Should we fear deflation?

As consumers the prospect of lower prices are always enticing as it means we suddenly have greater purchasing power over goods and services. However, as economists we often espouse the view that deflation, which is the decrease in the general price level of goods and services, is bad and that the economy should operate with mild inflation. A contradiction is immediately seen as personally we would prefer if prices were low whereas we have always learned that deflation is bad for the economy and must be avoided.

So let us try and reconcile this difference by actually considering what the consequences of deflation are for the economy. This is perhaps most effectively summarised by the Federal Reserve which suggests “deflation discourages spending and investment because consumers, expecting prices to fall further, delay purchases, preferring instead to save and wait for even lower prices. Decreased spending, in turn, lowers company sales and profits, which eventually increases unemployment.”

However, there are several issues with this argument. Firstly, it is often the tendency of consumers to maintain their current lifestyle and well-being and thus they will not necessarily defer their consumption. A prime example of this is consumer behaviour towards tech products. Since 1998 the price of computers has fallen approximately 93%, however there has been almost no evidence of deferring purchases, with consumer demand increasing by 2700% in that period. Furthermore, it is a large oversimplification to assert that our expectations are only based on the past. Past prices are only one of a multitude of factors which consumers base their spending decisions on, making human actions very difficult to model.

Secondly, even if we are consuming less basic economics tells us that we must be saving more and thus investment must be higher. This will in fact not decrease demand but simply change its composition as demand shifts towards capital goods as opposed to consumer goods. Such a shift could in fact be a positive for the economy as it means more consumer goods can be produced in the future.

Finally, let us consider the effect on the company profits. Profits are not based solely on the selling price of products but rather on the difference between selling prices and cost prices. In a deflationary setting both sets of prices will drop and thus profitability can continue for the business.

Yet despite all these reasons economic textbooks and economists continue to suggest that prolonged deflation is the cause of recessions and economic depressions.  The most common basis for this claim is econometric data regarding the US Great Depression. In many countries deflation and depression did indeed go hand in hand during this time period, however we must be careful to distinguish between causation and correlation. Atkeson and Kehoe recently completed a study of economies over the last 180 years and have found in the great majority of cases there is no relationship between deflation and depression. In fact in the last 29 economic depressions 21 have had no deflation, while in 65 of the last 73 deflationary periods there was no consequent depression. Furthermore, in two of the greatest deflationary periods, from 1820 to 1850 and from 1865 to 1900 where prices fell by 53% and 48%, the US economy sustained significant economic growth.

So given the lack of correlation between depressions and deflation, is it truly warranted for governments around the world to be so fearful of the prospect of deflation? Perhaps it is time to rethink the concept of deflation and acknowledge that it may be benign. Such deflation arises from increases in productivity, which is the same as declining production costs and correspond to lower prices to consumers. This means that deflation will in fact be beneficial for the economy. However, due to the constant prevention of deflation due to inflationary policy such as pumping money into the economy, these positive externalities are never reflected. For example, in America since 1945 the general real unit cost of production has halved, but due to artificial inflation promoted by the Federal Reserve general price levels have in fact risen nine-fold.

Furthermore, deflation can actually assist the recovery process for an economy. As any simple business cycle suggests, deflation follows inflation and is characterised by a decrease in the money supply. This decrease is the disappearance of money that was previously being pumped out by the central bank, created out of thin air. This type of money drives unproductive investments or ‘mal-investments’, which occur systematically through distorted price signals during this inflationary period. Deflation however can alleviate this matter by driving money away from these investments, which relied on the previously expanding money supply, and thus alleviate the misallocation of resources in the economy. Although, these effects are indeed unpleasant, they cannot be attributed to deflation, but rather an inevitable consequence of inflation. Furthermore, deflation will stop the pool of real savings from diminishing as it had during the inflationary phase as a result of the unproductive investment. This will provide the economy with solid foundation for future growth.

This has led me to question whether our paranoia of deflation is truly grounded in economic thought. The concept of deflation is currently shrouded by myths and misconceptions, whereas in reality it is a tool of economic revival. So next time you hear the exaggerated consequences of deflation remind yourself of the inconvenient fact that what was once the country with the greatest deflation, China, was also experiencing the greatest economic growth.

Image: ‘sign of deflation’ by garycicles8, Licence at by

5 thoughts on “Should we fear deflation?”

  1. A really interesting article breaking away from the traditional views delineated by other economic articles.

  2. Hey Chandan, enjoyed your article, you definitely take a different approach. However, associating deflation with ‘paranoia, myths and misconceptions’ is a very strong assertion. You seem to focus on deflation from a consumer point of view, but one of the most pernicious effects of deflation is increases in the real stock of debt. The current fear of deflation in the EU and, to a lesser degree in the US is based on this very idea; if prices fall many companies will be unable to service their rising debt as their receipts decline in value. This is very rational, especially as many firms are still stuck with post GFC debt.

    The last thing that struck me is your other assertion that rising savings MUST result in rising investment. The idea of paradox of thrift directly refutes this. For example, if we have a massive savings glut (as we may arguably have presently in the US), consumption and GDP falls. Consequently, there is lower utilisation in the economy, and less opportunity for investment. Importantly, falling GDP may cause national savings to fall itself. Therefore, investment may decline as savings fall. Also, what if we are at the zero lower bound like in the US and EU? Increased savings cannot put downward pressure on interest rates, and therefore would not raise investments in the way you imply.

    Therefore, I think its very sensible for academics and government to worry about deflation, especially as the latter are burdened with massive amounts of debt. Its great that you’ve presented the story from the other side but its also important to provide a balanced argument.

  3. Hey Chandan, thanks for the article mate. It’s definitely an interesting take on contemporary issue!

    Personally, my views of deflation echo Marco’s below. I’m a little surprised you didn’t mention the idea of deleveraging in times of rapidly falling prices. That risk-averse consumers allocate more of their income to debt servicing as their cash flow falls (falling prices also increase the real value of debt), seems like a logical explanation for why spending is curtailed during deflationary periods. When lots of households do this, I reckon that’s when we feel its serious effects on a macro level.

    I don’t think it’s as simple as when consumers don’t spend they automatically save. With the trajectory of the global economy placing great emphasis on the role of the financial/banking sector, the importance of debt can’t be overstated. Irving Fisher wrote a seminal work on this called ‘Debt-Deflation: Theory of Great Depressions.’ I reckon the GFC manifests these notions.

    It’s certainly an interesting area for policy makers! Appreciate your take on it all. Look forward to the next one!

  4. Hello from the UK. Very good piece.

    Deflation is demonised because governments and policymakers are terrified of it. Monetary policymakers lose the ability to manipulate real interest rates, while deflation forces governments to control spending. Just as inflation is theft via a stealth tax increase, deflation liberates and empowers people.

    This helps explains why governments and banks have colluded to enable leverage to increase so dramatically across virtually all sectors of the economy. It would make deflation more costly for those who have borrowed recklessly. So these entities are bailed out and prudent savers are penalised. Inflation is inimical to a fair distribution of income and wealth because those in the know, or closest to the authorities, can benefit from inflation at the expense of others.

    QE, which is designed to pump up asset prices, is a good example of that. The benefits of extra money printing are narrowly shared. So you have a recovery of sorts, but its sustainability is questionable because the spoils are so narrowly spread. QE increases the risks of future asset busts, and asset price deflations are historically much more harmful than goods and services deflations.

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