When most of us think of inflation, we think of rising prices that strain budgets and take away our buying power. During the late 1970s and early 1980s, inflation skyrocketed as high as 14.8% in the United States, and interest rates climbed to similar levels. Few living Americans know what it’s like to face the opposite phenomenon: deflation.
Since too much inflation is generally regarded as a bad thing, wouldn’t it follow that deflation might be a good thing? Not necessarily, since much depends on the cause and circumstances of the deflationary cycle and how long it lasts.
Key Takeaways
- Deflation might not be a good thing, since much depends on the cause and circumstances of the deflationary cycle and how long it lasts.
- Deflation is a general decline in prices as a function of supply and demand for products and the money used to buy them.
- If prices drop because an item can be produced more efficiently and cheaply in greater quantity, such as consumer electronics, that’s viewed as a good thing.
- Deflation will result in lower interest rates as the demand for money drops, in which case, the goal is to spur buyer demand to stimulate the economy.
- There are many reasons to be concerned about prolonged deflation, and there has been continuing debate on how best to combat recessions and deflation.
- If the U.S. were to enter sustained deflation, your best protection is to hold onto your job and have as little debt as possible.
Explaining Deflation
Deflation is a general decline in prices as a function of supply and demand for products and the money used to buy them. Deflation can be caused by a decrease in the demand for products, an increase in the supply of products, excess production capacity, an increase in the demand for money, or a decrease in the supply of money or the availability of credit.
Decreased demand for products can manifest itself in the form of less personal spending, less investment spending, and less government spending. While deflation is often associated with an economic recession or depression, it can occur during periods of relative prosperity if the right conditions are present.
Practical Application
If prices are dropping because a product can be produced more efficiently and cheaply in greater quantity, that’s viewed as a good thing. An example of this is consumer electronics, which are far better and more sophisticated than ever. Yet prices have consistently dropped as the technology improved and spurred more demand.
The effect on prices by fluctuations in the demand for money is usually a function of interest rates. As the demand for money increases during a period of inflation, interest rates rise to compensate for the higher demand and to keep prices from rising further. Conversely, deflation will result in lower interest rates as the demand for money drops. In that case, the goal is to spur buyer demand to stimulate the economy.
The Great Depression
Severe economic contraction during the Great Depression resulted in deflation averaging -10.2% in 1932. As the stock market began to crater in late 1929, the supply of money declined along with it as liquidity was drained from the marketplace.
Once the downward spiral had begun, it fed on itself. As people lost their jobs, this reduced the demand for goods, causing further job losses. The decline in prices wasn’t enough to spur demand because rising unemployment undercut consumer purchasing power to a far greater degree. The snowball effect didn’t stop there, as banks began to fold as loan defaults rose dramatically.
As banks stopped lending money and credit dried up, the money supply contracted, and demand tanked. Although the demand for money remained high, no one could afford it because the supply had shrunk. Once this vicious cycle took hold, it lasted a decade until the beginning of World War II.
Possible Effects
There are many reasons to be concerned about a prolonged deflationary period, even without an event as devastating as the Great Depression:
- Demand for goods decreases since consumers delay purchases, expecting lower prices in the future. This compounds itself as prices drop further in response to decreasing demand.
- Consumers expect to earn less and will protect assets rather than spend them. Since 70% of the U.S. economy is consumer-driven, this would have a negative effect on gross domestic product (GDP).
- Bank lending drops since borrowing money makes less sense in regard to the real cost. This is because the loan would be paid back with money that is worth more than it is now.
- Deflation ensures that borrowers who loot to purchase assets lose since an asset becomes worth less in the future than when it was bought.
- The more indebted you are, the worse your condition since your salary will likely decline while your loan payments remain the same.
- During inflation, there is no upper limit on interest rates to control inflation. During deflation, the lower limit is zero. Lenders won’t lend for zero percent interest. At rates above zero, lenders make money, but borrowers lose and won’t borrow as much.
- Corporate profits usually drop during a deflationary period, which could cause a corresponding decrease in stock prices. This has a ripple effect on consumers who rely on stock appreciation and dividends to supplement their incomes.
- Unemployment rises, wages decline as demand drops, and companies struggle to make a profit. This has a compounding effect throughout the entire economy.
What to Do
Ever since the Great Depression, there has been continuing debate on how best to combat recessions and deflation. During the 2007–2009 Great Recession, then-Federal Reserve Chair Ben Bernanke adopted a policy of quantitative easing, which essentially amounts to printing money to buy U.S. Treasuries. Following the Keynesian economic theory, he used the money supply to offset the economic contraction that resulted from the financial meltdown in 2008 and the bursting of the housing bubble. Bernanke’s actions contributed to the recovery of the global economy, but economists argued that he flooded the economy with too much money, contributing to inflation and increased individual and corporate debt.
If the U.S. were to enter a sustained deflationary cycle, your best protection is to hold onto your job and have as little debt as possible. You don’t want to be locked into paying off a loan with money that is increasing in value every day. Save as much money as possible and defer discretionary purchases until prices are lower. Finally, consider selling assets that you don’t need while they still have value.
What Is Deflation?
Deflation is a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time.
What Are Causes of Deflation?
Causes of deflation include:
- Decreased availability of credit
- Decreased demand for products
- Decreased supply of money
- Excess production capacity
- Increased demand for money
- Increased supply of products
What Is Your Best Defense Against Deflation?
Your best protection from deflation is to hold onto your job and have as little debt as possible. If you’re an investor, protect your portfolio by investing in assets that perform well even in times of deflation. Such defensive hedges include high-quality bonds, companies that produce essential consumer goods, and cash.
The Bottom Line
Too much inflation is generally regarded as a bad thing, but deflation might not necessarily be regarded as a good thing. It depends on the cause and circumstances of the deflationary cycle and how long it lasts.
Your best protections in a sustained deflationary cycle are to hold onto your job, have as little debt as possible, save as much money as possible, defer discretionary purchases until prices drop, and sell assets you don’t need while they still have value.