The Spectre of Deflation?
Deflation explained: why falling prices may be disastrous.
The first, and most important, thing to realise about deflation is its root cause: decreasing demand. Decreasing demand leads firms to cut prices in an attempt to maintain unit sales. This is just the beginning; they may well follow by decreasing production, for why produce if you can’t sell at a profit, which in turn leads to wage cuts and worse, higher unemployment.
Note that if a firm in a regular inflationary employment isn’t doing too well and needs to reduce wage costs, they do not have to actively go out and cut paychecks. Inflation, by reducing the value of money, does it for them. In a deflationary economy, however, things get a lot harder. While firms are doing what is necessary to stay alive and competitive, following the rules of a classical free market, this is one scenario where their actions don’t help. Falling wages and higher unemployment lead to further cutbacks in spending by the general population, shrinking profit margins even more, not providing an incentive for any supply expansion. This is the beginning of a very vicious disinflationary cycle.
If this scenario sounds improbable, here’s another one. Deflation feeds itself. In the slowing economy, monetary authorities like the BOE are furiously cutting interest rates. This decreases the value of holding money in the bank, and encourages spending, which can, theoretically, kick start the economy. However, in a deflationary scenario, there is another force acting against spending. Why not wait, since prices are falling anyway, until your money is worth more? Consumers postpone spending, forcing further price falls, and more interest rate cuts.
Of course, the rate banks offer on savings accounts, while linked to the base rate set by the BOE, is a nominal interest rate. The real interest you make on your money in the bank is this number less the inflation rate, which is the amount by which your money is decreasing in value over time. When nominal rates are low enough, with positive inflation, real rates are zero, or negative, meaning holding your money in the bank instead of spending it is effectively decreasing its value. When deflation persists though, despite the nominal rate of zero, real rates are positive. And since banks can’t really lower nominal rates below zero, they can’t get the true value of holding your money in a bank to zero. This just serves as a further disincentive to spend, which again, depresses economic growth.
If this sounds familiar, it is, just think about Japan in the early 90’s. It took Japan ten years to get out of the deflationary cycle and kick start the economy, for most of which the Bank of Japan had rates firmly held at zero. And ailing economies result in larger unemployment, more benefits paid out, higher national debt, and all things bad. Believe it or not, a small sustained amount of inflation is good for an economy. Or as Ben Bernanke put it in an address to the Federal Reserve, we’ve got to make “Sure it doesn't happen here.”
