Quezi

Deflationary Spiral (photo by FireChickenTA99 - CC-BY)

Deflation is the opposite of inflation. Deflation is what we call it when things get cheaper. What could possibly be wrong with that? And yet some people argue that deflation is one of the worst things that could happen. How can that be?

Suppose flat panel TVs keep getting cheaper. Some people will spend less on their next TV, leaving more money to spend on other things like holidays. Other people will spend the same amount of money, but buy a bigger screen. Others will be able to replace their old TV sooner than they otherwise would. From the point of view of the consumer, deflation is a win, and it also opens new kinds of markets for the manufacturer.

The same thing happens if computers keep getting cheaper, or cameras, or cars, or air travel, and so on. If we conveniently ignore the environmental and social effects of consumerism, deflation is a good thing all round.

But what people are worried about is a deflationary spiral. This doesn’t happen when improved efficiencies are making it possible to produce and sell things more cheaply. Instead it happens because something has become out of balance in the economy, which makes people suddenly unable to spend as much as they used to.

Suppose a large number of people suddenly discover (or come to believe) that they are not as wealthy as they thought they were. They will immediately reduce their purchasing, leaving shops with unsold stocks. The shops will reduce the price of these items to sell them, but won’t buy as much replacement stock. This may cause the manufacturer to close a factory, or lay off staff, or reduce working hours – and that’s where the real damage is done. The manufacturer might reduce prices to win some sales, but now people have even less money to spend and the process continues.

The shop may not be taking in enough money to pay its bills, so it defaults on its rent, pays its suppliers later and later, and may lay off staff. The suppliers in turn are squeezed and may default on their loans, and in turn the banks are at risk of collapse.

The situation will very soon correct itself because the greatly reduced prices will lead to increased demand again, but there is one proviso – and that is that there must be labor market flexibility so that the pool of unemployed (and therefore economically unproductive) workers does not continue to grow. If workers can be employed more efficiently (for example at lower rates of pay) then they can still maintain their standard of living (because everything is cheaper) and those who still have their previous rates of pay can increase their consumption due to the lower prices. Thus we have the seeds of recovery, and soon afterwards we see the “green shoots of recovery”.

The process of climbing out of a deflationary spiral is easier and faster when there is free international trade. That’s because deflation doesn’t hit all countries at the same time. The exports of those countries most affected will become relatively cheaper, leading to increased demand for their products and hastening the recovery.

In a sense, a period of deflation is a necessary part of the recovery from a catastrophic economic event. So why does the prospect of deflation cause so much fear? That’s because it primarily affects borrowers. Deflation increases the real debt burden, which can increase mortgage foreclosures and bankruptcies, and increase the risk of bank failures. Savers, on the other hand, find that their purchasing power increases during periods of deflation.

In the past, when interest rates were not manipulated to such an extent as they are now, the value of the currency tended to be maintained in the long run. Inflation and deflation occurred in roughly equal amounts, giving the currency long-term stability.

In recent decades, however, government policy has favored inflation and – due to difficult-to-predict feedback effects – the manipulation of interest rates has had a tendency to cause cycles of “boom and bust”. As of January 2009 we’re in one of the “bust” phases of the economic cycle.