What is Deflation? Causes, effects and solutions


27 Settembre 2022 - 13:19

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Excessive rise in interest rates will lead to deflation, according to Elon Musk and Cathie Wood. Here is an explanation of what deflation is and what are the causes, effects and solutions.

What is Deflation? Causes, effects and solutions

The term deflation indicates the general decline in the prices of goods and services, ie when the inflation rate becomes negative and leads to an increase in the purchasing power of money. Deflation occurs naturally when an economy’s money supply is manipulated. It should not be confused with disinflation, a simple slowdown in the rate of inflation.

Over the last year in Europe, the hottest word on the media has been "inflation" and the ECB itself has as its main task to govern economic policy in order to keep general inflation in Europe as close as possible to an annual value of 2%, arbitrarily considered as the "right" value for healthy economic growth.

Generally speaking, it is correct to say that a healthy economy in the context of balanced and sustainable economic growth produces a slight inflation. Currently, however, inflation levels are at the highest levels in 40 years: the latest data on the trend in consumer prices in Europe increased by 9.1%, in the United States by 8.1%. World central banks are working to cool the price spike through large interest rate hikes.

Despite these numbers, according to Elon Musk, CEO of Tesla, and Cathie Wood, head of the Ark Innovation tech fund, a maxi monetary squeeze could lead to "deflation".

In the following paragraphs we see a simple and clear explanation of what is deflation, what impact it has on the economy, what are the dangers as well as causes and its effects.

What is deflation?

Deflation is a phenomenon that concerns the trend of prices in a given area and defines the opposite situation of the better known inflation: the first deflation represents the general decline in prices, while inflation represents the general rise in prices. Both are very different concepts from stagflation.

Inflation and deflation are measured in Italy by ISTAT, which monitors the price trend of a certain number of goods called a basket. At the European level, these data are collected by Eurostat.

The measured change in the basket’s overall prices is called the inflation index and can have a positive (inflation) or negative (deflation) value.

Deflation causes nominal costs of capital, labor, products and services to reduce due to shrinking demand. Price deflation is often a side effect of monetary deflation, although this does not always happen.

Deflation has been a hotly debated topic among economists for decades. World-renowned economist Milton Friedman argued that inflation was always and everywhere a monetary phenomenon.

Friedman identified a relationship between the growth of the M2 money supply (money in circulation plus bank balances and cash funds) and a growth in inflation over the next 13 months.

In the United States, M2 growth accelerated in April 2020, in correspondence with the pandemic crisis, and core inflation began to accelerate exactly 13 months later, in May 2021. M2 growth hit an all-time high by 27% in February 2021, due to the 6 trillion injected into the system during the crisis by Covid-19, while the consumer price index reached its peak 13 months later, in March 2022.

The causes of deflation

By definition, monetary deflation can only be caused by a decrease in the supply of money or financial instruments redeemable for cash. In modern times, the money supply is influenced by central banks, such as the ECB.

Periods of deflation most commonly occur after long periods of artificial monetary expansion. In the early 1930s, there was a significant deflation within the US economy for the last time so far. The main contributor to this deflationary period came from the decline in the money supply following some catastrophic bank failures. Other countries, such as Japan in the 1990s, have instead experienced deflation in modern times.

Deflation is caused by a number of factors, but largely occurs as a result of two events:

  • a decline in aggregate demand (shift to the left in the aggregate demand curve);
  • increase in productivity.

A decline in aggregate demand typically then results in lower prices. Among the causes of this change are the reduction of public spending, the failure of the stock market, the desire of consumers to increase savings and the tightening of monetary policies (ie higher interest rates).

When it comes to productivity, businesses operate more efficiently as technology advances. These operational improvements lead to lower production costs and lower costs passed on to consumers in the form of lower prices.

Price deflation through increased productivity differs according to specific sectors. For example, consider how increased productivity affects the tech sector. Over the past few decades, technological improvements have led to significant reductions in the average cost per gigabyte of data. In 1980, the average cost of a gigabyte of data was $437,500. In 2010, the average cost was three cents. This reduction also causes the prices of products manufactured using this technology to decrease significantly.

On the basis of what has been expressed above, it is legitimate to state that an evident deviation from a state of slight inflation is a symptom of an economic problem.

There are obviously two possible problem states: excessive inflation and deflation.

In the first case it is a phenomenon due to the "overheating" of an economy (too fast and chaotic growth) or to a currency shock that creates a "chain reaction" that leads to the strong and prolonged devaluation of a currency with inevitable a long-term impact on the price level. A typical example is that of the Weimar Republic, and it could have happened in Europe in 2011 as well: a period of great tension in which the conditions seemed to exist for a possible disorderly collapse of the Euro with possible hyperinflationary drifts.

History then went differently: the strong German pressure towards a restrictive and anti-inflationary policy, the fall of Berlusconi with the effective commissioning of Italy by the Monti government and finally (and above all) Mario Draghi’s whatever it takes of summer 2012 gave way to the Eurozone to cross the ford and avert the danger of disorderly collapse and hyperinflation.

On the other hand, this process has led to the "German political victory" and its deflationist policies over Europe, policies that over the course of three years have produced exactly what could have been envisaged: a progressive reduction of inflation up to the first economic data, which indicates deflation.

The effects of deflation

Deflation is a far more treacherous problem than inflation: the general decline in prices could indeed appear to be a good thing, especially after decades of inflation demonization.

In reality, deflation triggers a vicious circle that feeds on itself and that in the long run hurts everyone: falling prices generate an expectation of further future falls in prices, this leads individuals to postpone purchases (each think "if I wait it will cost less") and the sum of these general expectations leads to a general decrease in consumption. Paradoxically, in a situation where purchases become cheaper, people don’t buy!

A drop in consumption then has an impact on companies that see both margins and turnover decrease and are forced at some point to lay off or even close: at this point we have new unemployed who will no longer have an income to spend on consumption, thus giving new "fuel" to the process of destruction of the economy.

A second harmful effect of deflation concerns debts: by devaluing the currency, inflation helps debtors to repay their debts by decreasing the value to be repaid in real terms, a sort of "discount" on the interest to be paid.

If inflation is too high, the losers are the creditors who see money returned devalued but if inflation is too low or even negative (deflation, in fact) the situation becomes unsustainable for the debtors who have to repay "heavier" capitals in real terms without any inflation discount on the interest rate and in a climate of economic depression due to the vicious circle we have described above: in the long run this situation is also dangerous for creditors who risk not recovering their money from debtors reduced to being insolvent.

Following the Great Depression, when monetary deflation coincided with high unemployment and rising defaults, most economists believed that deflation was an adverse phenomenon. Thus, most central banks have adjusted monetary policy by allowing large increases in the money supply, even if they cause chronic price inflation and encourage borrowers to borrow too much.

In recent times, economists have been busy revising old interpretations of deflation, especially after the 2004 study by economists Andrew Atkeson and Patrick Kehoe. After examining 17 countries over a 180-year time span, Atkeson and Kehoe found 65 out of 73 episodes of deflation without economic crisis, while 21 out of 29 periods of economic depression had no deflation.

To date, there is a wide variety of views on the usefulness of deflation and price deflation.

What are the solutions to deflation?

Japan is the historic victim of a deflationary crisis and has been trapped since the 1980s in a deflationary cage from which it cannot definitively escape.

The phenomenon is well explained by Paul Krugman in his book "End this depression now!" and it is to all intents and purposes a terrain yet to be fully explored and understood by economists in terms of policies to be adopted in order to get out of it.

In recent years Japan has embarked on the path of a strong stimulus to the economy to get out of the deflation trap, this policy has taken the name of Abenomics and the results so far have been relatively positive albeit with some controversial aspects, moreover the effects on the medium-long term are all to be verified.

One thing is practically certain: deflation is a possible next problem for Europe.
This means that the economic crisis cannot be considered completely over and that it seriously risks not ending soon, the next moves by the ECB will be decisive in this regard.

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