Deflation, inflation’s evil twin, has reared its ugly head – at least as a topic of conversation. In a briefing to Congress in May 2003, Alan Greenspan, chairman of the Federal Reserve Board of Governors, mentioned deflation. He added that deflation was currently a greater concern than inflation, while he believed the possibility of deflation in the US economy was distant. For the first time since the 1930s, when the world’s economies experienced worldwide deflation, his statement made deflation a hot topic.
Although the Federal Reserve (Fed) acknowledges that deflation in the United States is a remote possibility, the Fed has been on the lookout for any signals of a downward spiral in wages and prices. “…that inflation becoming undesirably low remains the major concern for the foreseeable future,” the Fed said in a statement following its October 28, 2003 meeting. The concern is that lower prices and wages may lead to expectations of more price reductions, delaying consumer and investment spending and therefore prolonging the current economic recession.
Deflation, as defined in Econ 101, is a steady decrease in the overall price level of goods and services. The discrepancy between actual and prospective Gross Domestic Product can be used to detect deflation (GDP). Potential GDP is a forecast of what the economy could produce if available resources, particularly labor, were used more efficiently. In a deflationary environment, aggregate spending falls below the level required for full employment, and potential GDP outnumbers actual GDP.
There are two types of deflation: benign and malignant. A rise in productivity (typically due to increased use of technology) is linked to benign deflation, which lowers prices. Malignant deflation is caused by low demand, which leads to a downward price spiral. Insufficient demand, combined with surplus supply, forces businesses to lower prices in order to shift their inventory. Profits are declining, and labor demand is dwindling. As unemployment rises, salaries decrease along with prices, perpetuating the downward wage-price cycle.
Even mild deflation causes profit weakness because increases in output due to productivity are offset by price decreases. Firms aim to reduce employment in order to save money and improve their bottom line. Instead of adjusting the price of labor, or wages, companies alter the quantity of labor. Individual income rarely decreases, though raises may be reduced. As unemployment rises, neither wages nor output fall at first. Companies are still focusing on increasing output through higher productivity rather than adding more people. The sluggish employment market, on the other hand, should constrain pay growth in the long run.
What conditions allow deflation to take control of an economy? There is evidence that deflation can be caused by a rigid market structure and ineffective government measures. This theory will be tested using three case studies: Japan, Germany, and the United States. Will the United States follow Japan’s path of chronic deflation and Germany’s stagnation? What is the best way to plan?
The Japanese economy was regarded as the paradigm of the future in the 1980s. Other countries looked into it and tried to emulate its methods. Japan, on the other hand, had begun its steady descent towards recession and deflation by the early 1990s. The Japanese economy’s decline was aided by a restrictive market framework in which change was slow, resources were difficult to shift to more productive and profitable uses, and profitability was protected by a controlled price system.
The price structure, rather than insufficient demand or a drop in asset prices, appears to be driving deflationary forces. Even for globally marketed products, Japanese consumers pay premium pricing in their home marketplaces. Food prices are four times more in Japan than in the United States, wholesale and retail prices are typically two to three times higher, and restaurant and hotel rates are much higher than in the United States. Because of these high domestic costs, there is nowhere for them to go except down especially in a global economy with few trade barriers and unfettered resource movement.
Evidence implies that asset price deflation was the effect of Japan’s economic troubles, not the cause. The market structure reduced the amount of viable investment options accessible. The stock market and real estate were two of the few options for absorbing the capital that Japan was generating. As a result, money poured into these markets, causing prices to rise past what was economically feasible, resulting in a “asset price bubble.” The impact of the market crash and the bursting of the bubble was enormous. The Nikkei, Japan’s stock market, has seen its long-term return drop from 15 to 16 percent in the 1980s to 8.5 percent today. Between 1990 and 2003, the value of residential real estate fell by one-third, while the value of commercial real estate fell by nearly half.
Deflation is currently a source of concern, despite the fact that it was formerly regarded to be beneficial to the Japanese economy, as lower costs would enhance consumers’ lives. Falling prices continue to put pressure on the Japanese labor market, with companies cutting jobs to maintain profits. Corporations have struggled to service their obligations as a result of lower profitability, and some have been forced into bankruptcy. The bankruptcies harm banks that handle the loans of deeply indebted business customers, and the Japanese financial system is in jeopardy.
The Japanese government’s early response was to apply “Band-Aids” to particular problems rather than addressing the problem as a whole. Initial ideas for bank reforms, such as measures to deal with bankruptcies, nationalization of banks, and capital injections, were watered down by senior politicians who lacked the guts to act on true reform.
After more than a decade of stagnation, Japan is showing some signs of life. The forces of deflation appear to be diminishing. The stock market appears to be recovering, corporate profits are increasing, and GDP increased by 2.3 percent annually in the second quarter of 2003. Analysts, on the other hand, caution against overconfidence. Prices are continuing to fall, especially for computer equipment. The unemployment rate is reaching historic highs, and banks are facing a $295 billion bad loan problem.
While deflation in Europe as a whole is unlikely, Germany faces it after three years of stagnation. An asset bubble has erupted in Germany, comparable to the one that has erupted in Japan. In addition, there is indications that the “bubble” is about to burst. Over the last three years, the DAX index (German stock market index) has lost 70% of its value. Germany’s banks are losing money, and the non-financial private sector’s debt has risen to 160 percent of GDP. Internal and external structural issues have hampered the government’s capacity to act to stabilize the economy.
The German economy is characterized by rigid labor and product markets. The post-World War II German economy was largely based on a symbiotic relationship between business, government, and labor. It is characterized by consensus, with trade unions participating in management and holding half of the seats on large corporation supervisory boards. This cooperative strategy has helped Germany prevent labor unrest, but it has also resulted in a labor market that is characterized by high wages, rigid labor rules, and extensive social benefits.
In the product marketplaces, German companies include both enormous industrial behemoths and medium-sized Mittelstand organizations (three million mostly family-owned firms). Many Germans consider the Mittelstand to be the heart of their economy, yet it, like the industrial titans, faces global competition. The Mittelstand, on the other hand, frequently lacks the managerial experience and/or financial muscle to compete successfully with larger enterprises. A number of regulations have been established to limit competition (and innovation), ranging from restrictions on operating days and hours to prohibitions on discounts and lifetime promises. Furthermore, several large German corporations have established webs of cross-holding and reciprocal board memberships comparable to those found in Japan. These ties have hampered competition and the free flow of resources to their most productive uses in some circumstances. Germany has done nothing to modify its markets’ rigidities to date. The Schroeder administration, on the other hand, is aware of the challenges and has launched “Agenda 2010,” a reform program to address some of them.
When Germany entered the European Monetary Union, it constrained its capacity to utilize fiscal and monetary instruments to sustain its economy. Interest rates in the euro zone are set by the European Central Bank, not by the banks of individual countries. As a result, Germany is unable to govern its economy using monetary means. Its use of fiscal policy (the use of the government’s taxing and spending powers to create deficits or surpluses) is also limited by the EU Stability Pact, which prohibits budget deficits of more than 3% of GDP. European economic policies, which include higher interest rates than those in the United States, appear to be at odds with the demands of an economy in recession and possibly deflation. The euro’s strengthening against the dollar has exacerbated the economic predicament. Because higher relative prices lead to a decrease in demand, an appreciating currency is comparable to tighter monetary policy. This is the policy that would be implemented to combat inflation rather than potential deflation.
- Since 2001, productivity has increased, adding to the lack of hiring.
- In September 2003, unemployment fell marginally to 6.1 percent, with 57,000 new jobs added for the first time in eight months. Since November 2001, however, almost one million jobs have vanished.
- In some industries, such as capital goods and consumer durable goods, global supply may be surpassing demand.
In the United States, there are encouraging indicators. Consumers have not postponed purchases in the hopes of lower prices in the future. Instead, consumer expenditure in the United States climbed by 1% in July and 1.1 percent in August, accounting for roughly two-thirds of all economic activity. This is due in part to an increase in available money as a result of the Bush Administration’s monetary and fiscal policies of refinancing home mortgages at lower interest rates (monetary policy) and tax cuts (fiscal policy). Consumer expenditure, on the other hand, decreased 0.3 percent in September, presumably reflecting the tax cut’s fading influence.
In addition to consumer expenditure, business and construction spending appear to be on the rise. For the second month in a row, new orders increased, bolstering factory activity in the United States. In July, construction spending reached its highest level since the start of the year.
Deflation should be avoided with the use of appropriate monetary and fiscal policy. Chairman Greenspan saw the danger early on, and the Fed cut short-term rates to 45-year lows. To stimulate the economy, the Bush Administration employed a combination of lower taxes and greater government spending (mostly for the military).
The structure of American markets also helps to combat deflation. Competition reallocates resources, reshapes sectors, and modifies the economy on a regular basis. Change tends to increase productivity and earnings, as well as add value to items, allowing some industries to boost pricing. While the United States and Japan both have low costs for capital goods and consumer durable goods, prices in the service sector began to rise at the end of the 1990s. Only recently has the rate of increase reduced. Rising service prices in the United States have more than compensated dropping goods prices.
Is the United States on the verge of deflation? Should companies concentrate on increasing productivity while limiting new hires? Should buyers put off purchases in order to take advantage of a price drop? Given the government’s competence and desire to implement monetary and fiscal policy, as well as the competitive structure of US markets, the answer is most likely “No.” The mildness of the recession and solid third-quarter growth in the United States are perhaps the best arguments against deflation in the United States. Instead, it appears that, barring an unexpected shock, the economy is on the mend, and inflation, according to the Fed, appears to be under control for the time being.
What exactly is malicious inflation?
A sharp drop in aggregate demand, followed by chronically low levels, has resulted in a protracted drop in the general price level, output, and employment. Negative demand shocks to one or more economies are frequently connected with deflationary impacts.
Benign deflation
Improvements in production and supply cut costs and shift the short run aggregate supply curve to the right, resulting in ‘benign’ deflation. As the name implies, benign deflation is not a concern because it stimulates demand and growth while also increasing efficiency. The implementation of new technology can be a catalyst for long-term price reductions.
What are the three different types of inflation?
- Inflation is defined as the rate at which a currency’s value falls and, as a result, the overall level of prices for goods and services rises.
- Demand-Pull inflation, Cost-Push inflation, and Built-In inflation are three forms of inflation that are occasionally used to classify it.
- The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the two most widely used inflation indices (WPI).
- Depending on one’s perspective and rate of change, inflation can be perceived favourably or negatively.
- Those possessing tangible assets, such as real estate or stockpiled goods, may benefit from inflation because it increases the value of their holdings.
Which of the four types of inflation are there?
When the cost of goods and services rises, this is referred to as inflation. Inflation is divided into four categories based on its speed. “Creeping,” “walking,” “galloping,” and “hyperinflation” are some of the terms used. Asset inflation and wage inflation are two different types of inflation. Demand-pull (also known as “price inflation”) and cost-push inflation are two additional types of inflation, according to some analysts, yet they are also sources of inflation. The increase of the money supply is also a factor.
Is benign deflation beneficial?
Is deflation beneficial or harmful? Deflationary experiences in western economies have mostly been negative – deflation has been linked to lower rates of economic growth and increased unemployment. However, a second sort of deflation can occur as a result of quickly growing productivity; in this case, deflation can be associated with faster rates of economic growth.
The key question is: what is generating the deflation, and what is happening to real wages and real interest rates if prices are falling?
Deflation caused by lower costs ‘good deflation’
In theory, corporations will be able to pay real wage increases if we have ‘good’ deflation – due to a significant gain in productivity and lower costs. Lower prices, but higher output, productivity, profits and hopefully higher real salaries are all signs of this sort of deflation. If customers see reduced costs but see their actual incomes rise, they are more likely to spend since they will have the money to acquire these cheaper things.
Consumers benefit from lower prices when production costs decline, while output rises.
Example of good deflation 1870-1890
The US and UK economies benefited from a worldwide drop in prices due to the “Second Industrial Revolution” during the end of the nineteenth century. This featured significant increases in productivity:
During this time, the US economy flourished significantly, thanks to new technology that helped cut expenses. Although prices fell during this time, salaries remained stable or rose, resulting in real pay growth for employees.
Deflation caused by falling demand
Firms will notice a reduction in profitability if we have ‘bad’ deflation decreasing prices due to sluggish demand. Firms will aim to cut wages rather than increase salaries in this situation. Also, if businesses are unable to reduce nominal wages, we may see an increase in unemployment (a combination of real wage unemployment and demand deficient unemployment).
As a result, reducing prices will not be enough to drive spending and more consumption in this scenario of lower incomes and higher unemployment. Instead, individuals will be risk averse, attempting to save and waiting for costs to drop much further.
Costs of deflation
We tend to have these issues when prices are falling but nominal incomes are also falling or stagnant.
- Consumers put off making purchases. Consumers expect prices to fall further in the future as a result of lowering prices, thus they put off acquiring items.
- Increase in the debt’s true value. It gets more difficult to pay off debt and satisfy debt obligations as prices and wages fall.
- Unemployment based on real wages. Firms cannot afford workers when prices decrease, but if workers oppose nominal salary cuts, real wage unemployment will result.
- Real interest rates are rising. Because interest rates cannot go below zero, the effective real interest rate rises in a deflationary environment. As a result, even when the economy is weak, real interest rates are high, deterring borrowing and boosting saving.
- Cycle of deflation. Lower demand causes lower prices, and dropping prices cause lower demand in a deflationary cycle, which is a vicious circle.
Deflation/low inflation of UK 2010s
Taking cost-push variables out of the equation, underlying inflationary pressures in the UK have been minimal, with inflation reaching zero in 2015. However, inadequate productivity and thus stagnant real wages is a primary cause of deflation/low inflation. Although inflation is low, household finances are deteriorating.
Is there a distinction between inflation and deflation?
When the price of goods and services rises, inflation happens; when the price of goods and services falls, deflation occurs. The delicate balance between these two economic circumstances, which are opposite sides of the same coin, is difficult to maintain, and an economy can quickly shift from one to the other.
Is it true that deflation is worse than inflation?
Important Points to Remember When the price of products and services falls, this is referred to as deflation. Consumers anticipate reduced prices in the future as a result of deflation expectations. As a result, demand falls and growth decreases. Because interest rates can only be decreased to zero, deflation is worse than inflation.
During a deflationary period, who suffers the most?
- Consumer spending is discouraged. When costs are falling, individuals are more likely to put off purchases since they will be cheaper later. It can deter buyers from purchasing luxury products or non-essential items, such as a flatscreen TV, because they could save money by waiting for a lower price. As a result, deflationary periods frequently result in decreased consumer spending and slower economic growth (this, in turn, creates more deflationary pressure in the economy). The Japanese experience of deflation in the 1990s and 2000s was marked by a drop in consumer expenditure (Japanese financial crisis).
- Increase the debt’s real value. The real worth of money and the real value of debt both rise as a result of deflation. Debtors find it more difficult to repay their debts as a result of deflation. As a result, consumers and businesses must devote a greater portion of their discretionary income to debt repayment. (In a deflationary phase, corporations will receive lesser revenue, and consumers will likely receive lower pay.) As a result, there is less money available for spending and investment. This is especially problematic during a balance sheet recession, when businesses and people are attempting to minimize their debt exposure. Europe has a large amount of government debt, and deflation will make lowering debt-to-GDP ratios more difficult.
- Real interest rates have risen. Interest rates are not allowed to fall below zero. If there is 2% deflation, we will have a real interest rate of +2%. Saving money, in other words, yields an acceptable return. As a result, deflation might lead to an unwelcome tightening of monetary policy. This is especially problematic for Eurozone countries who do not have access to alternative monetary strategies such as quantitative easing. Another issue that can contribute to lesser growth and increased unemployment is this.
- Unemployment based on real wages. ‘Sticky wages’ are common in labor markets. Workers, in particular, are resistant to nominal wage cuts (no one likes to see their salaries reduced, especially when they are accustomed to annual raises). As a result, real wages grow during deflationary periods. This could result in real-wage joblessness. Low inflation is one of the reasons for Europe’s high unemployment rate.
Why can’t we simply print more cash?
To begin with, the federal government does not generate money; the Federal Reserve, the nation’s central bank, is in charge of that.
The Federal Reserve attempts to affect the money supply in the economy in order to encourage noninflationary growth. Printing money to pay off the debt would exacerbate inflation unless economic activity increased in proportion to the amount of money issued. This would be “too much money chasing too few goods,” as the adage goes.