What is deflation? The consequences of falling prices and economic recession

Deflation refers to a widespread reduction in the prices of goods and services, often linked to a decrease in the availability of money and credit within an economy. During periods of deflation, the value of currency increases over time.

Understanding deflation

Deflation leads to lower nominal costs associated with capital, labor, goods, and services, although their relative prices may remain stable. Economists have been concerned about deflation for many years, as it typically arises from a reduction in the money supply or financial instruments that can be converted to money. In today’s economy, central banks like the Federal Reserve primarily influence the money supply. When there’s a decrease in money and credit availability without a corresponding drop in economic output, prices across the board tend to decline.

Deflationary periods often follow extended durations of artificial monetary growth. For instance, the United States experienced significant deflation during the early 1930s, primarily due to a decrease in the money supply following devastating bank failures. Similarly, Japan encountered deflation during the 1990s.

On the surface, deflation may appear beneficial to consumers, as it allows them to acquire more goods and services with the same nominal income over time. However, not all parties benefit from falling prices, leading economists to express concerns about the repercussions of deflation on various economic sectors, especially in financial contexts. Deflation can be particularly detrimental for borrowers, who must repay debts with money that holds greater value than when the loan was taken out, as well as for investors and speculators who rely on expectations of rising prices.

Factors contributing to deflation: Understanding the causes behind falling prices

Deflation can be attributed to several factors. Milton Friedman, a highly regarded economist, suggested that under ideal monetary policy, where the central bank aims for a rate of deflation equal to the real interest rate on government bonds, the nominal interest rate should be zero, and the price level should gradually decrease at the same rate as the real interest. This concept led to the development of the Friedman rule, a guideline for monetary policy.

One primary cause of declining prices is a decrease in aggregate demand, which reflects a reduction in the overall demand for goods and services. Such a decline often results in lower prices. Several factors can contribute to this shift, including reduced government expenditures, stock market downturns, an increased desire among consumers to save, and stricter monetary policies characterized by higher interest rates.

Additionally, falling prices can occur naturally when the growth of an economy's output surpasses the increase in the money and credit supply. This scenario is especially common when technological advancements enhance productivity, particularly within specific industries. As companies become more efficient due to technological progress, production costs decrease, leading to cost savings that are passed on to consumers as lower prices. This process differs from general price deflation, which denotes a broad decrease in price levels alongside a rise in the purchasing power of money.

Price deflation resulting from increased productivity varies across different industries. For instance, the technology sector has experienced significant cost reductions over the past few decades due to advancements in technology. In 1980, the average cost for one gigabyte of data was $437,500; by 2014, this cost had plummeted to just three cents. This dramatic drop has led to significant reductions in the prices of manufactured products that utilize this technology.

Evolving perspectives on the effects of deflation

In the aftermath of the Great Depression, when monetary deflation coincided with high unemployment and increasing defaults, many economists viewed deflation as a negative force. Subsequently, central banks adapted their monetary policies to encourage steady increases in the money supply, even if this led to persistent price inflation and prompted borrowers to take on excessive debt.

John Maynard Keynes, a prominent British economist, warned against the dangers of deflation, arguing that it exacerbates the cycle of economic pessimism during recessions. When asset owners witness declines in their asset values, they often become less willing to invest, which can further hinder economic recovery.

Irving Fisher, another influential economist, formulated a theory surrounding economic depressions based on the concept of debt deflation. He contended that when debts are liquidated following a negative economic event, this can cause a significant reduction in the available credit within the economy, leading to deflation. This deflation can place additional burdens on debtors, resulting in further liquidations and ultimately spiraling into a full-blown depression.

However, contemporary economists are beginning to question these traditional views on deflation. There is a spectrum of opinions regarding the potential benefits of deflation and price deflation. A 2004 study by economists Andrew Atkeson and Patrick Kehoe examined 17 countries over a period of 180 years and revealed that 65 out of 73 instances of deflation did not result in economic downturns, while 21 out of 29 depressions occurred without any associated deflation.

How deflation affects debt and equity financing

Deflation alters the economic landscape for debt and equity financing, making it less advantageous for governments, businesses, and consumers to rely on debt. In a deflationary environment, the real value of debt increases, making repayment more burdensome. As prices fall, the purchasing power of money rises, which can lead to higher debt-to-income ratios and greater financial strain for borrowers.

Conversely, deflation enhances the appeal of savings-based equity financing. Investors often prefer companies that hold substantial cash reserves or have low levels of debt, as these firms are better positioned to weather economic downturns and capitalize on opportunities. In times of deflation, firms with strong cash positions can invest in growth initiatives or acquire distressed assets at lower prices, making them more attractive to investors.

On the other hand, companies with high levels of debt and minimal cash reserves tend to be viewed unfavorably during deflation. These firms face increased financial pressure, as their obligations become more difficult to manage in a declining price environment. This situation can lead to greater risk of default, further diminishing investor confidence.

Additionally, deflation typically results in rising yields and an increased risk premium for securities. As investors seek compensation for the heightened risks associated with deflation, they demand higher returns on their investments. This shift in investor behavior can lead to increased volatility in financial markets and may require companies to offer more attractive terms to attract financing.

In summary, deflation fundamentally changes the dynamics of financing by making debt more burdensome while increasing the desirability of companies that prioritize equity financing through savings and cash reserves. As the economy navigates deflationary pressures, understanding these shifts is crucial for both investors and financial decision-makers.