FT primer: Deflation
By Christopher Swann, Economics Correspondent
Published: May 17 2003 5:00 | Last Updated: May 17 2003 5:00
Japan's economy slid into deflation in the mid-19901 and has yet to recover. Now, the Federal Reserve has warned of the possibility of an "unwelcome substantial fall in inflation". The European Central Bank has spoken of the need to provide "a sufficient safety margin to guard against the risks of deflation". FT economic correspondent Christopher Swann explains the phenomenon.
What is deflation?
Deflation is most commonly defined as a general fall in the price level. During the most notorious period of deflation - the great depression of the 1930s - a fall in the price level was accompanied by a sustained fall in gross domestic product.
A fall in one type of good - say consumer electronics - is not deflation.
Is deflation always bad news?
Deflation can be positive if it is caused by improvements in supply - such as a rise in productivity or a fall in the price of raw materials. The more efficient production of goods simply raises the spending power of the consumer.
The Japanese experience
Rising prices are tough. But falling prices can be even worse. Deflation, which brought down Weimar Germany, is now holding Japan in an iron grip.
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In the late 19th century, swift rises in productivity due to the industrial revolution led to periods in which prices were pushed lower even though demand was strong.
Falling oil prices pushed Germany into deflation in 1986 despite robust growth. Equally, the surge in Chinese manufacturing capacity is thought by many to exert a positive deflationary force - increasing real wages in industrialised countries that do not compete directly with Chinese industry.
Deflation is more damaging when it is the result of inadequate demand - when output in the economy falls below its potential.
Why is deflation damaging?
When deflation is the result of weak demand it has two pernicious effects.
First, it increases the real value of debt. Even if interest rates are lowered to combat deflation, the burden of debt can become a problem - especially since weak demand generally reduces the ability of debtors to meet their obligations.
Second, deflation encourages consumers to put off spending, in the expectation of lower prices in the future. The incentive to save becomes more powerful, since even if banks are not paying interest the value of savings is increasing.
This reduces demand in the economy and can lead to a vicious circle, as weakening demand leads to lower prices.
How can deflation be fought?
Once a deflationary psychology has become established, it is hard to shift. Consumers and companies come to expect lower prices and make their decisions on that basis.
It is often hard to fight deflation with conventional monetary policy. Once interest rates have been cut to zero they can go no lower. But real interest rates can continue to rise as prices fall - resulting in ever tighter monetary conditions.
Threat to the eurozone
Economic pressures on the eurozone are intensifying, damaging corporate performance and raising the spectre of deflation. But the policy options are narrowing.
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In order to escape from this monetary stranglehold, the central bank must print money and buy assets - bonds, equities, land or bad debt. Such policies frequently raise institutional, legal and political problems.
Some economists fear that monetary expansion can lead to an overshoot - as the deflation problem is substituted for rampant inflation. This is known as the "ketchup bottle theory" - you thump the bottle several times without getting any sauce and eventually it comes out in one large lump.
Most economists, however, believe that it is possible to escape from deflation without provoking runaway inflation.
Who benefits?
Deflation is a curse for debtors but seems like a godsend for lenders, since they will be repaid more in real terms. The danger, however, is that as the economy deteriorates, their debtors default. The safest options in a deflationary environment are to own government bonds or simply to have cash in the bank.
Equity investors tend to lose out. As deflation makes it hard for companies to put up prices, profits are squeezed. This undermines stock markets.
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