The big paradox of deflation

Tags: Economy
The big paradox of deflation
Deflation is a general fall in the overall level of prices. A feeling among common citizens persists that falling prices must be beneficial, since buying power is constantly decreasing due to rising prices. But ingrained deflation is bad for the same reason that high inflation is bad: it destroys money value. It eats into earnings. Anyone engaged in economic activity relies on prices of some sort for their income. Decreasing prices would imply contracting income too. In a deflation, a downward spiral sets in as prices are pulled down due to dwindling demand caused by contraction of income.

Deflation destroys incomes but not debts. Earnings may shrink, but borrowings remain stubbornly of the same size in nominal value and increases in real terms. This bears down on economic activity, worsening the squeeze. It also amplifies the sting of debt, since — after some period of significant deflation — the payments one is making in the service of a debt represent a larger amount of purchasing power than when the debt was

first incurred.

Consequently, deflation can be thought of as an amplification of a loan’s interest rate and act as a deterrent to private investment. Government debt as a share of GDP is high in India. If deflation gets entrenched, a dangerous debt-deflationary spiral of the kind suffered by Japan since the early 1990s—where government debt as a share of GDP almost tripled in less than 20 years—could ensue.

In a deflation, people expect prices to fall. For them it makes no sense to buy now what will be cheaper next week or month. This becomes a self-fulfilling prophecy of doom. As people hold off, prices fall further, until the commodity makes an exit from the market. Deflation is great news only for those with some sort of monopoly pricing power — top surgeons and lawyers, perhaps, along with holders of valuable patents and firms involved in major public projects. But pensioners and others on inflation-linked benefits will be

badly hit.

In more recent economic thinking, deflation is related to risk. It is a situation where the risk-adjusted return of assets drops to negative. In such circumstances, investors and buyers will hoard currency rather than invest. A central bank cannot, normally, charge negative interest, or even zero interest, because charging zero interest also means having zero return on government securities, or even negative return on short maturities. This creates a condition referred to as the “liquidity trap”, when reduction of interest rate or increase in money supply do not lead to increase in investment. In an open economy, it creates a carry trade and devalues the currency, producing higher prices for imports without necessarily stimulating exports to a

like degree.

In modern credit-based economies, a deflationary spiral may be caused by the central bank initiating higher interest rates to control inflation, thereby possibly popping an asset bubble. A fall in money supply leads to markedly less lending, and a consequent sharp fall-off in demand for goods. Demand falls, and with falling demand, there is a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets that have fallen dramatically in value since the (mortgage) loan was made, and if they sell those assets, it may cause further supply glut, which exacerbates the situation.

In the US, the first major instance occurred during the recession of 1836, when the currency contracted by about 30 per cent. This “deflation” satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money. The second one was after the Civil War between 1873-96, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War. The third was between 1930-1933 when the rate of deflation was approximately 10 per cent a year; part of the US slide into the Great Depression, where banks failed and unemployment peaked at 25 per cent.

In India, falling prices were experienced during the emergency in 1975–76, the reasons may be more political than economic. In the current year, Japan, Malaysia, South Korea, Taiwan and Thailand are likely to experience negative average annual inflation. Singa-pore may manage to remain afloat around zero. India is experiencing extremely low rates of inflation and a contraction in industrial output and exports. It may witness a period of negative inflation.

Keynesian economists argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand. With the rise of monetarist ideas, the focus while fighting deflation was on expanding demand by lowering interest rates. This view has received a setback in light of the failure of accommodative policies in both Japan and the US to spur demand after stock market shocks in the early 1990s and in 2000-2002, respectively.

The obvious answer to sustained deflationary pressures is the proposal for future inflation, since deflation is the result of an economy trying to get the expected inflation it needs. To avoid deflation, one must provide that expected inflation by credibly promising that future price levels will be sufficiently high compared with the present. Either policy gives the economy the inflation expectations it needs, or the economy will try to get that inflation via grinding deflation — a proposition that sounds paradoxical, but is actually a matter of pure economic logic.

The writer is a senior economist at National Institute of Public Finance and Policy, Delhi. These are his personal views


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