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What Is Deflation – Definition, Causes & Effects

Think back to your first job. Do you remember what it paid?

For many people, the answer is easy to remember: whatever the local minimum wage was at the time.

Depending on how much time has elapsed since that first foray into the labor force, you’ve probably advanced in your career such that you’re no longer earning minimum wage or close to it. Still, millions of workers do earn minimum wage today. And there’s a very good chance that wage is higher — perhaps significantly so — than yours was back in the day.

Deflation: A Rare But Troublesome Economic Condition

This is a simplistic illustration of the concept of inflation, the rate at which prices rise over time. Beyond wages, everyday examples of inflation abound, from grocery and gas prices to the cost of your Netflix subscription. We accept the fact that things get more expensive over time.

But that’s not always the case. Although rare, certain economic conditions give rise to negative inflation, popularly known as deflation.

According to data from a May 2020 Bloomberg report, the United States — and perhaps the broader global economy — looked like it could be heading in that direction in the wake of the COVID-19 pandemic. Consumer prices fell 0.8% from March to April 2020, according to the Consumer Price Index (CPI). Producer prices (prices paid to U.S.-based producer businesses) dropped by 1.3%, the steepest decline since 2009.

Those price drops proved to be anomalous. Indeed, as the economy bounced back from the initial shock of the pandemic and the stay-at-home orders it necessitated, prices rose at the fastest rate in years — prompting worries of a post-COVID inflation spike.

Nevertheless, those scary early-pandemic months underscored something economists have known for a very long time: that consistent and broad-based falls in the prices of goods and services are generally bad news for the economy.

Why should consumers and businesses care about falling prices or a negative inflation rate? Because lower grocery bills are beside the point when you pay them with temporary unemployment benefits or emergency savings.

Deflation is not a routine feature of the economic cycle, which is marked by alternating periods of expansion and contraction against a backdrop of steadily rising prices. Rather, deflation is a sign that something is seriously out of whack with the economy. And deflation isn’t easy to fix.

Deflation almost always occurs against a backdrop of high unemployment rates, falling business profits, and falling asset prices. It usually exacerbates both conditions, creating a vicious cycle that offsets temporary gains in purchasing power (real value of goods), further damages the economy, and prolongs any recovery.

Most historical examples of deflation preceded or occurred during economic depressions or extended periods of economic malaise, like the “lost decade” that occurred following an economic crash in Japan in the 1990s and early 2000s. During Japan’s lost decade, prices of goods fell consistently and measures of economic activity stagnated.

That’s a stark contrast to disinflation, a similar-sounding but very different condition in which the rate of inflation decreases over time without reaching zero or going negative.

What Are the Causes of Deflation?

Deflation can be caused by a number of factors, all of which stem from a shift in the supply-demand curve. The price levels of all goods and services are heavily affected by a change in supply and demand. If demand drops in relation to supply, aggregate demand declines and prices fall accordingly.

Likewise, a change in the aggregate demand of a national or single-market currency (such as the U.S. dollar or the euro) plays an instrumental role in setting the prices of the country’s goods and services.

Although there are many reasons why deflation may take place, the following causes seem to play the largest roles:

1. Change in Capital Market Structures

When many different companies are selling the same goods or services, they typically lower their prices as a means to compete. Often, the capital structure of the economy changes and companies have easier access to debt and equity markets, which they can use to fund new businesses or improve productivity.

There are multiple reasons why companies might have an easier time raising capital, such as declining interest rates, changing banking policies, or a change in investors’ aversion to risk. However, after they’ve used this new capital to increase productivity, businesses have to reduce their prices to reflect the increased supply of products, which can result in deflation.

2. Increased Productivity

Innovative solutions and new processes help increase efficiency, which ultimately leads to lower prices. Although some innovations only affect the productivity of certain industries, others may have a profound effect on the entire economy.

For example, after the Soviet Union collapsed in 1991, many of the countries that formed as a result struggled to get back on track. In order to make a living, many citizens were willing to work for very low prices, and as U.S. companies outsourced work to these countries, they were able to significantly reduce their operating expenses and bolster productivity.

Inevitably, this increased the supply of goods while decreasing their cost, which led to a period of deflation near the end of the 20th century.

3. Decrease in Currency Supply

Currency supplies generally decrease due to actions taken by central banks, often with the explicit aim of tamping down inflation. For instance, when the Federal Reserve was first created, it considerably contracted the U.S. money supply. Unfortunately, it’s easy for currency supply reductions to spiral out of control. For example, the Fed’s early moves caused severe deflation during the early 1910s.

Likewise, spending on credit is a fact of life in the modern economy. When creditors pull the plug on lending money, consumers and businesses spend less, forcing sellers to lower their prices to regain sales. This is why one of the Federal Reserve’s top priorities today is ensuring the smooth functioning of credit markets.

4. Austerity Measures

Deflation can be the result of decreased governmental, business, or consumer spending, which means government spending cuts can lead to periods of significant deflation. For example, when Spain initiated austerity measures in 2010, preexisting deflation began to spiral out of control in that country.

To date, Spain and other “peripheral” European economies badly affected by the sovereign debt crisis of the early 2010s contend with stagnant prices, high unemployment, and persistently slow economic growth.

5. Deflationary Spiral (Persistent Deflation)

Once deflation rears its ugly head, it can be very difficult to get the economy under control. While the actual mechanics of persistent deflation are complicated, the crux is that true deflation is self-reinforcing.

When consumers and businesses cut spending, business profits decrease, forcing them to reduce wages and cut back on investment. This short-circuits spending in other sectors, as other businesses and wage-earners have less money to spend.

Short of a massive monetary stimulus that can swing the pendulum too far in the other direction and precipitate runaway inflation — which central banks try to avoid at all costs — there’s no easy way out of this cycle.

Effects of Deflation

Deflation is like a terrible storm: The damage is often intense and takes far longer to repair than the storm itself. Sadly, some nations never fully recover from the damage caused by deflation. Hong Kong, for example, has yet to fully recover from the deflationary effects that gripped the Asian economy in 2002.

Deflation may have any of the following impacts on an economy:

1. Reduced Business Revenues

Businesses must significantly reduce the prices of their products in order to stay competitive. As they reduce their prices, their revenues start to drop. Business revenues frequently fall and recover, but deflationary cycles tend to repeat themselves multiple times.

Unfortunately, this means businesses need to increasingly cut their prices as the period of deflation continues. Although these businesses operate with improved production efficiency, their profit margins eventually drop as savings from material costs are offset by reduced revenues.

2. Wage Cutbacks and Layoffs

When revenues start to drop, companies need to find ways to reduce their expenses to meet their bottom line. They can make these cuts by reducing wages and cutting positions. Understandably, this exacerbates the cycle of deflation, as more would-be consumers have less to spend.

3. Changes in Customer Spending

The relationship between deflation and consumer spending is complex and often difficult to predict. When the economy undergoes a period of deflation, customers often take advantage of the substantially lower prices that result.

Initially, consumer spending may increase greatly. However, once businesses start looking for ways to bolster their bottom line, consumers who have lost their jobs or taken pay cuts must start reducing their spending as well. Of course, when they reduce their spending, the cycle of deflation worsens.

4. Reduced Stake in Investments

When the economy goes through a series of deflation, investors tend to view cash reserves as one of their best possible investments. Investors watch their money grow simply by holding onto it.

Additionally, investors’ returns on lower-risk investments often decrease significantly as central banks attempt to fight deflation by reducing interest rates, which in turn reduces the amount of money they have available for spending.

In the meantime, many other investments may yield a negative return or become highly volatile because investors are scared and companies aren’t posting profits. As investors pull out of stocks, the stock market inevitably drops.

5. Reduced Credit

When deflation rears its head, financial lenders quickly start to pull the plugs on many of their lending operations for a variety of reasons. First of all, as assets such as houses decline in value, customers cannot back their debt with the same collateral. In the event a borrower is unable to make their debt obligations, the lenders will be unable to recover their full investment through foreclosures or property seizures.

Also, lenders realize the financial position of borrowers is more likely to change as employers start cutting their workforce. Central banks might try to reduce interest rates to encourage customers to borrow and spend more, but many customers still won’t be eligible for loans.

Historical Examples of Deflation

Although deflation is a rare occurrence in the course of an economy, it is a phenomenon that has occurred a number of times throughout history. These are some of the most noteworthy incidents.

1. Late 19th Century: The Aftermath of the Industrial Revolution

During the late 19th century, manufacturers took advantage of new technology that allowed them to increase their productivity. As a result, the supply of goods in the economy increased substantially, and consequently, the prices of those goods decreased. Although the increase in the level of productivity after the Industrial Revolution was a positive development for the economy, it also led to a period of deflation.

2. Early 20th Century: Depression of 1920-1921

About eight years before the onset of the Great Depression, the U.S. underwent a shorter depression while recovering from the aftermath of World War I and the 1918-19 flu pandemic, which killed millions around the world.

During this time, 1 million members of the armed forces returned to civilian life, and employers hired a number of returning troops at lower wages. The labor market was already very tight before they returned, and due to the expansion in the workforce, unions lost much of their bargaining power and were unable to demand higher wages, which resulted in reduced spending.

3. Early 20th Century: Great Depression

The Great Depression was the most financially trying time in American history. During this dark period, unemployment spiked, the stock market crashed, and consumers lost much of their savings.

Employees in high-production industries such as farming and mining were producing a great amount but not getting paid accordingly. As a result, they had less money to spend and were unable to afford basic commodities, despite how much vendors were forced to reduce prices.

4. Early 21st Century: European Debt Crisis

The sovereign debt crisis in Europe came to a head in 2011 and caused a number of complications for the global economy that reverberate to this day. In response to mounting concerns among bondholders that they would be unable to repay their debts, several European governments implemented austerity measures that reduced GDP considerably, such as cutting government assistance to needy families.

Meanwhile, banks tightened up on lending, reducing the money supply within these countries. Widespread deflation was the predictable result, and while the worst of the crisis has passed, the European economy remains weak.

Policy Tools to Fix Deflation: How the Federal Reserve and Other Central Banks Fight Falling Prices

It’s possible to reduce the impact of deflation. But it requires a disciplined approach because deflation is not something that fixes itself.

Before the Great Depression, the economic consensus held that deflation was a temporary condition that runs its course without government or central bank intervention. However, the experience of the Great Depression, the most severe economic downturn in U.S. history, convinced economists and monetary policy wonks otherwise.

Concluding that something needed to be done was the easy part, however. During the throes of the Great Depression, the government failed in multiple intervention efforts. Scholars disagree over the reasons for these failures, and even the extent to which specific policies can be considered successes or failures, due in part to more modern political differences.

For example, left-of-center economists certainly don’t share the right-leaning Hoover Institution’s position that the Roosevelt administration’s tolerance of widespread labor strikes in the early 1930s set back wage growth for years afterward. But if the Hoover Institution’s supposition is accurate, FDR’s pro-labor policies could well have worsened the deflationary spiral.

Today, central banks are the most important forces in the fight against deflation (and inflation) due to their mandate to control national monetary supplies. For example, during the global financial crisis of the late 2000s and its long aftermath, the Federal Reserve (“the Fed”) engaged in multiple rounds of quantitative easing in an effort to stave off deflation.

While increasing the nation’s monetary supply too much could create excessive inflation, a moderate expansion in the nation’s monetary base is an effective means of fighting deflation, at least in theory.

Central banks’ efforts to fight deflation are not always effective. Their biggest handicap is that they can only decrease interest rates until they’re near 0%. Technically, central banks can set rates below 0%, but the Federal Reserve has shown extreme reluctance to set that precedent.

Other central bank tools, such as buying individual corporate bonds, might please the equities markets, but their impact on deflation is less clear. Despite years of study, there still exists no clear-cut, foolproof way to address deflation.

Final Word

Deflation is not only a theoretical concern. As we’ve seen, it has tangible and often devastating consequences for the economy.

In fact, former Federal Reserve chairman Ben Bernanke made fighting deflation one of the signature priorities of his tenure, which coincided with the nadir of the late-2000s global financial crisis and the prolonged period of economic stagnation that followed.

Bernanke and the Fed were largely successful in their efforts, although inflation remained low by historical standards through much of the 2010s and has cratered again amid the unprecedented economic shock of the COVID-19 pandemic.

Of course, any celebration of the Fed’s Bernanke-era achievement now seems premature in the face of the coronavirus pandemic and its economic aftereffects.

It’s too early to say with certainty what will come of the extraordinary moment we find ourselves in today. Trillions in economic stimulus could well spark a period of high inflation and give rise to a whole new set of fiscal problems.

Or the deflationary dog that failed to bark after the global financial crisis could finally awaken in the 2020s and establish a monetary regime unlike anything Americans have experienced in living memory.

Brian Martucci writes about credit cards, banking, insurance, travel, and more. When he's not investigating time- and money-saving strategies for Money Crashers readers, you can find him exploring his favorite trails or sampling a new cuisine. Reach him on Twitter @Brian_Martucci.