Many economists regard deflation as more dangerous than inflation, as it encourages consumers to delay purchases as they wait for a lower price tomorrow. When consumers put off buying in anticipation of lower prices it creates a downward spiral of lower demand followed by lower production.
Deflation harms debtors as well. Countries like Greece have to pay back the money they borrowed with money that will be more expensive next year. Paying down debt with cheaper money slows economic growth. Japan has struggled with deflation for the last two decades, as growth in Japan faltered.
A sign that deflation is near comes from countries like Ireland and Spain that saw prices fall in May. Inflation was below 1 percent in five other euro zone countries.
There are four causes of deflation:
- Decrease in the money supply
- Increase in demand for money
- Increase in supply of goods
- Decrease in demand for goods
Increasing demand or decreasing the supply of money results in “tight money”. Both result in higher interest rates that tend to balance demand for and supply of money. The Great Depression was due to a falling supply of money. The crash of the stock market caused the economy to contract as liquidity disappeared. People lost their jobs and the banks stopped loaning money as defaults rose. The spiral continued as the money supply contracted further and more people lost their jobs. Demand for money was high, while the supply of money was low. Most people could not afford to pay the interest rates.
If interest rates are kept low, and the supply of money is plentiful then the money supply is not a direct cause of deflation. Many people believe excess money results in inflation and in most cases, they are right, unless demand for goods declines.
Deflation can come from too many goods available for sale. If there are more goods than people demand, the prices will fall as stores and companies try to unload their goods. Falling prices leads to deflation. It also leads to a balancing of the supply, as some companies will stop making so many goods as they are unprofitable.
If we look back to the global expansion of manufacturing, in the 1990’s and 2000’s the developed world experienced a form of deflation as the prices of many goods stayed low or fell. Since goods could be manufactured cheaply, it caused prices paid for these goods to go down benefiting all consumers. In this case, deflation was a good thing. It allowed more people to be able to afford to buy goods, increasing everyone’s wealth.
What if the demand for goods slows or falters? If consumers do not want to buy more of a product, the price will fall as sellers try to unload their extra goods. If people curtail their spending fearing they will have less wealth due to threats to their income, prices will fall. When prices fall, people will delay buying, expecting the price to be lower in the future. For example, my wife is delaying the purchase of a new digital camera, as she believes the price will be lower in the coming months. She is contributing to the decrease in the demand for goods and encouraging a deflationary spiral.
For the European nations facing new austerity programs as they try to pay down their debt, deflation becomes a reality. Consumers will no longer have extra money to spend so they will reduce their buying. Demand for goods falls. As demand falls, the price of goods drops as well. Consumers will begin to wait for lower prices next month delaying their purchases. The ramifications of deflation set in.
Even if the central bank is tying to increase the money supply, demand for money remains weak, as much of the excess money is used to pay off the debt built up over the years.
The real challenge for many members of the European Union, especially Greece, Spain, Portugal, Ireland and Italy is how they will regain their competitive position in the world’s markets. They cannot devalue their currency, since they are part of the European Union. Their only choice is to cut salaries and keep them well below other European countries like France and Germany. Falling wages and lower government spending, places more downward pressure on prices.
The European Central Bank (ECB) remains focused on controlling inflation. By keeping a tight lid on inflation, the ECB is limiting the supply of money. As mentioned, limiting the supply of money contributes to deflation.
As Japan has experienced, deflation can make for difficult economic times. For now, we should expect to see falling prices in a number of European countries as demand for goods slows. Falling demand will slow the global economic recovery. It will pay to monitor how Europe navigates the treacherous deflationary waters ahead. Companies that heavily depend on Europe for sales may encounter a more difficult future.
