Why Deflation is Bad for the Economy
Deflation, a general decrease in prices of products and services, is a state of the economy that central banks avoid the most, as it is very difficult to control.
At first glance, deflation can seem beneficial for the economy as it increases the purchasing power of consumers, positively affects consumer spending, etc.
However, deflation, which is generally experienced during times of recessions or depressions, is being combated by many central banks (Ex. European Central Bank), which take extraordinary measures to bring the economy into the inflationary state again.
Deflation is bad for the economy as the price decrease affects the profits and production. This, in turn, causes the wages to decrease, driving companies to lay off workers, etc.
The full cycle of a typical deflationary state of the economy is described below.
- People become reluctant to spend their money as they expect prices to fall further. Why spend now when you can buy more products and services with the same amount of money tomorrow?
- Lower spending/lower demand causes the production to slow down, which in turn reduces the workforce, increasing unemployment. As the number of unemployed people grows, the losses incurred by the banks increase as many people default on their obligations, such as mortgages, car loans, student loan payments and credit cards.
- As the banks write these bad debts off, their balance sheets become shakier, making the depositors to withdraw their funds to avoid the risks of default.
- When a significant amount of deposits are redeemed, banks start to struggle meeting their obligations. Some of the banks begin to collapse, which means the new loans distributed to businesses and consumers is significantly reduced.
- Central Banks start to intervene by lowering the interest rate target and flooding money into the economy via open market operations, that is buying Treasury securities in the open market in exchange for newly printed money.
- In case the above-mentioned tactic fails to stimulate the demand, central banks implement quantitative easing by buying riskier private assets in the open market. In extreme cases, the central bank can also act as the lender of last resort if the financial sector is seriously hindered by such events.
- Governments may also implement expansionary fiscal policy by lowering taxes and increasing government spending. However, when the taxes are lowered the overall tax revenues are decreased, which in turn limits the ability of government to function at full capacity.
The majority of economists believe that a little bit of inflation is a positive thing for the economy, some of them suggesting a two percent inflation target as a perfect rate for the economic growth.
Generally, central banks try to build a mechanism to avoid deflation, viewing it as a severe problem to combat.
Therefore, many of them adjusted monetary policy to promote consistent increases in the money supply, even if it promoted chronic price inflation and encouraged debtors to borrow too much.
Moreover, these days, the central banks’ (such as ECB) implemented quantitative easing programs to fight deflation, is not viewed as an effective measure by many experts.
These ways of overcoming deflation is still a subject of considerable debates.