This means that deflation can be brought about either by an increase in the supply of goods and services or by a lack of increase or decrease in the supply of money and credit. In either case, if prices can adjust downward, then this results in a generally falling price level.
An increase in the supply of goods and services in an economy typically results from technological progress, the discovery of new resources, or an increase in productivity. This is an unambiguously positive process for the economy and society as a whole. At times some economists have expressed fears that falling prices would paradoxically reduce consumption by inducing consumers to hold out or delay purchases in order to pay lower prices in the future.
However, there is little evidence that this actually occurs during normal periods of economic growth accompanied by falling prices due to improvements in productivity, technology or resource availability. Moreover, the vast majority of consumption is made up of goods and services that are not easily deferred to the future even if consumers wanted to, such as food, clothing, housing services, transportation and healthcare.
Beyond these basic needs, even for luxury and discretionary spending consumers would only choose to reduce current spending if they expect the rate of decrease in prices to outweigh their natural time-preference for present consumption over future consumption. The one type of consumer spending that would suffer from falling prices would be items that are routinely financed by taking on large debts, since the real value of fixed debt will increase over time as prices fall.
Under specific conditions, deflation can also occur in and after periods of economic crisis. In a highly financialized economy, where a central bank , another monetary authority, or the banking system in general engages in continually expansion of the supply of money and credit in the economy, reliance on newly created credit to finance business operations, consumer spending, and financial speculation, which results in ongoing inflation in the commodity prices, rents, wages, consumer prices and asset prices.
More and more investment activity starts to take on the form of speculation on the price appreciation of financial and other assets, rather than profit and dividend payments on fundamentally sound economic activity. Businesses activities tend likewise to depend more and more on the circulation and turnover of newly created credit rather than real savings to finance ongoing operations. Consumers also come to finance more and more of their spending by borrowing heavily rather than self-financing out of ongoing saving.
To compound the problem, this inflationary process usually involves the suppression of market interest rates, which distorts decisions about the type and time horizon of business investment projects themselves, beyond simply how they are financed. Conditions become ripe for debt deflation to set in at the first sign of trouble. At that point, either a real economic shock or a correction in market interest rates can put pressure on heavily indebted businesses, consumers, and investment speculators.
Some of them have trouble revolving, refinancing, or making their payments on various debt obligations such as business loans, mortgages , car loans, student loans, and credit cards. The resulting delinquencies and defaults lead to debt liquidation and writedowns of bad debts by lenders, which start to eat away some of the accumulated supply of circulating credit in the economy. Banks' balance sheets become shakier, and depositors may seek to withdraw their funds as cash in case the bank fails.
A bank run may ensue, whereby banks have over extended loans and liabilities against inadequate cash reserves and the bank can no longer meet its own obligations. Financial institutions begin to collapse, removing liquidity that indebted borrowers have become even more desperate for. This reduction in the supply of money and credit then reduces the ability of consumers, businesses, and speculative investors to continue to borrow and bid up asset and consumer goods prices, so that prices may stop rising or even begin to fall.
Falling prices put even more pressure on indebted businesses, consumers, and investors because the nominal value of their debts remain fixed as the corresponding nominal value of their revenues, incomes, and collateral falls through price deflation. And at that point the cycle of debt and price deflation feeds back on itself. In the near-term this process of debt deflation involves a wave of business failures, personal bankruptcies, and increasing unemployment.
The economy experiences a recession and economic output slows as debt financed consumption and investment drop. A little bit of deflation is a product of, and good for, economic growth. But, in the case of an economy-wide, central bank fueled debt bubble followed by debt deflation when the bubble bursts, rapidly falling prices can go hand-in-hand with financial crisis and recession. Thankfully, the period of debt deflation and recession that follows is temporary, and can be avoided entirely if the perennial temptation to inflate the supply of money and credit in the first place can be resisted.
All in all, it is not deflation, but the inflationary period that then leads to debt deflation that is dangerous for a country's economy.
Perhaps unfortunately, consistent and repeated inflation of these kind of debt bubbles by central banks has become the norm over the past century or so. At the end of the day this means that while these policies persist, deflation will continue to be associated with the damage they cause to the economy.
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Learn more and compare subscriptions content expands above. Full Terms and Conditions apply to all Subscriptions. Or, if you are already a subscriber Sign in. If you are a business with falling revenue, or a household with a declining income, debt payments become more of a burden. Governments can be caught in the same trap, because if prices and incomes fall, so does tax revenue. And to state the obvious, there is an awful lot of debt floating around the eurozone - money owed by governments, households and banks.
Deflation could aggravate that problem. In the case of the eurozone, those countries experiencing very low inflation - or actual deflation, as a few are including Greece - tend to be those with relatively high levels of private or public debt.
There is, however, some comfort to be had from that. Those with debt problems also tend to be those that have seen their competitiveness decline.
Falling or barely rising prices and incomes do help address that. Another issue is the effectiveness of central bank policy at a time of economic weakness. The key point here is the level of central banks' real interest rates: that is, after subtracting inflation.
There have been many episodes in the past when real rates have been below zero. That is impossible to do when there's deflation, as you can't get interest rates much below zero. So it makes it much harder for the central bank to do anything to stimulate a flagging economy.
Then there is the incentive to delay spending that can come with deflation. If something will be cheaper next year, some people might delay buying it. It doesn't apply to everyday essential purchases; you cannot wait 12 months for lunch. But it can be relevant to items where there is more room for delay - are you going to replace that fridge now or next year?
The key factor here is expectations of future prices. The fact that prices fell last year does not necessarily mean they will do so next year. But last year's inflation or deflation can be a factor when people form their expectations about what lies ahead. There is also a downside in terms of the adjustment that is needed to restore competitiveness in some eurozone countries. They need to either reduce costs or increase productivity by more than the competitive nations - such as Germany.
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