Deflation (economics)

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Deflation in economics refers to a decrease in the general price level. Basically, this means things get cheaper. Technically, the 'general price level' means both wages and the nominal cost of goods and services, so while consumers can buy more with the same money, they have less money coming in as wages. Deflation is the opposite of inflation.

Deflation is generally regarded negatively in that it is usually a symptom of a depression or severe recession. In a deflationary situation, people tend not to spend money because they expect prices to drop further. This postponement of consumption causes demand to temporarily decrease causing prices to fall. This can also cause factories to close and people to lose their jobs, so that people reduce spending even further, and prices drop further, creating a vicious circle. Also, deflation causes people to hold on to cash rather than to invest their money. These adverse effects of deflation are arguably due to rigidities in the economy: If wages, prices and interest rates adjusted seamlessly to deflationary expectations, they would have no real economic effects.

Examples of deflation include the Great Depression and the economy of Japan during the 1990s. There was also a slow decline of the general price level in the late 19th century. During this time 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. With World War I, countries began to move away from the gold standard.

Table of contents

1 Causes
2 Example of Deflationary Effects
3 Tools to fight deflation
4 Deflation in the United States
5 Deflation in Japan
6 Deflation: Bad, Tolorable, or Good?

Causes

Deflation may generally be caused by:

Rising currency (decreasing the cost of imports): Domestic currency increases in value - this means foreign raw materials fall in price, driving down overall production costs, lowering prices for goods.
Rising currency (decreasing the quantity of exports): Domestic currency increases in value - this causes foreigners to buy fewer exports (because they are now relatively more expensive), which drives down overall demand, and prices fall due to excess supply.
Decreasing consumer confidence: when consumers get gloomy about the future, they conserve money and buy less. This decreases demand and drives down prices.
Aging population: aging populations are less trendy than teenagers; they are stable and already have basic consumer goods (thus need to buy fewer of new ones), and they like to save more money for retirement as a portion of their income, leading to reduced demand (Japan is an example of this).
Technology: improvements in manufacturing and business processes lower the cost of producing a good, driving prices down (this is common in the computer industry).

Deflation is specifically caused by:

economic contraction: If the economy slows or reduces output, this is typically associated with a falling demand, and if supply remains unchanged, there will be excess supply, so prices will decrease, which is deflation.

decrease in the money supply (the M3). If there is less money, each unit of currency becomes more valuable, and this is deflation.

When an economy contracts, production is too high and must fall to meet (decreased) demand. However, the capacity to produce often remains the same for a while.

Example of Deflationary Effects

An automobile manufacturing plant that costs $1 billion of debt to build. It creates $200 million worth of cars per year (20% return on investment). Suddenly, the economy slows, and no one buys cars. The plant keeps producing cars, hoping things will improve, and supply increases, dropping the price of cars (deflation).

Several months later, the plant closes, the machines are sold to pay a portion of the $1 billion debt (creating cash flow for the manufacturer) as well as cheaper machine tools for a widget manufacturer (who is still in business and going strong). After this deflationary adjustment, economic growth returns due to reallocated capital: more accurately adjusted supply/demand, and more accurately valued goods.

Tools to fight deflation

Basically, governments and central banks try to increase consumption, many times through incentives to reduce savings. They also attempt to assist reallocation of production capacity to places it can generate economic growth. To do this, they can:

Lower interest rates (if interest rates are not already at zero).
- Increases investments. People tend to buy shares instead of Treasury bonds (since the bond yields are lower).
Lower taxes
- Citizens have more money available.
Reduce the value of the local currency (makes it cheaper)
- Imports inflation by increasing the cost of imports.
- Reduces the yield from savings.
Increase government spending
- Makes up a shortfall in consumer spending with government spending.
- Wisely spending on infrastructure like roads, bridges, water/sewer, electrical, etc., can enable quicker economic growth as well as providing jobs and solving needs;

Other government policy changes that can have a positive effect on deflation include:

Improve public safety
- Safe and happy populations buy more goods, work harder, are more efficient workforces, etc.
- Money spent on safety is, in a sense, wasted; it is capital not spent in a way that generates economic growth;
- Money transferred during crime is often inefficiently allocated;
- Many crimes causes damage to capital goods or service capabilities, reducing economic growth potential;
Improve bankruptcy laws
- When businesses fail, they trap business assets including both the physical plant and monetary assets;
- Business assets being well-deployed is vital to economic growth;
- Bankruptcy laws dictate how assets of failed businesses are sold off to pay creditors;
- Creditors have a portion of their cash back and can use it for economic growth;
- Bad bankruptcy laws trap business' physical assets and creditors cash in limbo until a court settles things
- Good bankruptcy laws make very clear how courts should decide ownership of a failed company's assets, increasing economic turnover and enabling good growth.
Improve overall property ownership laws. Various countries should:
- Reduce tight restrictions on real estate property sales preventing efficient transfer of property to where it's more useful and thus increase economic growth;
- Reduce limits on foreign ownership of certain asset classes (real estate, corporate stock, food- or defense-related industries, etc.), preventing foreign transfer payments (investment) from buying up and exporting excess capacity or capital equipment. This turns excess capacity directly into growth-inducing and inflation-producing cash, and thus is a very effective tool;
- Engage in trade agreements that reduce mutual tarrifs. This increases exports, and reduces excess domestic capacity;
- Solidify laws surrounding private ownership. Some former communist countries do not have clear laws on private ownership, which leads to highly inefficient allocation of capital, reduced foreign investment, etc.
- Improve contract laws so transfers of property during a execution of a contract is very predictable and reliable;
- Improve both criminal and civil justice systems: court systems that are predictable, just, fair, ethical, and reasonably quick can improve economic growth very quickly.
- Improve government transparency: money wasted by corruption or fraudulent government activities like confiscation of private property stifles growth and drives the economy ;
- Reduce government red tape: if there are complex procedures required to create any new business, even a small one, prevent economic growth;
- Reduce incentives for captial flight by creating a predictable business policy environment. Capital flight is wehre money is sent out of the country for safekeeping, reducing capital available to grow the economy.
Loosen labor laws to enable businesses to:
- freely reduce their workforces (lay off or fire workers) to quickly adjust their capacity to the demand;
- easily fire inefficient, incompetent, and/or unethical workers;
- change workers hours such that a factory can work multiple shifts, using physical capital more efficiently and generating growth;
Tighten some business regulation:
- Force businesses to state their real assets and liabilities, so companies that should be bankrupt can be seen and either bought out or forced into liquidation;
- Better environmental regulation may reduce production capacity by taking inefficient and polluting equipment offline;
- Simplify and/or fine-tune tax collection to enable government to receive a more fair share of the income from business activity and use it for transfer payments (to needy people) or growth projects;
Increase interest rates (if interest rates are already at zero, during extreme situations) (NOTE: this is a controversial tactic)
- Deflation is caused by excess capacity.
- Reducing capacity forces reduction in supply, redistributes production capacity to new (more efficient) uses.
- Raising interest rates raises cost of capital
- Fragile businesses fail, reducing capacity.
- Fragile consumers who had high debt burdens go bankrupt, forcing redistribution / write-off of bad debt; money moved to more productive uses;
- Banks are forced to write off bad loans & improve loan-giving decision making;
- Overall credit quality improves, driving capital to on-average-better performing areas, inducing growth.

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.

Minor deflations: Throughout the nations' history, inflation has approached zero and dipped below for a short time (negative inflation is deflation). This was very common in the late 1800's, and even more recently in 2001 through 2004.

Deflation in Japan

Deflation started in the 1990s. The Bank of Japan and the government did not succeed in getting rid of deflation, although interest rates are near zero. The reasons for deflation in Japan are:

Bad loans. Banks lent money to several companies which are now in dire straits. Japanese people are afraid that banks will collapse so they prefer to buy gold or Treasury bonds instead of saving their money in a bank account. Bad loans also reduce the supply of money available for lending.
Deflation exported from China. Since Chinese raw materials and wages are lower, prices of manufactured products tend also to be much lower.

Deflation: Bad, Tolorable, or Good?

It is obvious that extreme deflation can cause serious economic side effects (a kind of vicious circle known as a deflationary spiral). However, inflation is also obviously quite bad, with serious side effects itself.

However, whether it is best for an economy to have periods of deflation as well as periods of inflation is an economics question that is not at all resolved. Rather, it seems it is highly influenced by point-of-view. If someone is in debt, the debt shrinks in real terms during inflation. If someone owns bonds, their net worth shrinks in real terms during inflation. The situation is reversed during deflation. Since most people have large mortgage debt, inflation is their friend (and that's probably where the political power lies if politics influences central banking policy).

Maybe with 50 or 100 more years of good economic statistics gathering, the answer to this will be known.