How Will Deflation Affect You

A discussion of the cause and effect of deflation on the US economy.

The recent economic downturn starting in 2008 has been caused by several factors and has resulting in lower employment levels, reduced value in US and European currency, and higher commodity prices such as gold and crude oil. Economists are split as to whether we will see inflation or deflation in the next 12 to 24 months.

Deflation is characterized by a fall in the general price level over a specific time period which is the opposite of inflation. Deflation can denote a reduction in the size of money supply, where inflation is commonly caused by too many dollars chasing too few goods and services. Deflation is commonly known as the 'Contraction' of the money supply. Moreover, when Deflation affects the economy of a country, the demand for liquidity rises, followed by escalation in the purchasing power of money as well. In a modern economic condition, Deflation is considered a matter of deep and serious concern, due to a possible rise in deflationary spiral.

Why Deflation Occurs?

• At a condition where there is enough competition, Capitalism also acts as the driving force behind Deflation. Development of capital stocks furthers the competition, leading to increase in the supply of goods. Under this circumstance, the prices automatically reduce till they stabilize the demand. Capitalism initiates innovation and efficiency, whereby the prices go down, leading to Deflation.

• From the monetary point of view, Deflation results from a decrease in the velocity of money and/or the amount of money supplied per person.

Note: Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services and helps investors gauge how robust the economy is. It is usually measured as a ratio of GNP (Gross National Product) to a country's total supply of money.

Theories regarding Deflation:

• Neo-classical theory: Neo-classical theorists say that there is zero chance of deflation in a theoretically ideal competitive market, as the control of money will be under the monetary authorities and prices will be permitted to oscillate.

• Keynesian concept: According to the Keynesians, deflation occurs when there is increase or fall in the wages at various rates, than that of productivity. When wages do not increase at the productivity rate for prolonged time period, it causes Deflation.

• Austrian School: Followers of the Austrian School of Thought hold Deflation responsible for a general reduction in the prices, and do not consider it to be a general price fall itself. To them, Deflation is a contraction of money supply.

Deflation in the world:

• United States of America: As far as the United States of America is concerned, it underwent two significant eras of deflation, one immediately after the Civil War, commonly known as The Great Deflation. At this time, Deflation resulted out of the intentional and premeditated policy of outdating the paper notes printed during the Civil War. The other one occurred between 1930-1933, when the deflation rate was around 10% annually. This was followed by failure of the banks and increase in the unemployment rates to about 25%. Roosevelt attempted to stem deflation by price controls which forbade businesses from charging less than the government set price.

• British Isles: Deflationary trend started in United Kingdom in the post-First World War period when the pound reverted back to the gold standard, on the basis of the pre-War price of gold. Since this price was higher than the equivalent gold price, it required deflation to occur, in order to realign it with pound's high target value.

Japan had the “Lost Decade,” which in some respect is still going into it’s second decade, where the economy stalled and the government repeatedly tried to stimulate it artificially. Japan had the benefit of a large reserve of savings, which the US consumer does not have, but the savings rate has increased dramatically recently. The Federal Reserve is keeping interest rates artificially low to induce consumers to spend more and fuel our debt-driven economy.

Differences between Japan and the US

• Look for steeply rising unemployment in the US. One of the consequences of those debt write-downs in the US is that US corporations will be forced to cut expenses. The biggest expense for many companies is employees. Japan had far more loyalty to its employees than US corporations.

• Enormous consumer debt makes the problem the US faces far more severe than the problem Japan faced. Consumer debt that that cannot be repaid will be defaulted on. Rising unemployment will further aggravate mortgage related problems and credit card related problems.

• Consumption continued in Japan because of savings. The US will be forced to cut back on consumption and increase savings.

• Japan had the benefit of a global internet boom followed by a global housing boom to help the economy. The US is facing a global contraction of the housing boom.

• Most people in the US "own" their own home, close to one third of Americans owe nothing on their homes. The debt is carried by those who can least afford to carry that debt in an economic downturn.

• Japan had a huge valuation problem in real estate. The US has a huge valuation problem as well as commercial real estate that is overbuilt.

The pent up deflationary forces in the US are such that Deflation in the US will be worse than Deflation in Japan. Also, fiscal stimulus failed in Japan and simply eroded their savings where the US did not have any savings to begin with.


Additional Reading

Ludwig von Mises Institute

US Debt Clock



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