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Hard money advocates argue that if there were no "rigidities" in an economy, then deflation should be a welcome effect, as the lowering of prices would allow more of the economy's effort to be moved to other areas of activity, thus increasing the total output of the economy.
Deflation has effects on two main levels: on the corporate and on the governmental level.
The most obvious is on the level of companies. By definition, in the event of a deflation, Companies not only cannot raise, but have to actually decrease their prices for their products and services. If they hadn’t decreased their prices, they would go out of business. Although in a deflationary environment, most likely their production costs also decrease, most majority of companies’ profit decrease also, and after a few years they are going to annual losses (there may be companies in sectors with low competition and high profitability ratios, such as utilities, and also companies that have a large portion of profits coming from either foreign operations or from exports). In such scenarios companies cannot plan for and invest in its future growth and development.
When governments want to maintain or increase the real value of their tax income in a deflationary economy, one of three options: increase the tax base, increase tax rates, or a combination of the above two.
Tax base is the number of people and companies that pay taxes. Due to the consumption and corporate environment governments have to be very careful with broadening the tax base, but especially cautious with increasing taxes, as it may cause the economy to sink more deeply into a recession (deflationary economies are also shrinking ones).
Some wages: as companies cannot afford to increase wages, the nominal value of those wages stays the same (however, their real value increases) not only for the period of deflation, but also for some time during the following stagflation and inflationary period.
Deflationary economies have many indirect socio-, political-, financial-, and economical effects:
Rising unemployment: as companies need to cut cost, they need to fire employees, which are not producing (because they don’t have any work to do).
Higher government deficits: as most costs stay the same (for political reasons), and some expenditures increase (e.g.: rising unemployment aid payments cost of jumpstarting the economy).
Recession: no price increase; no economic growth.
More expensive imports: same foreign currency is worth more domestic currency.
More income from exports: same foreign currency income is worth more in domestic currency.
4. Alternative causes and effects
4.1 The Austrian school of economics
The Austrian school defines deflation and inflation solely in relation to the money supply. Deflation is therefore defined to be a contraction of the money supply. Only a decrease in money supply can cause a general fall in prices.
Increased productivity, however, can appear to cause deflation; but it is not general deflation; as the price of produced goods falls, while labor rates remain constant. Austrians show this as a benefit of sound money, which increases or decreases very little in total supply. Prices should simply confer the exchange ratio between any two goods in an economy. Increased productivity generally means less labor for more goods, whereas increased money supply should mean the same amount of labor for the same amount of goods.
For instance if there is a fixed money supply of 400 kg of gold in an economy that produces 200 widgets, then one widget will cost 2 kg of gold. However, next year if output is 400 widgets with the same money supply of 400 kg of gold the price of each widget will drop to 1 kg of gold. In this case the general fall in price was caused by increased productivity.
The opposite of the above scenario has the same effect on prices, but a different cause. If there is a fixed money supply of 400 kg of gold in an economy that produces 200 widgets, then once again each widget will cost 2 kg of gold. However, if next year the money supply is cut in half to 200 kg of gold with the same output of 200 widgets, the price of each widget will now only be 1 kg of gold. When capital profits are dropping rapidly, there is no reason to invest gold, which breaks the savings identity, and thus the automatic tendency of the economy to move back to equilibrium.
Austrians view increased productivity to be a good cause of a general fall in prices, while credit/money supply contraction as being a bad cause of a general fall in prices. Austrians also take the position that there are no negative distortions in the economy due to a general fall in prices in the first scenario. However, in the second scenario where a general fall in prices is caused by deflation, Austrians contend that this confers no benefit to society. For in this scenario wages will simply be cut in half and lower prices will not reflect a general increase in wealth.
Also, Austrians believe that some entity being able to inflate or deflate a money supply is given a privilege, as all prices will not change both simultaneously and proportionally. Rather price changes will occur as a response to what seems to be changes in demand, although this is only in nominal terms. Those who can inflate or deflate the money supply (or those closest to this source) can take advantage of an otherwise unknown change in the money supply by making exchanges that appear sound in nominal terms, but actually confer more profitable exchange rates in real terms, once prices have adjusted to the change.
For example, if a widget costs 5g of gold today and there is 20g of gold in the money supply, if the central bank decreases the money supply to 10g, it can sell its widgets for the formerly agreed upon price. Once the market finds less overall demand, however, prices will halve. While the central banks' money supply deflation was the cause of the price decrease, it received double the money for its widgets that they are now worth in real terms.
4.2 Keynesian economics
Keynesians insist on the distinction between consuming goods and producing goods, and between government based and credit based money supply.
For a given money supply, if wages rise faster than productivity, profits will fall and with them the price of producing goods (deflation), while consuming goods will rise (inflation). This happens in times when labor supply is tight and bargaining power is strong. When wages rise slower than productivity, profits rise as do the prices of assets relative to consuming goods. This can occur when labor supply is great and bargaining power is weak.
Inflation and deflation occur when the economic policies allow wages to increase or decrease at differing rates than productivity. Wages rising faster than productivity lead to inflation. Wages failing to increase at the rate of productivity for protracted periods will ultimately cause deflation.
Indeed, if growth continues despite lagging wages, it is because of debt accumulation, producers lend to wage earning consumers part of their profits, in order to sell their products. For protracted periods, there is a lot of endogenous money creation.
Then, when debt payments exceed the borrower's ability to pay, debt accumulation and endogenous money creation stops, demand and goods' prices fall, manufacturers reduce production, employment falls, and fewer borrowers are thus able to pay their debts, and the cycle exacerbates.
Once preventive action has failed, Keynesians advocate corrective action. In case of debt deflation, Keynesians advocate "pump priming" or government creation of fiat money. As witnessed since 1990 in Japan, and in the 1930s in the USA, this policy is not very effective unless government creates employment via public works projects or military manufacturing.
Austrians and Keynesians agree on the idea that there are counterproductive cycles of booms and bust but while the former believe the government tends to be a cause of those cycles, the latter believe it is a means to reduce the size of those cycles.
5. Historical examples
5.1 In Ireland
In February 2009, Ireland's Central Statistics Office announced that during January 2009, the country experienced deflation, with prices falling by 0.1% from the same time in 2008. This is the first time deflation has hit the Irish economy since 1960. Overall consumer prices decreased by 1.7% in the month.
Brian Lenihan, Ireland's Minister for Finance, mentioned deflation in an interview with RTÉ Radio. According to RTÉ's account, "Minister for Finance Brian Lenihan has said that deflation must be taken into account when Budget cuts in child benefit, public sector pay and professional fees are being considered. Mr Lenihan said month-on-month there has been a 6.6% decline in the cost of living this year" [9].
This interview is notable in that the deflation referred to is not discernibly regarded negatively by the Minister in the interview. The Minister mentions the deflation as an item of data helpful to the arguments for a cut in certain benefits. The alleged economic harm caused by deflation is not alluded to or mentioned by this member of government. This is a notable example of deflation in the modern era being discussed by a senior financial Minister without any mention of how it might be avoided, or whether it should be.
5.2 In Japan
Deflation started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates, but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended.
Systemic reasons for deflation in Japan can be said to include:
Unfavorable demographics. Japan has an aging population: 22.6% over age 65 that is not growing and will soon start a long decline. The Japanese death rate recently exceeded the birth rate [6].
Fallen asset prices. In the case of Japan asset price deflation was a mean reversion or correction back to the price level that prevailed before the asset bubble. There was a rather large price bubble in equities and especially real estate in Japan in the 1980s [20].
Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks made even more loans to these companies that are used to service the debt they already had. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off, it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by The Economist) as methods to speed this process and thus end the deflation.
Insolvent banks: Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.
Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.
Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods (due to lower wages and fast growth in those countries) and inexpensive raw materials, many of which reached all time real price minimums in the early 2000s. Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary.
In November 2009 Japan has returned to deflation, according to the Wall Street Journal. Bloomberg L.P. reports that consumer prices fell in October 2009 by a near record 2.2% [20].
4.3 In the United States
There have been three significant periods of deflation in the United States.
The first was the recession of the late 1830s, following the Panic of 1837, when the currency in the United States contracted by about 30%, a contraction which is only matched by the Great Depression. This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money.
The second was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War.
"The Great Sag of 1873-96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to Milton Friedman, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year [18].
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