an inflationary spiral.

Deflation is generally regarded as a negative in modern currency environments, because a deflationary spiral may cause large falls in GDP and purchasing power, and may take a very long time to correct.

However, a deflationary bias is the norm under specie or money economies, as population and production tend to increase faster than the stock of specie, conversely, an inflationary bias is the norm under credit money economies. There are also episodes where there may be deflation in only a particular kind or type of goods, such as commodities during the Great commodities depression of 1982-1998.

Deflation should not be confused with disinflation which is a slowing in the rate of inflation, that is, where the general level of prices are still increasing, but slower than before.

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. In the IS-LM model this is caused by a shift in the supply and demand curve for goods and interest, 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. Since this idles capacity, investment also falls, leading to further reductions in aggregate demand. This is the deflationary spiral. The solution 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 borrow at rates which are below those available to private entities.

In monetarists theory, deflation is defined in terms of a rise in the demand for money, based on the quantity of money available. The Quantity Theory of Money is founded on the Fisher equation (also called the equation of exchange),

MV = PT,

where M is the money supply, V is the velocity of money, P is the average price level and T is the total number of transactions.

In more recent economic thinking, deflation is related to risk, where the risk adjusted return of assets drops to negative, investors and buyers will hoard currency rather than invest it, even in the most solid of securities. This can produce the theoretical condition, much debated as to its practical possibility, of 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. The experience of Japan during its 1988-2004 depression is thought to illustrate both of these problems.

In monetarist theory deflation is related to a sustained reduction in the velocity of money or number of transacitons. This is attributed to a dramatic contraction of the money supply, perhaps in response to a falling exchange rate, or to adhere to a gold standard or other external monetary base requirement.

Deflation is generally regarded negatively, as it is a tax on borrowers and on holders of illiquid assets, which accrues to the benefit of savers and of holders of liquid assets and currency. In this sense it is the opposite of inflation (or in the extreme, 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 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, it 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 onto 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 scarcer; and consequently, the purchasing power of each unit of currency increases. The late 19th century provides an example of sustained deflation combined with economic development under these conditions.

Deflation also occurs when improvements in production efficiency lowers the overall price of goods. Improvements in production efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit margins, resulting from the production improvements that they make. But despite their profit motive, 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 a deflationary pressure is introduced, since purchasing power has increased. Periods of rapid technological inovation can also produce deflationary pressures in goods or services that are becoming obsolete, as inventories are sold off. For example, when ink jet printers became readily available, dot matrix printers were sold off at much lower prices. However these deflationary pressures only become general if the technological improvements are across the economy, otherwise the economy will adjust with demand and investment moving other areas. In essence localized deflationary effects will free up capital and demand for other goods and forms of production.

However in macroeconomics, "one man's expenditure is another man's income." What this means is that while currency holders benefit from deflation, those whose wages and assets are deflating are made worse off. Thus, deflation can actually cause hardship when to those with majority the majority of their income in wages or the majority of their assets held in illiquid form, such as homes, land, and other forms of private property. It also amplifies the sting of debt, since after some period of significant deflation the payments made in the service of a debt represent a larger amount of purchasing power than they did when the debt was first incurred. This means that unexpected deflation is a risk to borrowers, since it will mean that the real rate of interest could increase during the term of the loan, just as unexpected inflation is a risk to lenders who may see a reduction in the real rate of interest during the course of the loan.

This lesson about protracted deflationary cycles and their attendant hardships has been felt several times in modern history. During the 19th century, the Industrial Revolution brought about a huge increase in production efficiency, that happened to coincide with a relatively flat money-supply. These two deflationary catalysts led, simultaneously, not only to tremendous capital development, but also to tremendous deprivation for millions of people who were ill-equipped to deal with the dark side of deflation. Business owners-- on average, better educated in economic theory than their unfortunate cohorts (or just better able to withstand the economic stresses)-- recognized the deflation cycle as it unfolded, and positioned themselves to leverage its beneficial aspects.

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, while there have been periods of 'beneficial' deflation more often it has led to the more severe form with negative impact to large segments of the populace and economy. Examples of deflationary pressures seen as beneficial in recent times are the rapid improvements in information technology which are seen as having increased productivity without increasing demand for scarce resources.

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 hard money standards and back to a money standard based on the more inflationary (because more abundantly available) metal silver.

Most economists agree that the effects of modest long-term inflation are less damaging than deflation (which, even at best, is very hard to control). Deflation raises real wages which are both difficult and costly for management to lower. This frequently leads to layoffs and makes employers reluctant to hire new workers, increasing unemployment. However, in the last 5 years or so, real wages for the average worker has remained fixed or actually decreased, with little effect on unemployment.

Causes of deflation

From a monetary perspective deflation is caused by a reduction in the velocity of money and/or the amount of money supply per person. In a hard money economy, with limited specie sources, deflation is the more natural state of the economy - people multiply and economies grow faster than hard money is created. Within the market mechanism, capitalism is generally 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. These are referred to as "Smithian" and "Schumpterian" capital effects respectively.

A distinction then, is sometimes drawn between deflation in hard currency economies, such as those on the gold standard and economies which run on credit. In modern credit based economies, a deflationary spiral may be caused by the central bank initiating higher interest rates to reduce inflation or inflation risks, thereby possibly popping an asset bubble. It is also associated with the collapse of a command economy which has been run at higher level of production than its allocation of capital and labor can support. In a credit based economy, a fall in money supply leads to a credit crunch. This reduces the level of demand, which, in turn contracts the 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 in turn leads holders of inventories to sell their stocks at lower prices, often at a loss, further depressing prices.

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 they loaned the funds, 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.

In unstable currency economies, barter and other alternate currency arrangements are common, and therefore when legal tender becomes scarce, or unusually unreliable, commerce can still continue. 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 way to make money in such an economy is to dig it out of the ground.

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 - "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 zero nominal rate of interest, which could still be a very high real rate of interest, due to the inflation rate in order to intentionally increase the money supply.

This cycle has been traced out on the broad scale during the Great Depression. Specifically when the collapse of the Viennese Credit-Anstalt bank led to the subsequent collapse of the entire global financial system. 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. There are economists who argue that the post-2000 recession had a period where the US was at risk of severe deflation, and that therefore the Federal Reserve central bank was right in holding interest rates at an "accommodative" stance from 2001 on.

Keynesians insist on the distinction between consuming goods and producing goods, and less often between exogeneous and endogeneous money supply.

For a given money supply, if wages rise faster than productivity, profits will fall, and with them the price of productive goods, while consuming goods will rise. This happens in times when labor supply is tight and bargaining power is strong. When wages rise slower than productivity, profits rise as do the prices of assets relative to consuming goods. This can occur when labor supply is great and bargaining power is weak. In the first case there should, all other things being equal, be inflation, because there is higher consumption demand and less investment. In the second case, all other things being equal, there should be deflation, as there is a drop in consuming demand and a rise in investment. A deflationary spiral occurs when the drop in demand is sufficient to also reduce expected profits for long enough to reduce the value of capital as well. Thus less consumption and less investment feed off of each other.

Since, in the Keynesian view, the source of deflation is a lack of consumer demand, and a lack of confidence to invest Keynesians advocate "pump priming" or government creation of credit/money that has a cost interest rate below inflation or market rates. As witnessed since 1990 in Japan, and in the 1930's in the USA, this policy is not very effective unless government creates employment via public works projects or military manufacturing.

The reason this view has become the dominant one in deflation fighting is because the most important alternate view prior to Keynes was that increasing business confidence was the way to end business downturns, and the most important steps to doing this were to instill confidence in holders of currency that their buying power was secure. Classical political economy held that Say's Law was true, and that economies would self-right themselves after a period of monetary adjustment, unless there was interference from some external, probably government, source. Hence, the previous policy regime prescribed balancing government budgets by lowering expenditures and raising taxes, and raising interest rates to give holders of currency more incentive to lend. The general view in mainstream economics is that this lead to the "Great Contraction" of money supply in the 1928-1932 period, which was a contributing, or even primary, cause of during a downturn in business into what is known as The Great Depression.

In modern monetarist theory, monetary policy is thought to be a more effective means of ending deflationary spirals, by flooding an economy with liquidity. It was this policy which was pursued by the United States in the early 2000s in order to fight off what was seen as a potential deflationary spiral.

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 temporarily palliative, leading to the aggravation of an eventual future debt deflation crisis. These arguments parallel some made during the 1880-1920 period about the possibility that over-investment could be a cause, or contributing cause, in economic downturns.

Alternative causes and effects

The Austrian school of economics

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 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 kg of gold. 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 to be a good cause of a general fall in prices, while credit/money supply contraction 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.

Examples of deflation

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 the First World War; 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.

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 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.

The second was between 1930-1933 when the rate of deflation was approximately 10 percent/year. The first was possibly spurred by the 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%. Both were world-wide phenomena.

The deflation of the Great Depression did not occur because of any sudden rise or surplus in output. It is generally thought that, because there was an enormous contraction of credit and the money supply into an environment of high asset prices, an ordinary downturn in business was turned into a catastrophic drop in production. The lack of liquidity generated bankruptcies created an environment where cash was in frantic demand, and the Federal Reserve did not adequately accommodate that demand, so even sound 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 concommitant drop both in money supply (credit) and the velocity of money which was so profound that 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.

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 . 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 .

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. In July 2006, the zero-rate policy was ended.

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.

References

• Ben S. Bernanke, 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
• Michael Bordo & Andrew Filardo, Deflation and monetary policy in a historiscal perspective: remembering the past or being condemned to repeat it?, In: Economic Policy, October 2005, pp 799-844.
• Georg Erber, The Risk of Deflation in Germany and the Monetary Policy of the ECB. In: Cesifo Forum 4 (2003), 3, pp 24-29
• Charles Goodhart and Boris Hofmann, Deflation, credit and asset prices, In: Deflation - Current and Historical Perspectives, eds. Richard C. K. Burdekin & Pierre L. Siklos, Cambridge University Press, Cambridge.
• International Monetary Fund, Deflation: Determinants, Risks, and Policy Options - Findings of an Independent Task Force, Washington D. C., April 30, 2003.
• International Monetary Fund, World Economic Outlook 2006 - Globalization and Inflation, Washington D. C., April 2006.
• Otmar Issing, The euro after four years: is there a risk of deflation?, 16th European Finance Convention, 2 December 2002, London, Europäische Zentralbank, Frankfurt am Main
• Paul Krugman, Its Baaaaack: Japan's Slump and the Return of the Liquidity Trap, In: Brookings Papers on Economic Activity 2, (1998), pp 137-205
• Steven B. Kamin, Mario Marazzi & John W. Schindler, Is China "Exporting Deflation"?, International Finance Discussion Papers No. 791, Board of Governors of the Federal Reserve System, Washington D. C. Januar 2004.

See also

• Stagflation
• Hyperinflation
• Macroeconomics

External links

• Wiktionary:Deflation
• Cato Policy Report - A Plea for (Mild) Deflation
• Deflation (EH.Net economic history encyclopedia)
• What is deflation and how can it be prevented? (About.com)
• Deflation, Free or Compulsory from Making Economic Sense by Murray N. Rothbard

• Inflation