Deflation is a process over which the nominal prices of goods and services drop. At a glance, deflation is positive from the perspective of the consumer. It directly boosts purchasing power. At a closer look, it is, however, akin to poison for the economy.
Still, not all deflation is bad. The kind stemming from technological advancement, only affecting a given industry, is usually positive and welcome.
Several economic factors can trigger deflation. By definition, the common denominator linking these factors is the reduction of the money supply. Other deflation triggers may be:
- The reduction of government spending.
- Reduced consumer demand.
- A drop in business investment.
Deflation often pops up as a reaction to sustained artificial monetary expansion. Those controlling the money supply (central banks) can counteract deflation by artificially increasing the money supply.
Types Of Deflation
Technological innovation, the hallmark of progress, leads to deflation. This type of deflation is, however, not only good but necessary.
Consider the following scenario: you purchase a laptop computer in the $2,000 range. A year from now, for that same amount of money, you will be able to buy a much better/advanced system. By then, inflation will have bitten a fair share of value out of your $2,000 as well. You will get better technology for less value.
In this case, increased economic output is responsible for deflation. Deflation shows up in the form of savings resulting from more efficient production processes. These savings trickle down to the consumers.
When deflation escapes the boundaries of more efficient economic output, it shows its ugly face. As the purchasing power of currency goes up, borrowers take a hit. They borrow today, and they have to pay back disproportionately more value tomorrow. Thus, borrowing/lending slows down. The economy follows it in short order.
As a deflationary spiral takes hold, almost all economic activity grinds to a halt. Consumers put off buying goods since they know they will pay less for them tomorrow. Producers have to cut back production as demand wanes. Eventually, most of them go out of business. Some survive but lay off workers. The unemployed have a hard time finding work.
The very pulse of the economy grinds to a halt.
Causes of Deflation
The root cause of deflation is the reduction of the money supply. This is what triggered the 1930 deflationary spiral in the US. As banks went under, the money supply took a hit.
Deflation is a real problem today, most acutely present within the Eurozone. The ECB has been artificially inflating the money supply for some time now, through its quantitative easing program.
Like increased productivity, dropping aggregate demand leads to deflation as well. Declining demand can result from reduced government spending. Higher interest rates, stock market failure and the increasing tendency of the population to save can also trigger declining demand.
There is a reason why most central banks aim to maintain annual inflation rates in the 2-3% range. Such an approach combats deflation. It also provides an adequate degree of stability.
Inflation can get out of hand as well. When it does, it too ravages the economy, much like deflation does. It is, however, easier to control and its effects are less profound.
Black Swan Example of “Good Deflation”
In some extreme cases, deflation does not slow down the economy. Not even when it does not originate from increased economic output.
Such a case is that of Switzerland. In 2015, the devaluing of the Euro drove investors to the safe-haven of the Swiss Franc. To counter the tide and its deflationary effects, the Swiss National Bank introduced negative interest rates.
Despite the odds, the Swiss economy continued to grow and most economic indicators showed positive trends. Wages dropped somewhat but so did prices. The Swiss economy simply shrugged off the bogeyman of deflation.
No other European country managed to replicate this experience, however.