What is Deflation?

A broad decrease in the cost of goods and services, known as deflation, is usually accompanied by a reduction in the amount of credit and money available to the economy. The buying power of money increases over time during a deflation.

Understanding Deflation

Deflation, the decline in the general price level, impacts various aspects of the economy, including capital, labor, goods, and services, by reducing their nominal costs. While the relative prices of these items may remain unchanged, economists have long been concerned about the implications of deflation. At first glance, deflation seems beneficial to consumers as it allows them to buy more goods and services with the same nominal income over time.

However, the effects of lower prices aren't universally positive. Economists worry about the repercussions of declining prices on different sectors of the economy, particularly in financial contexts. For instance, borrowers may suffer because they're obligated to repay debts in money that holds greater value than when they initially borrowed it. Additionally, those involved in financial markets, such as investors or speculators banking on price increases, could face challenges due to deflationary pressures.

Reasons for Deflation

Monetary deflation occurs when there is a decrease in the supply of money or financial instruments convertible into money. Central banks, like the Federal Reserve, primarily influence the money supply in modern times. A decrease in the money supply, not matched by a decline in economic output, leads to falling prices across all goods. Typically, deflation follows periods of excessive monetary expansion, as seen in the early 1930s in the United States due to bank failures. Japan also experienced deflation in the 1990s.

Milton Friedman proposed the Friedman rule, advocating for a steady fall in the price level at the real interest rate, with a nominal interest rate of zero under optimal policy. However, price declines can stem from various factors, such as decreased aggregate demand or increased productivity. Reduced government spending, market downturns, and higher interest rates can lead to lower demand and prices.

Productivity-driven price deflation occurs when the economy's output grows faster than the circulating money supply. Technological advancements, particularly in sectors like technology, enhance operational efficiency, reducing production costs. Consumers benefit from cost savings through lower prices. For instance, the cost per gigabyte of data has significantly decreased over the years due to technological progress, leading to lower prices for products reliant on such technology.

Rethinking the Effects of Deflation

Following the Great Depression, when monetary deflation coincided with high unemployment and rising defaults, the prevailing belief among most economists was that deflation had negative consequences. Consequently, many central banks adjusted their monetary policies to ensure consistent increases in the money supply, even if it led to chronic price inflation and excessive borrowing by debtors.

British economist John Maynard Keynes cautioned against deflation, arguing that it contributed to a downward economic spiral during recessions. He observed that asset owners, seeing their asset prices decline, became less willing to invest.

Economist Irving Fisher developed a comprehensive theory of economic depressions centered around debt deflation. Fisher posited that the process of debt liquidation following a negative economic shock could lead to a significant reduction in credit supply, triggering deflation. 

This deflationary pressure would exacerbate the financial strain on debtors, resulting in further debt liquidation and potentially spiraling into a depression.

In more recent times, economists have increasingly challenged traditional views on deflation, particularly following the 2004 study by economists Andrew Atkeson and Patrick Kehoe. 

Their analysis of 17 countries over a 180-year period revealed that 65 out of 73 deflation episodes did not coincide with economic downturns, while 21 out of 29 depressions occurred without deflation. As a result, there is now a diverse range of opinions on the implications and utility of deflation and price deflation.

Deflation Changes Debt and Equity Financing

Deflation reduces the cost-effectiveness of debt financing for consumers, corporations, and governments. Deflation, on the other hand, strengthens the financial viability of savings-based equity financing.

In a deflationary environment, organizations with substantial cash reserves or low levels of debt are more appealing to investors. Conversely, heavily indebted companies with low financial reserves can say the opposite. Moreover, deflation promotes rising rates and raises the required risk premium on securities.

Who Suffers from Deflation?

Deflation can be particularly harmful to debtors, as the value of their debts remains the same or even increases while prices for goods and services fall. This impact is felt by individuals and can also affect larger economies, especially those with high levels of national debt.

How Can Deflation Be Addressed?

To combat deflation, governments and central banks like the Federal Reserve have various tools at their disposal, primarily through implementing expansionary policies. These measures may involve reducing bank reserve requirements, purchasing government bonds, and lowering target interest rates. Fiscal strategies such as increasing government spending and cutting tax rates can also stimulate spending among both individuals and businesses.

Which Investments Perform Well in Deflationary Environments?

Investors can safeguard their portfolios by allocating funds to assets that tend to perform strongly even during periods of deflation. These defensive investments may include high-quality bonds, companies that produce essential consumer goods, and maintaining a portion of assets in cash.

Conclusion

A broad decrease in the cost of goods and services, or deflation, raises the value of money. It's linked to several factors, such as a decline in the amount of money available, as well as higher production and technological developments. It was once viewed by economists as a negative phenomena, but today's viewpoints are more varied.