The standard deflation definition is when asset and consumer prices continue to fall. This may seem like a great thing to consumers, except that the cause for widespread deflation is a long-term drop in demand. Unfortunately, a drop in demand means that a recession is probably already underway, with job losses, declining wages, and an ongoing decline in the value of your home and your stock portfolio. As a result, businesses drop prices in a desperate attempt to get people to buy their products.
How Is It Measured?
Officially, deflation is measured by a decrease in the Consumer Price Index. However, the CPI does not measure stock prices, which retirees use to fund purchases, and businesses use to fund growth. More important, the CPI does not include sales price of homes. Instead, it calculates the monthly equivalent of owning a home, which it derives from rents. This is very misleading, since rental prices are likely to drop when there is high vacancy, usually when interest rates are low and housing prices are rising. Conversely, when home prices are dropping due to high interest rates, rents tend to increase. Therefore, the CPI gives a false low reading when home prices are high (and rents are low). This is why it did not warn of asset inflation during the housing bubble of 2006. If it had, then the Federal Reserve could have raised interest rates higher at that time to prevent the bubble, and the resultant pain when the bubble burst in 2007.
How Is It Stopped?
To combat deflation, the Fed must stimulate the economy with expansionary monetary policy. It reduces interest rates, and increases the money supply, in an attempt to jump-start economic growth. In addition, the government can offset falling prices with expansionary fiscal policy. It can put more money into circulation by lowering taxes, increasing government spending, and incurring a temporary deficit to do so. Of course, if the deficit is already at record levels, that tool becomes less available.
Why does expansionary monetary or fiscal policy work? If done correctly, it stimulates demand. People have more money to spend, and they are willing to buy now even though they expect prices to continue to fall. Once the government restores confidence in economic growth, a lot of people will feel like low prices have hit their bottom, and will "get in while the getting is good." When enough people do this, demand will outstrip supply and prices will reverse their downward trend.
Why Is It Worse than Inflation?
Deflation is the opposite of inflation, which is when prices rise. Both are very difficult to combat once entrenched. That's because of peoples' expectations, which worsen price trends. When prices rise during inflation, they create an asset bubble. However, this bubble can be burst by central banks raising interest rates enough. Fed Chairman Paul Volcker proved this in
Deflation is worse because interest rates can only be lowered to zero. As businesses and people feel less wealthy, they spend less, reducing demand further. Prices drop in response, giving businesses less profit. Once people expect the price declines, they delay purchases as long as possible. They know the longer they wait, the lower the price will be. This further decreases demand, causing businesses to slash prices even more. It is a vicious, downward spiral.
Massive deflation helped turn a recession into the Great Depression. As unemployment rose, demand for goods and services fell. Prices dropped 10% a year. As prices fell, companies went out of business. More people became unemployed. When the dust settled, world trade essentially collapsed. The amount of goods and services traded fell 25%, but -- thanks to lower prices -- the value of this trade was down 65% (as measured in dollars).
Can Deflation Ever Be a Good Thing?
A massive, widespread drop in prices is always bad for the economy. However, deflation is certain asset classes can be good. For example, the price of consumer goods, especially computers and electronic equipment, continues to fall. This isn't because of lower demand, but from innovation. In the case of consumer goods, production has moved to China, where wages are lower. This is an innovation in manufacturing, which results in lower prices for many consumer goods. In the case of computers, manufacturers find ways to make the components smaller, adding more power for the same price. This is technological innovation, and it keeps computer manufacturers competitive.
Japan: A Modern Example
Japan's economy was caught in a deflationary spiral for the last 20 years. It started in 1989, when the Bank of Japan raised interest rates causing the asset bubble in housing to burst. During that decade, the economy grew less than 2% per year as businesses cut back on debt, spending and lost productivity with excess workers (Japan's culture discourages employee layoffs). The Japanese people are also savers, and when they saw the signs of recession, they stopped spending and put away funds for bad times.
A study by Daniel Okimoto at Stanford University identified five other factors:
- The political party in power did not take the difficult steps needed to spur the economy enough.
- Taxes were raised in 1997.
- Banks kept bad loans on their books, which tied up capital needed to invest in growth.
- The yen carry trade kept the value of Japan's currency high relative to the dollar and other global currencies. The Bank of Japan tried to create inflation by lowering interest rates. However, traders took advantage of the situation by borrowing yen cheaply and investing it in currencies with a higher return.
- The Japanese government spent heavily, buying dollars to battle the yen carry trade. This created a 200% debt to GDP ratio, which further depressed expectations of economic growth. Article updated November 12, 2013