What Is Deflation? Definition, Examples, Causes & Solutions

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What Is Deflation? Why Is It Bad?

Who doesn’t love a bargain? Shoppers may rejoice at the idea of a price cut, but when price decreases hit an entire economy, deflation is the culprit. Economists fear this rare phenomenon, which happens when both the costs of goods and services decrease while the monetary supply contracts.

If that sounds like a double negative, that’s because it is. When there’s deflation, the economy becomes mired in recessionary stagnation—and it takes a whole lot to get out of this precarious situation.Luckily, central banks like the Federal Reserve have a few tools at their disposal to fight deflation, although sometimes finding the right one feels like a case of throwing darts at a board and seeing which ones stick.

Deflation Example: Japan’s Lost Decade

One of the best examples of deflation occured during Japan’s Lost Decade. Japan’s economy became stuck in a lose-lose situation of declining prices and slackening demand between 1991 and 2001.

Rewind back to the 1970s and 1980s, when Japanese businesses had discovered a way to gain a competitive edge in global markets by creating high-quality products at a cheap cost. This fueled an incredible boom in Japan’s real estate market and Nikkei stock exchange, which quickly inflated to bubble proportions thanks to rampant speculation.

The Nikkei peaked at 38,916 on December 29, 1989 but would fall 43% in under a year. Why? Noticing inflationary pressures, Japan’s central bank instituted a series of interest rate hikes, which effectively popped the bubble. Speculators defaulted on their loans, businesses declared bankruptcy, and banks needed to be bailed out by the government. GDP declined, and Japan’s stock market crashed.

Japan had entered a recession, but the “typical” steps a central bank takes to fix this problem—namely interest rate decreases—were not enough. The Bank of Japan slashed rates to zero, known as the “zero lower bound,” and kept them there for several years. Next, the Japanese government tried to replicate the New Deal policies that had helped the United States out of the Great Depression by embarking upon large-scale infrastructure projects. Still, Japanese consumers were reluctant to spend the savings they were hoarding.

That’s because a key element of Japan’s crisis centered around its consumers’ lack of confidence: Workers feared losing their jobs, while depositors worried about bank runs. No one was spending.

In order to finally wake Japan’s economy from its decade-long slumber, its central bank needed to literally create demand by injecting liquidity back into the markets—it would turn out to be a five-year effort. Japan’s quantitative easing measures finally helped to restart the economy and get consumers spending again, and by 2003, Japan’s GDP would once again reach a healthy, 3% level of growth.

When Does Deflation Occur? What Causes It?

Deflation occurs when there is a liquidity trap, when an economy is in a recession but interest rates are already as low as they can go; Japan’s former economic troubles are a prime example. It’s a sticky situation.

The problem is, when interest rates are at the zero lower bound, the opportunity cost of holding cash is also zero. Why would someone invest their assets in short-term bonds like Treasury Securities in such an environment? There’s little incentive to take on even minimal risk.

While it might seem positive for prices of goods and services to decline, deflation can have devastating consequences. Prices fall when demand contracts. This takes its toll on the entire economy, since decreased demand makes manufacturers less willing to keep up production or hold inventories. This affects company profits, and businesses lay off workers. Unemployment rises, recessions stretch, and demand falls even further. It’s a vicious circle.

How Is Deflation Resolved?

As seen in the example with Japan, central banks have the ability to make large-scale asset purchases—we’re talking trillions of dollars—in order to increase market liquidity and make it easier for banks to lend again. The central bank will usually purchase long-term securities, such as government bonds. but it could also invest in corporate bonds, municipal banks, or even common stock. In the case of the Financial Crisis of 2007–2008, the Federal Reserve even purchased some of the toxic mortgage-backed securities that had been causing so much trouble.

But monetary policy efforts alone might not fix the deflationary problem—sometimes it takes coordination with the government in the form of fiscal support through legislation or even stimulus relief.

Helicopter money is another tool at a central bank’s disposal. Similar to quantitative easing measures, a government can inject large sums into the monetary supply either by making tax cuts or by sending stimulus checks directly to its citizens. What would you do if money fell from the sky? Spend it, probably. Usually, this option is a central bank’s last resort.

Then again, a good old fashioned interest rate hike might also do the trick, because it would prompt savers to invest again, since other financial assets, such as bonds, would finally start to look more attractive than merely sitting on cash.

Deflation vs. Inflation

Deflation is the opposite of inflation. It’s a period of declining prices as well as a corresponding increase in purchasing power. But what good is that when no one is spending? Deflation is also marked by a decline in demand, as well as the transfer of wealth to liquid assets (i.e., cash).

Inflation, on the other hand, is a period of rising prices and decreased purchasing power. Here consumer spending declines simply because people can’t afford to buy as much.

Deflation vs. Disinflation

Deflation is not to be confused with disinflation, either. Disinflation is a period where there’s inflation happening, just at a slower rate than it had been previously.

Will Deflation Happen in 2023?

Tesla founder and newly minted Twitter impresario Elon Musk believes if the Fed doesn’t start cutting interest rates, the U.S. economy will face deflation in 2023. TheStreet’s Luc Olinga unpacks it here.

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