Deflation

Deflation and Its Effects on National Economy

Inflation is an indicator for the level of price increase. This is a very important figure as this indicates the country’s economy not only for internal transaction but also for international business relations. Inflation determines the buying power of a specific currency as an increase in price level means money could buy less. The government has to control inflation as much as possible in order to maintain their economic standing while pushing for improvement. If inflation is never controlled, the country could be in economic turmoil and it will take decades for recovery. Zimbabwe is a good example of hyperinflation since their economy tanked when the inflation rate got out of control.

Although inflation should be controlled at all costs, the other end of the spectrum is not necessarily a good thing. Deflation refers to negative inflation or the price level of goods is decreasing. As the price level of products decreases, the purchasing power of a specific currency increases. Consumers can naturally buy more as the prices of products have become affordable.

But even though deflation may seem like good news for everyone, it does have some effects to the national economy. If deflation is never controlled, economic turmoil could also happen.

Basic Cause of Deflation

Inflation and deflation can be easily triggered by supply and demand. Inflation could be experienced when there is an increase of demand that it outpaces the supply. While inflation sees an increase in demand-side, deflation sees the increase of the supply side. As more and more products are offered in the market, consumers could end up hesitating to spend because they start to realize that there are too many products and prices will drop because competition is fierce. Although consumers continue spending, the market will have to attract the consumers by decreasing their prices. This is where deflation starts. Although it has a good effect on consumers, its advantage is only experienced temporarily. Many economists believe that deflation, like inflation, should be controlled to prevent financial problems in the long run.

Deflation During the Great Depression

A good example of deflation affecting the national economy is the Great Depression. It is considered one of the factors that triggered the downfall of the US economy. When deflation started, consumers were able to purchase products at a good price – at the expense of businesses. One bad effect of deflation is unknown increase of interest rate. In this economic condition, businesses can gain access to credit but even the stipulated interest rate of 0% could be costly. The money they accessed will be worth more in the future which increases the difficulty of payment. This is the reason why deflation will lead to unemployment as more businesses are hesitant to get into any type of financial risk. As unemployment grew, deflation will continue to increase as supply outpaces demand. During the late 20s, the end result is the Great Depression.

Deflationary Spiral

Aside from becoming one of the driving forces for the Great Depression, deflation during the late 20s is also an example of an economic condition called the deflationary spiral. Simply put, it’s a condition wherein the decrease in demand experiences a snowball effect that ultimately leads to economic downturn. During the Great Depression, increase in supply without the necessary demand naturally lowered prices. But businesses are not cutting prices without ensuring they will earn in some way. Because of lower prices, they have to cut costs in production including salary. Some businesses will fold because of price wars and jobs are lost.

As more jobs are lost, the power to buy certain products and services weaken. Businesses have no choice but to further adjust their rates and prices just to attract customers. Of course, this business decision will affect production cost and employment. This process continues until the economy can no longer employ anyone or attract customers to buy products or accept services. The events that following deflationary spiral is also a good example on why deflation, although will look good on paper, ends up costing more than creating opportunities for consumers and businesses.

Liquidity Trap

Another effect of deflation is “liquidity trap.” One of the biggest problems during deflation is that consumers will start to hesitate to spend. They could be facing some financial problems or they are waiting for prices to further go down. Either way, money is no longer spent – they are saved or kept in the bank where it just sits there without any positive effect on the economy. Although it does not do anything to harm the economy, saving the funds for future use is actually damaging the economy because of liquidity trap. What made this situation even more dangerous is the fact that the monetary policy cannot do anything to stimulate spending.

Through monetary policy, the government or its regulating body could increase or decrease interest rate to stimulate the economy. On certain conditions, they could even increase monetary supply so that people will be encouraged to spend. But because of the looming deflation, consumers will simply keep the money as a way of protecting themselves from the possible effects of deflation.

The other spectrum of inflation may look good at first. But its long term effect can easily bring the economy down. For this reason, the government, through its monetary policy should continue to monitor this specific figure and create actions based on the figures to control the economy.

Deflation Quotes (7)

As echoed in the preceding tale, falling prices don't hurt Duffy. In fact, as prices for all things come down through similar productivity gains in other industries, the fish he earns will enable him to buy more things.

Innovation is a one-way process. Unless people forget what they already know, efficiency always compounds. As a result, prices tend to come down over time.

Steadily dropping prices also encourage savings as islanders begin to understand they their fish would likely buy more goods in the future than they do in the present. As crazy as it sounds, a fish saved is indeed a fish earned. This encourages savings, thereby swelling the amount of capital available for loans.
— Peter Schiff; How an Economy Grows and Why It Crashes

There is no greater propaganda victory in economics today than the complete vilification of deflation (and the relative acceptance of inflation). As far as economists and politicians are concerned, deflation, which is defined as the overall decline of prices over time, is the economic equivalent of the bubonic plague. At the slightest whiff of deflation, governments will typically enact policies to push prices back up.

But what's wrong with falling prices? Habituated as we have become to steadily rising prices, it would shock just about everyone to know that prices in the United States fell steadily for almost 150 years...from the late 1700s all the way to 1913! But during that time we experienced some of the fastest economic growth in the history of the planet. This was made possible for the precise reasons described in this chapter: increased efficiency. When combined with a stable supply of money (as existed in the United States until the establishment of the Federal Reserve), efficiency will push prices down.

The vastly increased productivity of the industrial revolution made it possible for working-class people to afford all kinds of goods, like upholstered furniture, tailored clothing, plumbing, and wheeled transportation, that were previously available only to the rich. Deflation meant that $100 saved in 1850 could buy many more goods and services in 1880. Why is this not a good thing? While modern grandparents habitually point out how much cheaper stuff was when they were kids, their own grandparents likely told stories to them about how much more expensive things were in their youth.
— Peter Schiff; How an Economy Grows and Why It Crashes

Yet despite the obvious benefits of lower prices, we still fear deflation. We are told that if prices were to fall, people would stop buying, companies would stop spending, workers would lose their jobs, and we would all return to the economic dark ages.

But we all see time and time again how falling prices do not deter particular industries. In the early twentieth century, Henry Ford made a fortune, and his workers became the best paid in the industry, by steadily bringing down the price of cars. More recently the computer industry has made bundles of money despite the fact that its products constantly experience significant price deflation. Yet despite plunging prices the computer revolution continues unabated. As a result of this efficiency in design and manufacture, millions and millions of people each year spend less and less to experience the marvels of digitization.

Despite this, most people assume that deflation is okay if it's confined to just one industry. Why would that be?
— Peter Schiff; How an Economy Grows and Why It Crashes

Modern economists mistakenly assume that spending drives growth, and that when deflation is present, people tend to defer purchases (to allow prices to fall); and when they do spend, the diminished price makes less of an economic impact. This is absurd.

As we've said before, it's not the spending that means anything. It's the production that counts!

People do not need to he persuaded to spend. Given that human demand is essentially endless, if people don't want something there is likely a good reason. Either the product is no good or the consumer simply cannot afford to buy it. Either way, the act of deferring a purchase, or saving instead of spending, is made for rational reasons and tends to benefit the economy as a whole.

In fact, if consumers are not spending, the best way to spur demand is to allow prices to fall to more affordable levels. Sam Walton made billions with this simple concept.
— Peter Schiff; How an Economy Grows and Why It Crashes

When Plasma TV's first came out, few Americans bought them. Although just about everyone wanted one, not many could come up with the $10,000 needed to bring one home. However, as prices fell more people took the plunge and profits rose as higher volumes made up for lower prices.

It takes a gifted economist to argue that consumers are hurt by falling prices. Would lower food and energy prices really be so bad? Would more affordable health care or education require government to protect us from the danger?

Despite all the exculpatory evidence, deflation remains economic enemy number one. This is because inflation (the opposite of deflation), is every politician's best friend. More about this later.
— Peter Schiff; How an Economy Grows and Why It Crashes

One thing is often forgotten: deflation can only take place after a previous inflation; only pseudo-receipts, not gold coins, can be retired and liquidated.
— Murray Rothbard; What Has Government Done to Our Money?

The government's greatest fear is deflation, and the one way to combat deflation is by inflation.
— Robert Kiyosaki; Rich Dad's Conspiracy of The Rich