Posted on: 23-06-2015 in Holborn Assets
Deflation is negative inflation – when the general price level in the economy is falling. Goods and services becoming cheaper and more affordable look like a positive thing at first glance. All of us would like our salaries to have greater purchasing power. Unfortunately, deflation not only makes things cheaper; it also reduces the revenues of our employers and, eventually, puts our very salaries in danger.
Inflation and Deflation Expectations
You don’t need to be an economist to know when the prices rise or fall. People of all backgrounds and income levels do notice changes in prices of the items they regularly buy. These changes don’t just affect their finances; they also get reflected in their mind. When you have seen prices rising for some time, you (consciously or subconsciously) expect them to continue doing so in the near future. Conversely, in a period of deflation people tend to expect a further decline in prices. This is called inflation (or deflation) expectations.
The problem with deflation and people expecting even lower prices in the future is that these expectations result in a decline in consumption. Think about it – if you had been planning to buy a new car and you thought its price would be £1,000 lower next month, wouldn’t you put the money aside and wait? Maybe you wouldn’t if you really needed the car, but out of thousands of people in the entire economy, there will always be some who would delay their spending when expecting a lower price in the future. Deflation leads to expectations of further deflation, which lead to lower consumption.
When consumers become reluctant to buy and are hoarding cash instead, businesses get in trouble. The demand for their goods and services declines and their revenues fall. At some point, some businesses end up in financial difficulties and they will have to reduce their output and as a result, they may lay off employees (or avoid hiring new ones or do not increase salaries).
The Vicious Cycle of Deflation
The negative effects inevitably influence household spending. Unemployment rises and disposable incomes fall. What will the typical consumer do when his income has fallen and he is expecting goods and services to become cheaper in the future? He will of course further reduce his spending. The cycle goes on.
Other parts of the economy get affected too. Banks will suffer from an increased share of bad loans, as some consumers and businesses become unable to keep up with debt repayments. The government will find itself in a difficult situation too, trying to stimulate the stagnating economy with more public spending, but facing a drop in tax revenue and more people claiming social benefits at the same time. Public deficit and government debt will rise.
A lot of serious problems in all parts of the economy may arise when prices drop and the vicious cycle unfolds. In practice, short periods of very small deflation may not lead to a depression of such enormous scale. The economy is a complex system of relationships and its equilibrium is very fragile. Most economists believe that a modest and controlled increase in prices (inflation of 2-3%) is best for long-term economic development because zero inflation would be too dangerous and too close to the deflation area.
When the risk of deflation increases, typically during a recession or in the years following it, central banks try to ease monetary policy, reduce interest rates and sometimes apply more aggressive expansionary measures (such as quantitative easing) to stimulate economic activity and prevent prices from falling. Since the 2008 financial crisis, this has been the main driving force of economic policy in most developed countries, including the US, UK, Eurozone and Japan.