The Risk of Deflation

What is deflation?

Deflation occurs when consumer and asset prices decline over time, effectively increasing your purchasing power. Essentially, you’re able to buy more tomorrow with the same amount of money you have today.

Isn’t this a good thing?

Not really. You may feel it’s beneficial to have more purchasing power, but, unfortunately, it comes along with other detrimental side effects. For example, the value of your home may decrease in a deflationary environment, but your mortgage will not change. Consequently, you could find yourself paying a mortgage on a home worth less than the mortgage itself. This phenomenon of “underwater” loans can cause financial difficulties for lenders, further restricting the availability of credit and worsening the deflation problem.

Causes

Deflation typically arises from a contraction in the overall money supply, which usually occurs for two distinct reasons: a decrease in overall demand or an increase in the supply of goods. Both of these factors can be traced back to the fundamental economic interplay between supply and demand. If the supply remains unchanged, a drop in aggregate demand can lead to falling prices.

This can signal an impending recession and economic hardship. When people anticipate falling prices, they tend to delay their purchases, hoping for better deals later. Naturally, reduced consumer spending leads to lower income for producers, which generally has a negative impact on employment and the broader stock market.

Historical Lessons

While the United States has mostly experienced inflation throughout its history, there are noteworthy periods of deflation that are important to understand.

• The Great Depression: This time period showcases the devastating consequences of a prolonged and severe decrease in overall price levels. During this tumultuous era, the United States and much of the world experienced a dramatic deflationary spiral, where falling prices led to reduced consumer spending, business investment, and widespread unemployment.
• Deflation in Japan: Japan’s experience with deflation over the past few decades serves as a unique case study in the modern world. Beginning in the early 1990s, Japan entered into a prolonged period of deflation, characterized by persistently falling prices across various sectors of its economy. This deflationary trend was primarily rooted in a complex web of factors, including a bursting asset price bubble, an aging population, and a persistent liquidity trap. The Japanese government and central bank employed unconventional monetary policies, including zero interest rates and massive quantitative easing, to combat deflation and stimulate economic activity. Although Japan has made some progress in addressing deflation, it remains a lingering concern.
  
• The Great Recession: While it is often associated with the collapse of the housing market and the subsequent financial crisis, a significant aspect of the Great Recession was the deflationary forces at play. As the housing bubble burst and financial institutions faced severe losses, asset prices plummeted, leading to a widespread reduction in wealth. The Great Recession illustrates how deflation, intertwined with financial instability, can have severe economic consequences and underscores the importance of swift and effective policy responses.

Current Scenario

Currently, China faces many challenges, including declining consumer spending, dwindling factory production, elevated youth unemployment, and an aging population. These issues inevitably raise questions about their potential impact on the US and the rest of the world, including the possibility of transitioning into a deflationary environment. Although the outcome is hard to predict at this point in time, China’s current economic state could certainly affect the growth of other major economies and will be something to keep an eye on over the next cycle.