5 reasons why Deflation spells bad news for any economy

Do you know that deflation is not the same as disinflation and definitely, not inflation? Sounds confusing? I know. Inflation in economics definition means a sustained increase in the aggregate or general price level in an economy. In short, it means there is an increase in the cost of living. Disinflation, on the other hand means prices are still going up, but at a decreasing rate. In short, it means slowing periods of inflation. Of course, this is not to be confused with deflation, because deflation means a reduction in the general price level of prices in an economy. So now that we are all clear about what these three terms are, let’s dive into why deflation is so dreaded by any economy and governments would do all they can just to avoid this one thing, deflation.

 

#1: Hey, everything’s cheaper than it was last week!

(Photo by Mario Tama/Getty Images)
(Photo by Mario Tama/Getty Images)

In a deflationary environment, everyone including consumers and businesses began to form expectations that prices are going to fall in the future anyway, so why not wait? Consumers become less willing to spend and businesses become less willing to borrow to invest. Can you tell what happens to demand and supply? Yes, demand declines on a whole and economies will start shrinking as a result.

#2: Lesser goods and services produced, lesser workers needed to produce goods.

Source: Google
Source: Google

When demand for goods and services declines, companies began having excess supply of current goods and services. This may force some of them to sell their products cheaply. When revenues decline, businesses cannot afford to pay workers as well as they did before and wages began to fall as well. Workers may then be forced into accepting their lower pay unwillingly as switching jobs may not be necessary guarantee them a higher pay in such an environment. Companies are unlikely to be incentivized to invest and produce new goods and services. When companies are not doing well, share prices begin to decline as people sell off investments that are no longer attractive to them. If the economy does not pick up, workers start to become redundant and expensive for businesses to employ. Lay-offs become necessary if these companies wish to remain sustainable. Unemployment begins to rise. In the long run where businesses still cannot afford to employ and eventually go bust, it may lead to social problems where people resort to crimes for survival.

#3: Even when everything else falls, debts do not.

Source: Google
Source: Google

While falling prices may sound like a good thing, that is not the case when incomes/wages start falling as well. If people loses their jobs eventually, they may not be able to pay off their debts. Debt payments from the past starts to become a heavier burden for businesses with falling revenues and households with falling incomes. This forces people to spend more of their decreased income/revenue on repaying debts which forces them to cut back spending on goods and services even more. Can you see how this spirals into a vicious cycle?

#4: People starts hoarding cash

Photo by Abrams | Lacagnina | Getty Images
Photo by Abrams | Lacagnina | Getty Images

When cash starts becoming a scarcity, those who have cash would start hoarding it. There is little case for putting money into banks when you never know when is the next time you need it, it could be tomorrow or the next day after and it could incur more transaction charges with umpteen withdrawals instead. If the reserve requirement is low, and money is not being lent by banks, companies can’t grow and the economy becomes deflated.

#5: Rising REAL interest rates

Credit: Shutterstock
Credit: Shutterstock

During deflation, central banks usually find a way to stimulate consumer and business spending by lowering interest rates. However, despite how much governments would like to encourage spending, it is not possible for them to lower nominal interest rates to a negative level or even at zero. Since real interest rates states the rate after inflation is being factored in, it is possible for real interest rates to be negative if the inflation rate exceeds the nominal interest rates. As such, in a deflationary environment, when falling prices causes inflation rate to be -1% for example, an investment with a nominal interest rate of 4% would cause its real interest rate to rise to (4% – (-1%)) 5%. This causes the real price of debt to rise even higher.

 

Bottom Line

In a deflationary environment, it is not unlikely to see governments printing money or namely does quantitative easing (QE) to help bolster the economy out of depression. One of the short term benefits of QE includes devaluing the currency where exports would become more competitive; companies may then borrow at historic-low interest rates to invest or hire more workers to increase their production etc. Of course, these are easier said than done, and it is not known when and how long would counter measures take effect and whether they are truly effective. All these factors often creates a vicious and downward deflationary spiral that is hard to get out of, otherwise Japan would not be battling deflation for almost 20 years.

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