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Is Deflation an Inherently Negative Phenomenon?


In the realm of monetary economics, the question of how best to control inflation levels in the economy - such that it falls within a 2-4% change in an inflation index - is considered to be among the most prominent areas of concern within the field. Central banks around the world set interest rates with the goal of keeping inflation within the desired range while also encouraging economic growth. The necessity of avoiding deflation when implementing such policies is therefore naturally assumed as monetary institutions have explained in past statements (Lagarde, 2014) (Bernanke, 2002). This article will attempt to show that despite the consensus that exists among policymakers in this regard, economic theory and empirical data provide no definitive answer on whether mild deflation is an inherently negative phenomenon for an average growing economy.


The commonly leveled economic criticisms of deflation are addressed below.


Deflationary Spiral

The onset of sustained falling prices due to a deficiency in aggregate demand is commonly associated with a vicious cycle called a deflationary spiral. According to this view:


  • firms reduce the output they produce due to a lack of demand and, in the process, fire employees or reduce their wages;

  • this in turn exacerbates the fall in demand as people have less income to spend;

  • the economy then experiences a further drop in prices, output and employment, perpetuating a cycle that results in recessions and decreased incomes.


Deflationary spirals may also be triggered by consumers postponing purchases in anticipation of lower prices in the future, and by nominal wages that do not change in response falling prices, creating losses for firms. During such downturns, consumers prefer saving over consumption due to their lower levels of income, prevailing uncertainty in the economy and greater purchasing power of money. The renowned English economist John Maynard Keynes called this phenomenon the ‘paradox of thrift’, noting that while saving during times of uncertainty may be good for an individual, it can be disastrous for an economy if everyone does it at the same time: after all, one individual’s consumption is another person’s income (Vermann, 2012).  

What becomes clear from these arguments are that deflation necessarily causes deficient demand, and that this deficient demand inevitably results in a positive feedback loop that intensifies unemployment and depresses incomes. It is worth investigating both these premises.


Deficient demand is defined as a “situation when aggregate demand (AD) is less than the aggregate supply (AS) corresponding to full employment level of output in the economy” (Chand, yourarticlelibrary.com). Deflation is often the result of supply outstripping demand; however, the task at hand is to figure out whether it is also its cause.

 Deficient Demand as per AD-AS Model(Source: Geeksforgeeks)
 Deficient Demand as per AD-AS Model(Source: Geeksforgeeks)

As argued by Charles Plosser, while anticipated inflation increases nominal interest rates (as banks try to account for the weaker purchasing power of the money that their loans will be repaid with), anticipated deflation has the opposite effect i.e., lowering nominal interest rates (as banks now have to incur the cost associated with repaying deposits with money having greater purchasing power).

This relationship between anticipated inflation and interest rates is known as the ‘Fisher effect’, named after the American economist Irving Fisher. It can be represented in the form of an equation as shown below, where R is the nominal interest rate, r is the real interest rate and a is the anticipated rate of inflation:

R = r + a

A lower nominal interest rate during deflationary periods suggests it may not necessarily lead to lower levels of aggregate demand, as the gains that would come with consumers postponing purchases would be offset by the reduced rate of interest on savings. 


Another important factor to consider when trying to assess the influence that deflationary pressures have on aggregate demand is the cause for the deflation itself. Several studies including Bordo et al., 2004; Beckworth, 2008; and EPRS, 2015 distinguish between deflation that results from negative demand shocks and deflation that results from positive, productivity-induced supply shocks. Both types of deflation arise due to higher levels of aggregate supply relative to aggregate demand; in the case of the former, however, deflation is accompanied with the recessionary conditions that popularly accepted theories would suggest. In the case of the latter, deflation coexists with positive levels of economic growth.


Deflationary downturns stemming from a collapse of demand are well-documented and include the experience of the US, UK, Canada, France and Germany during the Great Depression in the 1930s (Albers, Uebele, 2015) and that of Japan during the 1990s and 2000s (IMF, 2003). Episodes of productivity-induced deflation, though, require one to go further back in time and consequently risk losing relevancy to today’s economic conditions due to the vastly different nature of the current monetary system; nevertheless, they serve to demonstrate how deflation need not necessarily lead to self-reinforcing downward spirals. 

As highlighted by EPRS the period in the United States from 1869-1896 was characterized by a mild deflation of 2.9% while the economy expanded annually at 4.6%. A similar experience of economic growth in spite of deflation during this time period was found in other economies as well (Bordo, Filardo, 2005). Countries that experienced deflation during this time - including the US, UK, Germany, France and Italy - reported markedly positive trends in both nominal and real per capita income figures while profits, apart from a few sectors, remained stable (Selgin p 50, 1997). Possible reasons for deflation during this time include the constraints imposed by the gold standard and the greater productivity during the period due to the diffusion of technologies like the spread of railways and electrification.

 

Deflation and Economic Growth in the US during the late 19th century. Source: (Beckworth, 2007)
Deflation and Economic Growth in the US during the late 19th century. Source: (Beckworth, 2007)

It can thus be concluded here that deflation that results from greater productivity does not lead to downward spirals as demand remains unaffected. The lower per unit costs of production for companies due to greater productivity offsets the fall in prices, thereby keeping profit margins and employment stable. 

 

Debt Deflation 

The theory of debt deflation, first described by Irving Fisher, offers another explanation for how falling prices may trigger recessionary conditions. Due to the increased real debt burdens faced by debtors on account of having to repay debts as per nominal value despite falling prices, debtors end up liquidating assets through distress selling to cover their payments, causing a contraction in deposit currency. This in turn leads to a further decline in prices and a fall in the net worth of businesses, precipitating bankruptcies and leading to depressed incomes, profits and output (Fisher, 1933). In other words, this theory claims that it results in a feedback loop between debt and deflation that affects real output through financial crises.

In my view, this theory provides a strong case for the necessity of avoiding high levels of deflation; however, I believe that mild deflation - specifically the productivity-induced kind - is unlikely to result in such a collapse as it would not be enough to cause the kind of distress associated with an economy-wide contraction of money due to repayments. Additionally, the theory fails to address the greater real incomes at the disposal of debtors due to fall in prices which they could make use of to pay off the correspondingly larger debts. 

 

Lower Bound of Zero for Nominal Interest Rates

This concern of deflation’s effects relates to the potential it has to drive nominal interest rates down to zero. Rates cannot fall below zero as lenders, at that point, would rather hold cash than lend money while paying interest to borrowers. This situation would render conventional monetary policy ineffective as the central bank would not be able to stimulate aggregate demand through lower interest rates and open market operations, which could result in the situation of a liquidity trap as in the case of Japan (Svensson, 2003). 

While this view presents the idea of 0% nominal interest rates as negative due to its incompatibility with conventional monetary policy, the American economist Milton Friedman, through his optimal quantity theory of money, argued that nominal interest rates of 0% could be beneficial for an economy as it eliminates the opportunity cost associated with holding cash balances and hence incentivizes a greater volume of transactions through greater holdings of cash balances (Sanchez, 2012). Additionally, interest rates historically that have fallen as low as the zero bound during the deflationary pre-war periods have rarely occurred (Bordo, Filardo, 2004). This again raises questions on the tendency to characterize deflation as a solely damaging phenomenon and makes a case for nuance in assessing its causes and effects.


Conclusion

In summary, this article has covered some of the most levelled criticisms against deflation to highlight some of the ways in which the economically destructive tendencies associated with deflation may not manifest. The takeaway from this is not that deflation as a phenomenon is to be encouraged, but rather that the response to deflation must be carefully considered before taking action. In trying to alleviate a situation presumed to be adverse, central banks may do more harm than good by creating distortions in the mechanisms of the market and preventing the potential gains to be reaped from lower prices.    


References:


(Bernanke, 2002)

 

 


(Plosser, 2003)


(EPRS, 2015)


(IMF, 2003)


(Beckworth, 2008)


(Bordo, Filardo, 2004)

(Bordo, Filardo, 2005)


(Bordo et. al, 2004)


(Albers, Uebele, 2015)


(Selgin, p 50, 1997)


(Svensson, 2003)


(Sanchez, 2012)


(Vermann, 2012)


(Fisher, 1933)

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