What Is Deflation? Its Causes and Why It's Bad

Deflation Threatens You More Than Inflation

sale.jpg
At first, deflation seems like a good thing to consumers as prices are lowered. Photo by Mario Tama/Getty Images

Definition: Deflation is when asset and consumer prices continue to fall. This may seem like a great thing for shoppers, except that the cause of widespread deflation is a long-term drop in demand. That means that a recession is probably already underway, with job losses, declining wages, and an ongoing decline in the value of your home and your stock portfolio. This aggravates deflation because businesses lower prices in a desperate attempt to get people to buy their products.

How Is It Measured?

Officially, deflation is measured by a decrease in the Consumer Price Index. However, the CPI does not measure stock prices, which retirees use to fund purchases, and businesses use to fund growth. That means when the stock market drops, the CPI might be missing one important indicator of deflation as it's felt in people's pocketbooks. For more, see How a Stock Market Crash Can Cause a Recession.

The CPI does not include sales price of homes. Instead, it calculates the "monthly equivalent of owning a home", which it derives from rents. This is very misleading since rental prices are likely to drop when there is high vacancy, usually when interest rates are low and housing prices are rising. Conversely, when home prices are dropping due to high-interest rates, rents tend to increase.

Therefore, the CPI can give a false low reading when home prices are high (and rents are low).

This is why it did not warn of asset inflation during the housing bubble of 2006. If it had, then the Federal Reserve could have raised interest rates higher at that time to prevent the bubble, and the resultant pain when the bubble burst in 2007. 

Causes

Until now, deflation is a greater risk than inflation.

That's for three reasons. First, China exports have kept prices low. It has a lower standard of living, so can pay its workers less. China also keeps its exchange rate pegged to the dollar, which makes its products cheaper.

Second, technology such as computers keep workers' productivity high. Most information can be gotten in seconds from the Internet, so workers don't have to spend time tracking it down. Email is quicker than snail mail, reducing time and boosting productivity.

Third, the surfeit of aging Baby Boomers allows corporations to keep wages low. These lower costs mean companies haven't needed to raise prices. 

Why Deflation Is Bad

Deflation slows economic growth. As prices fall, people put off purchases, hoping they can get a better deal later. You've probably experienced this yourself when thinking about getting a new cell phone, iPad, or TV. You might wait until next year, and get this year's model for less.

This puts pressure on manufacturers to constantly lower prices and come up with new products. That's good for you, but constant cost-cutting means lower wages and less investment spending. That's why only companies with a fanatically loyal following, like Apple, really succeed in this market.

 

Massive deflation helped turn a recession into the Great Depression. As unemployment rose, demand for goods and services fell. Prices dropped 10% a year. As prices fell, companies went out of business. More people became unemployed. When the dust settled, world trade essentially collapsed. The amount of goods and services traded fell 25%, but thanks to lower prices the value of this trade was down 65% (as measured in dollars).

How Is It Stopped?

To combat deflation, the Fed stimulates the economy with expansionary monetary policy. It reduces the Fed funds rate, buys Treasuries with its open market operations, and uses its other tools to increase the money supply. For more, see Is the Federal Reserve Printing Money?

In addition, our elected officials can offset falling prices with discretionary fiscal policy.

That means lowering taxes, increasing government spending, and incurring a temporary deficit to do so. Of course, if the deficit is already at record levels, that tool becomes less available.

Why does expansionary monetary or fiscal policy work? If done correctly, it stimulates demand. People have more money to spend, making them more willing to buy what they want as well as what they absolutely need. They'll stop waiting for prices to fall further. This increase in demand will actually push prices up, reversing the deflationary trend. 

Is Deflation Really Worse than Inflation?

The opposite of deflation is inflation, which is when prices rise. Both are very difficult to combat once entrenched. That's because of peoples' expectations, which worsen price trends.  When prices rise during inflation, they create an asset bubble. However, this bubble can be burst by central banks raising interest rates. 

Former Fed Chairman Paul Volcker proved this in the 1980s. He fought double-digit inflation by raising the Fed funds rate to 20% and keeping it there, even though it caused a recession. He had to take this dramatic action to convince everyone that inflation could actually be tamed. Thanks to Volcker, central bankers now know the most important tool in combating inflation, or deflation, is controlling people's expectations of price changes.

Deflation is worse because interest rates can only be lowered to zero. As businesses and people feel less wealthy, they spend less, reducing demand further. Prices drop in response, giving businesses less profit. Once people expect price declines, they delay purchases as long as possible. They know the longer they wait, the lower the price will be. This further decreases demand, causing businesses to slash prices even more. It is a vicious, downward spiral.

Can Deflation Ever Be a Good Thing?

A massive, widespread drop in prices is always bad for the economy. However, deflation in certain asset classes can be good. For example, the price of consumer goods, especially computers and electronic equipment, continues to fall.

This isn't because of lower demand, but from innovation. In the case of consumer goods, production has moved to China, where wages are lower. This is an innovation in manufacturing, which results in lower prices for many consumer goods. In the case of computers, manufacturers find ways to make the components smaller, adding more power for the same price. This is technological innovation, and it keeps computer manufacturers competitive.

Japan: A Modern Example

Japan's economy was caught in a deflationary spiral for the past 20 years. It started in 1989, when the Bank of Japan raised interest rates causing the asset bubble in housing to burst. During that decade, the economy grew less than 2% per year as businesses cut back on debt, spending and lost productivity with excess workers (Japan's culture discourages employee layoffs). The Japanese people are also savers, and when they saw the signs of recession, they stopped spending and put away funds for bad times.

A study by Daniel Okimoto at Stanford University identified five other factors:

  1. The political party in power did not take the difficult steps needed to spur the economy enough.
  2. Taxes were raised in 1997.
  3. Banks kept bad loans on their books, which tied up capital needed to invest in growth.
  4. The yen carry trade kept the value of Japan's currency high relative to the dollar and other global currencies. The Bank of Japan tried to create inflation by lowering interest rates. However, traders took advantage of the situation by borrowing yen cheaply and investing it in currencies with a higher return.
  5. The Japanese government spent heavily, buying dollars to battle the yen carry trade. This created a 200% debt to GDP ratio, which further depressed expectations of economic growth.