Deflation has effects on two main levels: on
the corporate and on the governmental level.
The most obvious is on the level of companies.
By definition, in the event of a deflation, Companies not only cannot raise, but
have to actually decrease their prices for their products and services. If they
hadn’t decreased their prices, they would go out of business. Although in a deflationary
environment, most likely their production costs also decrease, most majority of
companies’ profit decrease also, and after a few years they are going to annual
losses (there may be companies in sectors with low competition and high profitability
ratios, such as utilities, and also companies that have a large portion of profits
coming from either foreign operations or from exports). In such scenarios companies
cannot plan for and invest in its future growth and development.
When governments want to maintain or increase
the real value of their tax income in a deflationary economy, one of three options:
increase the tax base, increase tax rates, or a combination of the above two.
Tax base is the number of people and companies
that pay taxes. Due to the consumption and corporate environment governments have
to be very careful with broadening the tax base, but especially cautious with increasing
taxes, as it may cause the economy to sink more deeply into a recession (deflationary
economies are also shrinking ones).
Some wages: as companies cannot afford to increase
wages, the nominal value of those wages stays the same (however, their real value
increases) not only for the period of deflation, but also for some time during the
following stagflation and inflationary period.
Deflationary economies have many indirect socio-,
political-, financial-, and economical effects:
Rising unemployment: as companies need to cut
cost, they need to fire employees, which are not producing (because they don’t have
any work to do).
Higher government deficits: as most costs stay
the same (for political reasons), and some expenditures increase (e.g.: rising unemployment
aid payments cost of jumpstarting the economy).
Recession: no price increase; no economic growth.
More expensive imports: same foreign currency
is worth more domestic currency.
More income from exports: same foreign currency
income is worth more in domestic currency.
4.1 The Austrian school of economics
The Austrian school defines deflation and inflation
solely in relation to the money supply. Deflation is therefore defined to be a contraction
of the money supply. Only a decrease in money supply can cause a general fall in
prices.
Increased productivity, however, can appear
to cause deflation; but it is not general deflation; as the price of produced goods
falls, while labor rates remain constant. Austrians show this as a benefit of sound
money, which increases or decreases very little in total supply. Prices should simply
confer the exchange ratio between any two goods in an economy. Increased productivity
generally means less labor for more goods, whereas increased money supply should
mean the same amount of labor for the same amount of goods.
For instance if there is a fixed money supply
of 400 kg of gold in an economy that produces 200 widgets, then one widget will
cost 2 kg of gold. However, next year if output is 400 widgets with the same money
supply of 400 kg of gold the price of each widget will drop to 1 kg of gold. In this case the general fall in price was caused by increased productivity.
The opposite of the above scenario has the same
effect on prices, but a different cause. If there is a fixed money supply of 400 kg of gold in an economy that produces 200 widgets, then once again each widget will cost 2 kg of gold. However, if next year the money supply is cut in half to 200 kg of gold with the same output of 200 widgets, the price of each widget will now only be 1 kg of gold. When capital profits are dropping rapidly, there is no reason to invest gold, which breaks
the savings identity, and thus the automatic tendency of the economy to move back
to equilibrium.
Austrians view increased productivity to be
a good cause of a general fall in prices, while credit/money supply contraction
as being a bad cause of a general fall in prices. Austrians also take the position
that there are no negative distortions in the economy due to a general fall in prices
in the first scenario. However, in the second scenario where a general fall in prices
is caused by deflation, Austrians contend that this confers no benefit to society.
For in this scenario wages will simply be cut in half and lower prices will not
reflect a general increase in wealth.
Also, Austrians believe that some entity being
able to inflate or deflate a money supply is given a privilege, as all prices will
not change both simultaneously and proportionally. Rather price changes will occur
as a response to what seems to be changes in demand, although this is only in nominal
terms. Those who can inflate or deflate the money supply (or those closest to this
source) can take advantage of an otherwise unknown change in the money supply by
making exchanges that appear sound in nominal terms, but actually confer more profitable
exchange rates in real terms, once prices have adjusted to the change.
For example, if a widget costs 5g of gold today
and there is 20g of gold in the money supply, if the central bank decreases the
money supply to 10g, it can sell its widgets for the formerly agreed upon price.
Once the market finds less overall demand, however, prices will halve. While the
central banks' money supply deflation was the cause of the price decrease, it received
double the money for its widgets that they are now worth in real terms.
Keynesians insist on the distinction between
consuming goods and producing goods, and between government based and credit based
money supply.
For a given money supply, if wages rise faster
than productivity, profits will fall and with them the price of producing goods
(deflation), while consuming goods will rise (inflation). This happens in times
when labor supply is tight and bargaining power is strong. When wages rise slower
than productivity, profits rise as do the prices of assets relative to consuming
goods. This can occur when labor supply is great and bargaining power is weak.
Inflation and deflation occur when the economic
policies allow wages to increase or decrease at differing rates than productivity.
Wages rising faster than productivity lead to inflation. Wages failing to increase
at the rate of productivity for protracted periods will ultimately cause deflation.
Indeed, if growth continues despite lagging
wages, it is because of debt accumulation, producers lend to wage earning consumers
part of their profits, in order to sell their products. For protracted periods,
there is a lot of endogenous money creation.
Then, when debt payments exceed the borrower's
ability to pay, debt accumulation and endogenous money creation stops, demand and
goods' prices fall, manufacturers reduce production, employment falls, and fewer
borrowers are thus able to pay their debts, and the cycle exacerbates.
Once preventive action has failed, Keynesians
advocate corrective action. In case of debt deflation, Keynesians advocate
"pump priming" or government creation of fiat money. As witnessed since
1990 in Japan, and in the 1930s in the USA, this policy is not very effective unless
government creates employment via public works projects or military manufacturing.
Austrians and Keynesians agree on the idea that
there are counterproductive cycles of booms and bust but while the former believe
the government tends to be a cause of those cycles, the latter believe it is a means
to reduce the size of those cycles.
5.1 In
Ireland
In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced
deflation, with prices falling by 0.1% from the same time in 2008. This is the first
time deflation has hit the Irish economy since 1960. Overall consumer prices decreased
by 1.7% in the month.
Brian Lenihan, Ireland's Minister for Finance,
mentioned deflation in an interview with RTÉ Radio. According to RTÉ's
account, "Minister for Finance Brian Lenihan has said that deflation must be
taken into account when Budget cuts in child benefit, public sector pay and professional
fees are being considered. Mr Lenihan said month-on-month there has been a 6.6%
decline in the cost of living this year" [9].
This interview is notable in that the deflation
referred to is not discernibly regarded negatively by the Minister in the interview.
The Minister mentions the deflation as an item of data helpful to the arguments
for a cut in certain benefits. The alleged economic harm caused by deflation is
not alluded to or mentioned by this member of government. This is a notable example
of deflation in the modern era being discussed by a senior financial Minister without
any mention of how it might be avoided, or whether it should be.
5.2 In
Japan
Deflation started in the early 1990s. The Bank
of Japan and the government tried to eliminate it by reducing interest rates, but
this was unsuccessful for over a decade. In July 2006, the zero-rate policy was
ended.
Systemic reasons for deflation in Japan can be said to include:
Unfavorable demographics. Japan has an aging population: 22.6% over age 65 that is not growing and will soon start a long
decline. The Japanese death rate recently exceeded the birth rate [6].
Fallen asset prices. In the case of Japan asset price deflation was a mean reversion or correction back to the price level that
prevailed before the asset bubble. There was a rather large price bubble in equities
and especially real estate in Japan in the 1980s [20].
Insolvent companies: Banks lent to companies
and individuals that invested in real estate. When real estate values dropped, these
loans could not be paid. The banks could try to collect on the collateral (land),
but this wouldn't pay off the loan. Banks delayed that decision, hoping asset prices
would improve. These delays were allowed by national banking regulators. Some banks
made even more loans to these companies that are used to service the debt they already
had. This continuing process is known as maintaining an "unrealized loss",
and until the assets are completely revalued and/or sold off, it will continue to
be a deflationary force in the economy. Improving bankruptcy law, land transfer
law, and tax law have been suggested (by The Economist) as methods to speed this
process and thus end the deflation.
Insolvent banks: Banks with a larger percentage
of their loans which are "non-performing", that is to say, they are not
receiving payments on them, but have not yet written them off, cannot lend more
money; they must increase their cash reserves to cover the bad loans.
Fear of insolvent banks: Japanese people are
afraid that banks will collapse so they prefer to buy Treasury bonds instead of
saving their money in a bank account. This likewise means the money is not available
for lending and therefore economic growth. This means that the savings rate depresses
consumption, but does not appear in the economy in an efficient form to spur new
investment. People also save by owning real estate, further slowing growth, since
it inflates land prices.
Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods (due to lower wages
and fast growth in those countries) and inexpensive raw materials, many of which
reached all time real price minimums in the early 2000s. Thus, prices of imported
products are decreasing. Domestic producers must match these prices in order to
remain competitive. This decreases prices for many things in the economy, and thus
is deflationary.
In November 2009 Japan has returned to deflation,
according to the Wall Street Journal. Bloomberg L.P. reports that consumer prices
fell in October 2009 by a near record 2.2% [20].
4.3 In
the United States
There have been three significant periods of
deflation in the United States.
The first was the recession of the late 1830s,
following the Panic of 1837, when the currency in the United States contracted by about 30%, a contraction which is only matched by the Great Depression.
This "deflation" satisfies both definitions, that of a decrease in prices
and a decrease in the available quantity of money.
The second was after the Civil War, sometimes
called The Great Deflation. It was possibly spurred by return to a gold standard,
retiring paper money printed during the Civil War.
"The Great Sag of 1873-96 could be near
the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing
technologies. It flummoxed the experts with its persistence, and it resisted attempts
by politicians to understand it, let alone reverse it. It delivered a generation’s
worth of rising bond prices, as well as the usual losses to unwary creditors via
defaults and early calls. Between 1875 and 1896, according to Milton Friedman, prices
fell in the United States by 1.7% a year, and in Britain by 0.8% a year [18].
The third was between 1930-1933 when the rate
of deflation was approximately 10 percent; part of the United States' slide into the Great Depression, where banks failed and unemployment peaked at
25%.
The deflation of the Great Depression, as in
1836, did not begin because of any sudden rise or surplus in output. It occurred
because there was an enormous contraction of credit (money), bankruptcies creating
an environment where cash was in frantic demand, and the Federal Reserve did not
adequately accommodate that demand, so banks toppled one-by-one. From the standpoint
of the Fisher equation, there was a concomitant drop both in money supply and the
velocity of money which was so profound that price deflation took hold despite the
increases in money supply spurred by the Federal Reserve.
Throughout the history of the United States, inflation has approached zero and dipped below for short periods of time (negative
inflation is deflation). This was quite common in the 19th century and in the 20th
century before World War II.
Some economists believe the United States may be currently experiencing deflation as part of the financial crisis of 2007-2010;
compare the theory of debt-deflation. Year-on-year, consumer prices dropped for
six months in a row to end-August 2009, largely due to a steep decline in energy
prices.
Consumer prices dropped 1 percent in October,
2008. This was the largest one-month fall in prices in the US since at least 1947. That record was again broken in November, 2008 with a 1.7% decline.
In response, the Federal Reserve decided to continue cutting interest rates, down
to a near-zero range as of December 16, 2008 [18]. In late 2008 and early 2009,
some economists feared the US could enter a deflationary spiral. Economist Nouriel
Roubini predicted that the United States would enter a deflationary recession, and
coined the term "stag-deflation" to describe it [19]. It is the opposite
of stagflation, which was the main fear during the spring and summer of 2008. The
United States then began experiencing measurable deflation, steadily decreasing
from the first measured deflation of - 0.38% in March, to July's deflation rate
of - 2.10%. On the wage front, in October 2009 the state of Colorado announced that
its state minimum wage, which is indexed to inflation, is set to be cut, which would
be the first time a state has cut its minimum wage since 1938 [19].
Whereas policy makers today speak of the need
to avoid deflation their assessment is colored by the experience of the bad deflation
of the 1930s, and its spread internationally, and the ongoing deflation in Japan.
Hence, not only do policy makers worry about deflation proper they also worry about
its spread on a global scale.
If ideology can blind policymakers to introducing
necessary reforms then the second lesson from history is that, once entrenched,
expectations of deflation may be difficult to reverse. The occasional fall in aggregate
prices is unlikely to significantly affect longer-term expectations of inflation.
This is especially true if the monetary authority is independent from political
control, and if the central bank is required to meet some kind of inflation objective.
Indeed, many analysts have repeatedly suggested the need to introduce an inflation
target for Japan. While the Japanese have responded by stating that inflation targeting
alone is incapable of helping the economy escape from deflation, the Bank of Japan's
stubborn refusal to adopt such a monetary policy strategy signals an unwillingness
to commit to a different monetary policy strategy. Hence, expectations are even
more unlikely to be influenced by other policies ostensibly meant to reverse the
course of Japanese prices. The Federal Reserve, of course, does not have a formal
inflation target but has repeatedly stated that its policies are meant to control
inflation within a 0-3% band. Whether formal versus informal inflation targets represent
substantially different monetary policy strategies continues to be debated, though
the growing popularity of this type of monetary policy strategy suggests that it
greatly assists in anchoring expectations of inflation.
1. Borio, Claudio, and Andrew Filardo. "Back to
the Future? Assessing the Deflation Record." Bank for International Settlements,
March 2004.
2. Burdekin, Richard C.K., and Pierre L. Siklos.
"Fears of Deflation and Policy Responses Then and Now." In Deflation:
Current and Historical Perspectives, edited by Richard C.K. Burdekin and Pierre
L. Siklos. New York: Cambridge: Cambridge University Press, 2004.
3. Brezina Corona. How Deflation Works? Rosen Young
Adult, 2007.225p.
4. Capie, Forrest, and Geoffrey Wood. "Price Change,
Financial Stability, and the British Economy, 1870-1939." In Deflation: Current
and Historical Perspectives, edited by Richard C.K. Burdekin and Pierre L. Siklos.
New York: Cambridge: Cambridge University Press, 2004.
5. Charles Stanton Devas. Political Economy. LLC, 2009.310p.
6. "Deflation", #"#">#"#">#"#">#"#">#"#">http://books.google.ru/books? id=gt6UBd0UXXUC&printsec=frontcover&dq=related:
ISBN0521837995&lr=#v=onepage&q&f=false
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