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What is Deflation? Why is it bad?
Who doesn’t love advertising? Consumers may be excited by the idea of lower prices, but when lower prices affect the entire economy, inflation is the cause. Economists fear this rare phenomenon, which occurs when both the cost of goods and services fall while the money supply contracts.
If that sounds like a double negative, that’s because it is. When there is inflation, the economy is in recession—and it takes a lot to get out of this dangerous situation. one feels like a case of throwing dice at the board and seeing which ones stick.
A reductionist example: Japan’s lost decade
One of the best examples of inflation occurred during Japan’s Lost Decade. The Japanese economy was stuck in a lose-lose situation of deflation and declining demand between 1991 and 2001.
Go back to the 1970s and 1980s, when Japanese businesses figured out how to compete in global markets by making high-quality products at low prices. This created a spectacular boom in the Japanese housing market and the Nikkei stock exchange, which quickly rose to bubble levels due to widespread speculation.
The Nikkei reached 38,916 on December 29, 1989 but would fall 43% less than a year later. Why? Sensing inflationary pressure, Japan’s central bank set a range of interest rate hikes, which created a bubble. Consumers paid off their loans, businesses were declared bankrupt, and banks had to be bailed out by the government. GDP fell, and the Japanese stock market collapsed.
Japan was in a recession, but the “normal” steps taken by the central bank to address the problem—namely, lowering interest rates—were not enough. The Bank of Japan lowered rates to zero, known as the “zero floor,” and kept them there for several years. After that, the Japanese government tried to replicate the policies of the New Deal that helped the United States out of the Great Depression by starting big infrastructure projects. Still, Japanese consumers were reluctant to spend their savings.
That’s because the core of Japan’s problem centered on consumer distrust: Workers fear losing their jobs, while savers worry about bank runs. No one was spending.
To finally awaken Japan’s economy from its decade-long slumber, the central bank must create demand by injecting liquidity back into the market—a five-year effort. Japan’s austerity measures eventually helped restart the economy and get consumers spending again, and in 2003, Japan’s GDP will once again reach a healthy, 3% growth rate.
When did Deflation happen? What Causes It?
Inflation occurs when there is a liquidity trap, when the economy is in recession but interest rates are already as low as they can go; Japan’s past economic problems are a prime example. It’s a sticky situation.
The problem is, when interest rates are low, the opportunity cost of holding money is zero. Why would anyone invest their assets in short term bonds such as Treasury Securities in such an environment? There is less incentive to take less risk.
While it may be it appears While it is good for prices of goods and services to fall, deflation can have negative consequences. Prices drop when contracts are sought. This takes a toll on the economy as a whole, as the drop in demand makes producers less interested in maintaining production or holding inventories. This affects the company’s profits, and businesses lay off workers. Unemployment rises, the economy stagnates, and demand shrinks even more. It’s a vicious circle.
How is Deflation Solved?
As seen in the example with Japan, the central banks have the power to buy large assets – we are talking about trillions of dollars – in order to increase the liquidity of the market and make it easier for the banks to lend again. A central bank will often buy long-term securities, such as government bonds. but can invest in corporate bonds, municipal banks, or even common stocks. During the Financial Crisis of 2007-2008, the Federal Reserve bought some of the mortgage-backed securities that caused the crisis.
But monetary policy efforts alone may not solve the problem of inflation – sometimes it takes coordination with the government in the form of statutory financial support or even stimulus aid.
Helicopter currency is another tool used by the central bank. Similar to austerity measures, the government can inject large sums into the money supply either by cutting taxes or by sending stimulus checks directly to its citizens. What would you do if money fell from the sky? Spend it, maybe. Usually, this option is the last resort of the central bank.
Also, rising interest rates would do the trick, because it would encourage savers to invest again, because other financial assets, such as bonds, would eventually start to look more attractive than just sitting in cash.
Depreciation and inflation
Deflation is the opposite of inflation. It is a time of falling prices and a corresponding rise in purchasing power. But what good is it if no one spends it? Inflation is also characterized by a decrease in demand, and a transfer of wealth to liquid assets (ie, money).
Inflation, on the other hand, is a period of rising prices and decreasing purchasing power. Here consumer spending decreases because people cannot afford to buy more.
Deflation vs. Disinflation
Deflation should not be confused with disinflation, either. Disinflation is a time when inflation is occurring, at a lower rate than before.
Will Deflation Happen in 2023?
The founder of Tesla and the newly created Twitter impresario Elon Musk believes that if the Fed does not start cutting interest rates, the US economy will face bankruptcy in 2023. TheStreet’s Luc Olinga reports here.
