Deflation – definition, causes, and effects

Every currency in the world has a specific value. Some gain from it, and others lose. Things are very fluid by nature. While there is a lot of talks today about inflation, its economic opposite is usually kept quiet. So what is deflation? How much should it be, and why is it as dangerous as…

Every currency in the world has a specific value. Some gain from it, and others lose. Things are very fluid by nature. While there is a lot of talks today about inflation, its economic opposite is usually kept quiet. So what is deflation? How much should it be, and why is it as dangerous as inflation? Find out the answers to the most common questions.

Basic concepts

In the economy, many things work like a system of connected vessels. Very often, one segment influences the other here. Therefore, before we deal with deflation, it is worth setting some terminological boundaries at the beginning and introducing simplifications within which we will move.

So, let’s start with money, which is what is closest to everyone in this topic. The simplest model we can adopt here is that money is a commodity for which there is both demand and supply. Pretty simple, isn’t it?

It is clear from this that there may be too little or too much of them on the market at any given time. The principle is as simple as the definition. The faster the economic development, the greater the demand for money in circulation. In the case of inflation, there is often talk of excess funds in the market. We will therefore call the shortage of monetary deflation.

Monetary policy

In general, the economy likes balance. However, without price controls for goods and services, the market is often exposed to rapid and, what is worse, long-term destabilization. A perfect example is the United States of the 1930s. The panic in the stock market then led to a huge wave of bankruptcies and debts. The global economy has also felt this.

Affected by the negative effects of the Great Depression, the US drew conclusions and completely moved away from the extreme free-market theories – focusing on government intervention in the economy. Thanks to this, the United States managed to effectively respond to the effects of the great financial crisis in 2007-2009.

Leaving aside specific examples, it’s probably obvious that without tools, it’s hard to fix anything. It’s the same in the economy, and that’s why central banks are so essential today. For example, in Poland, the NBP is responsible for monetary policy, using the inflation targeting strategy. This means that the central bank undertakes to maintain inflation at the level of 2.5% with a symmetrical range of deviations of ±1 percentage point.

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What is deflation?

All right, we’ve already learned all the necessary basics to get down to business. Ready? Deflation is a long-term fall in prices, increasing money’s purchasing power. You buy more for less, so this is the essential opposite of inflation. Should we, therefore, strive for the highest possible deflation? Well… not really.

When there is too little money in the market, their purchasing power increases – they are more valuable. Saving becomes more profitable (banks offer more attractive deposits). But at the same time, debt is felt more painfully. Deflation discourages investment using credit.

So we are dealing here with a kind of self-perpetuating spiral. The decrease in demand results in lower turnover in companies, which translates into the earnings of employees. And here, the circle closes. Lack of work or declining wages leaves the consumer’s wallet empty. So basically, everyone loses on deflation. That is why it is so crucial to compensate for the shortage of money on the market to the needs of a fast-growing economy, i.e., the intervention of the central bank.

Long-term deflation ultimately leads to very negative effects, such as an increase in the unemployment rate or overproduction of resources in the face of falling demand. The above phenomenon also makes all goods lose their value. Deflation should therefore be seen as a general lack of economic growth in money issuance commensurate with market demand.

Read also: What is GDP, and how does it affect me?

Causes of deflation

Causes of deflation

As we have already established – the economy is a system of interconnected vessels full of reciprocity. Of course, the reasons for this can be very different. Therefore, there is no single direct factor that would cause deflation.

Deflation is caused by:

  • lack of money issuance proportional to market needs;
  • a deep recession leading to a sharp drop in demand;
  • excessive interest on term deposits ;
  • repayment of credit obligations with no money issues and no lending.

It is worth noting here that lowering prices does not always mean deflation. They can also be a derivative of technological or economic development – ​​for example, in high-tech industries. In such a situation, prices do not fall because we are dealing with deflation but because production has become cheaper and more profitable.

The effects of deflation

Long-term deflation means lower prices of consumer goods and services. When it comes to the real economy, this situation has basically nothing but negative effects. A low commodity price index may paradoxically cause a drop in demand.

There is no reason to be surprised. Why buy now when prices are lower tomorrow? This is why the NBP inflation target is +2.5% and not -2.5%. Central banks only care that the effects of deflation do not block the consumer’s wallets.

Lower prices also mean lower income in enterprises, which directly translates into lower wages for employees or, worse, layoffs. As a result, the number of unemployed may increase. This, in turn, leads to an increase in state spending, e.g., on unemployment benefits.

The housing market and loans

For many people, such deflation is an absolutely catastrophic process. Not only that apartments lose their value and cease to be interesting for investors, but it is also increasingly difficult to pay off debts with lower income due to deflation. As a result, taking out housing loans becomes less profitable.

Due to the fact that the nominal interest rate does not fall below zero, in this case, deflation, especially strong deflation, puts debtors in a difficult situation. As prices fall, revenues shrink. At the same time, the nominal debt remains unchanged. Thus, the debtor must allocate an increasing part of his income to its service. With long-term deflation and declining revenues, an indebted entrepreneur may not be able to cope with such a situation. This can lead to a chain of bankruptcies.

Deflation can cause a deep recession. When the phenomenon is prolonged, banks are forced to adjust their offers and implement the central bank’s low-interest rates policy. In extreme situations, this makes loans completely unprofitable. After all, no institution will grant a loan for less than 0%. Ultimately, such a situation will lead to a sharp reduction in credit supply and a contraction of the economy.

Deflation in Poland

What is deflation

Currently, it is hard to imagine, but in Poland, they have already dealt with it. According to the data of the Central Statistical Office, price deflation in Poland lasted for 28 months – in the years 2014 – 2016. It was the first episode of such length in the history of the Third Republic of Poland. 

The largest drop in prices (-1.6%) was recorded in February 2015. The drop in prices of consumer services in Poland was already quite noticeable then, and consumers often paid attention to the greater possibilities of their own wallets.

In the second half of 2016, the media reported that economic growth was slowing down, which translated into stabilizing the level of prices in the country and improving the condition of the Polish zloty.

Interestingly, there are countries that have been struggling with the effects of long-term deflation for years and are still perceived as economic powerhouses. An example is Japan, where inflation only reached its shores last year.

In April, Japan’s Bureau of Statistics reported that inflation exceeded the Bank Of Japan’s 2 percent target for the first time in over seven years. The CPI in the Land of the Rising Sun was then 2.4% year over year against 1.2% recorded in March and began to harass Japanese companies. 

Which is worse, inflation or deflation?

At first glance, it can be seen that central banks prefer low inflation – a few percent. It allows you to maintain the pace of economic development with a stable value of money. However, in the long run, the opposite phenomenon carries many risks.

On the other hand, poorly conducted monetary policy can lead to so-called hyperinflation, i.e., excess money in circulation, where the CPI exceeds 50%. An example of such an economy today is Turkey.

Interestingly, opinions on the right price level are divided. Some experts advocate stable deflation. For example, André Marques of the Mises Institute in the US, in an article he published 4, argues that deflation is bad only for the government.

According to a member of one of the leading think tanks in the United States, under such conditions, consumers and entrepreneurs are the only entities benefiting from lower prices and higher profit margins, respectively.

In the variant discussed by the expert, the authorities cannot tax people indirectly through inflation or use monetary policy to artificially drive the economy. After all, deflation slows down economic growth, and that’s what we’re all trying to avoid.

Sources:

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What is deflation

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