A broad decrease in the cost of goods and services, known as deflation, is usually accompanied by a reduction in the amount of credit and money available to the economy. The buying power of money increases over time during a deflation.
Understanding Deflation
Although the relative prices of capital, labor, goods, and services may not vary, deflation lowers their nominal costs. Economists have been concerned about deflation for many years. Initially, consumers gain from deflation as it allows them to gradually acquire more products and services for the same nominal income.
Lower prices do not, however, benefit everyone, and economists are frequently worried about how declining prices would affect other economic sectors, particularly those related to finance. Specifically, deflation can hurt investors and those involved in the financial markets who speculate or make investments based on the expectation of rising prices. Borrowers may be forced to repay their obligations with money that is worth more than what they borrowed.
Reasons for Deflation
Monetary deflation, as defined, arises when there is a reduction in the supply of money or financial instruments redeemable in money. Central banks, like the Federal Reserve, typically exert the most influence on the money supply in modern times. When the supply of money and credit decreases without a corresponding decline in economic output, the prices of all goods tend to decrease.
Instances of deflation often follow extended periods of artificial monetary expansion, with the early 1930s marking the last significant deflationary period in the United States, attributed to a decline in the money supply due to catastrophic bank failures.
Milton Friedman, a renowned economist, argued that optimal policy, where the central bank aims for a deflation rate equal to the real interest rate on government bonds, should lead to a nominal interest rate of zero, resulting in a steady fall in the price level according to his Friedman rule.
However, falling prices can also be driven by other factors, such as a drop in aggregate demand (total demand for goods and services) and increased productivity. Reduced government spending, stock market failures, a consumer desire to boost savings, and tighter monetary policies (higher interest rates) can contribute to lower prices due to decreased aggregate demand.
Natural occurrences of falling prices happen when the economy's output grows faster than the circulating money and credit supply. Technological advancements play a crucial role in this scenario, leading to operational efficiencies, lower production costs, and subsequent savings for consumers, ultimately resulting in lower prices. This phenomenon, distinct from general price deflation, is evident in specific industries, such as the technology sector.
Over the last few decades, technological improvements have significantly reduced the average cost per gigabyte of data, causing a notable drop in prices for products utilizing this technology.
Rethinking the Effects of Deflation
After the Great Depression, a period marked by monetary deflation, high unemployment, and increasing defaults, the prevailing view among economists was that deflation had negative consequences. In response, many central banks adjusted their monetary policies to ensure a steady increase in the money supply, even if it meant fostering persistent price inflation and encouraging excessive borrowing by debtors.
The British economist John Maynard Keynes cautioned against deflation, asserting that it contributed to a downward economic cycle during recessions. According to Keynes, when asset owners witnessed a decline in asset prices, they tended to reduce their willingness to invest, perpetuating economic pessimism.
Economist Irving Fisher developed a comprehensive theory on economic depressions based on debt deflation. Fisher argued that the liquidation of debts following a negative economic shock could lead to a significant reduction in the credit supply, triggering deflation. This deflationary pressure on debtors could result in further liquidations, creating a downward spiral into a depression.
In more recent times, economists have increasingly challenged traditional interpretations of deflation, particularly following the 2004 study by economists Andrew Atkeson and Patrick Kehoe. After analyzing 17 countries over a 180-year period, Atkeson and Kehoe found 65 out of 73 deflation episodes with no associated economic downturn, while 21 out of 29 depressions had no deflation. Consequently, a diverse range of opinions now exists regarding the utility and impact of deflation and price deflation.
Deflation Modifies Equity and Debt Financing
Deflation reduces the cost-effectiveness of debt financing for consumers, corporations, and governments. Deflation, on the other hand, strengthens the financial viability of savings-based equity financing.
In a deflationary environment, organizations with substantial cash reserves or low levels of debt are more appealing to investors. Conversely, heavily indebted companies with low financial reserves can say the opposite. Moreover, deflation promotes rising rates and raises the required risk premium on securities.
Who Suffers from Deflation?
Deflation adversely affects debtors, as the value of debt remains constant even when prices of goods and services decline. This impact extends to individuals and larger economies, especially those burdened with high national debt.
How Can Deflation be Addressed?
Governments and central banks, like the Federal Reserve, have various tools to combat deflation, primarily through the implementation of expansionary policies. These measures may involve reducing bank reserve limits, purchasing treasuries, and lowering target interest rates.
Additional fiscal tools include boosting government spending and reducing tax rates, both of which stimulate spending among individuals and businesses.
Which Assets Perform Well in Deflation?
Investors can safeguard their portfolios by choosing assets that thrive in deflationary environments. Defensive hedges encompass high-quality bonds, companies specializing in essential consumer goods, and holding cash.
Disclaimer
Derivative investments involve significant risks that may result in the loss of your invested capital. You are advised to carefully read and study the legality of the company, products, and trading rules before deciding to invest your money. Be responsible and accountable in your trading.
RISK WARNING IN TRADING
Transactions via margin involve leverage mechanisms, have high risks, and may not be suitable for all investors. THERE IS NO GUARANTEE OF PROFIT on your investment, so be cautious of those who promise profits in trading. It's recommended not to use funds if you're not ready to incur losses. Before deciding to trade, make sure you understand the risks involved and also consider your experience.
