Deflation

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Defined as a sustained fall in the general level of prices, deflation is not necessarily harmful, but there there is a danger that it could have disastrous economic consequences.

The causes of deflation

Deflation is nowadays usually side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices in order to find buyers.The economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress.

The effects of deflation

First-round effects

Deflation tends to make consumers reduce their purchases in the expectation of being able to buy more cheaply at a later date. That can have a depressing effect upon demand and lead to a reduction of output. Another potentially important effect is to require borrowers to repay more than they had borrowed (for example, if prices declined by 20 percent, a farmer who had previously borrowed £100 to buy ten pigs would have to repay the equivalent of twelve pigs). The resulting loss to borrowers may be balanced by gains to lenders, but if borrowers are forced to default, the resulting disruption can lead to a further reduction in output. Another effect is to require employers to pay their employees the same wages despite a reduction in income from their employees' output. Unless there is a compensating wage reduction, that may result in a reduction in employment and another reduction in output.

Second-round effects : the "deflationary spiral"

A sudden and unexpected deflation can result in output losses that feed upon themselves by reinforcing the tendencies that produced them. For example the output loss from the deferrment of purchases could lead to an increase in unemployment, which could prompt a further reduction in spending and thus a further increase in unemployment.

Policy responses

Central bank policy makers generally, recommend early preemptive action to avert the danger of deflation - on the grounds that it is difficult to devise effective policies to counter it once it has taken hold. Their principle precautionary weapon is a rapid relaxation of monetary policy by reductions in interest rates [1] [2]. Most of them also advocate supplementing monetary action with short-term fiscal measures, especially when interest rates approach zero and the liquidity trap renders conventional monetary policy ineffective [3]. To deal with severe threats of deflation they also advocate supplementing interest rate cuts with direct action to increase the money supply by "printing money" (otherwise known as "quantitative easing"[4]). They recognise, however, that such remedies can be costly and difficult to manage. Delay is likely to reduce their effectiveness, but hurriedly-devised public expenditure projects are apt to be uneconomic. The intention would be to remove the stimulus once it had served it purpose, but public awareness of that intention could reduce its effectiveness (a quandary that prompted the economist Paul Krugman to suggest that "the way to make monetary policy effective, then, is for the central bank to credibly promise to be irresponsible" [5]). On the other hand, failure to reverse policy as recovery commences, creates a danger of inflation. Thus the decision to launch anti-deflation measures involves a balancing of risks, and their success depends upon accurate diagnosis and rapid response to change.

Historical experience

General

There had been few accounts of falling price levels until the nineteenth century, when falling prices occurred in several countries (the price level is reported to have fallen in the course of the century by a third in Britain and a half in America) [6]. That decline in prices was not associated with a fall in demand and was not accompanied by what are now seen as deflationary effects, partly because of compensating productivity gains. In the twentieth century by contrast the Great Depression and the Japanese banking crisis, which were the two major deflationary episodes, were both driven by falls in demand following the bursting of asset price bubbles, and led to further and sustained, demand restrictions [7]

The great depression

In the United States, consumer prices fell by 24 per cent from August 1929 to March 1933 and GDP fell by almost 30 per cent. The recession itself was attributed by Irving Fisher to debt deflation [8], but other causative factors are nowadays considered to have been more important, and there is held to be no firm evidence concerning the contribution of deflation to the mic downturn.

Japan's "lost decade"

The collapse of a housing price bubble in the 1990s led to a decade-long period of deflation and economic stagnation. Simulations by Federal Reserve Board economists showed that the development of an inflationary spiral and of a deep depression were averted by remedial monetary and fiscal action, and that deflation could have been averted had that action been taken more promptly. [9]. The policy mistakes that are believed to have prevented an earlier recovery have been extensively examined by Paul Krugman [10]

References

  1. Ben Bernanke: Deflation: Making Sure "It" Doesn't Happen Here (Remarks made at the National Economists Club, Washington, D.C. November 21, 2002) Federal Reserve Board 2002
  2. Lorenzo Bini Smaghi, (Member of the Executive Board of the ECB): Careful with (the "d") words!, speech to the European Colloquia Series, Venice, 25 November 2008, European Central Bank 2008
  3. Paul Krugman: It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap
  4. For an explanation of quantitative easing, see the article on banking)
  5. Paul Krugman: Japan's Trap" May 1998
  6. Deflation: Determinants, Risks, and Policy Options, Findings of an Interdepartmental Task Force, International Monetary Fund, April 2003
  7. Michael Bordo and Andrew Filardo: Deflation in Historical Perspective, BIS Working Paper no 186, Bank for International Settlements, November 2005
  8. Irving Fisher: The Dept-deflation Theory of Depressions, Econometrica 1933
  9. Alan Ahearne, Joseph Gagnon, Jane Haltmaier, and Steve Kamin and others: Preventing Deflation: Lessons from Japan’s Experience in the 1990s, International Finance Discussion Papers, Number 729 Federal Reserve Board, June 2002 [1]
  10. Paul Krugman: A Special Page on Japan