"Since deflationary periods favor those who hold currency over those who do not, they are often matched with periods of rising populist sentiment, as in the late 19th century, when populists in the United States wanted to move off hard money standards and back to a money standard based on the more inflationary (because more abundantly available) metal silver.
Most economists agree that the effects of modest long-term inflation are less damaging than deflation (which, even at best, is very hard to control). Deflation raises real wages which are both difficult and costly for management to lower. This frequently leads to layoffs and makes employers reluctant to hire new workers, increasing unemployment."
From wiki:
Examples of deflation
United Kingdom
During World War I the British pound sterling was removed from the gold standard. The motivation for this policy change was to finance the First World War; one of the results was inflation, and a rise in the gold price, along with the corresponding drop in international exchange rates for the pound. When the pound was returned to the gold standard after the war it was done on the basis of the pre-war gold price, which, since it was higher than equivalent price in gold, required prices to fall to realign with the higher target value of the pound.
Deflation in the United States
Major deflations
There have been three significant periods of deflation in the United States.
The first was the recession of 1836, when the currency in the United States contracted by about 30%, a contraction which is only matched by the Great Depression. This "deflation" satisfies both definitions, that of a decrease in prices and a decrease in the available quantity of money.
The second was after the Civil War, sometimes called The Great Deflation.
"The Great Sag of 1873-96 could be near the top of the list. Its scope was global. It featured cost-cutting and productivity-enhancing technologies. It flummoxed the experts with its persistence, and it resisted attempts by politicians to understand it, let alone reverse it. It delivered a generation’s worth of rising bond prices, as well as the usual losses to unwary creditors via defaults and early calls. Between 1875 and 1896, according to Milton Friedman, prices fell in the United States by 1.7% a year, and in Britain by 0.8% a year. [1]
The third was between 1930-1933 when the rate of deflation was approximately 10 percent/year. The first was possibly spurred by the deliberate policy in retiring paper money printed during the Civil War; the second was part of America's slide into the Great Depression, where banks failed and unemployment peaked at 25%. Both were world-wide phenomena.
The deflation of the Great Depression, as in 1836, did not begin because of any sudden rise or surplus in output. It occurred because there was an enormous contraction of credit (money), bankruptcies creating an environment where cash was in frantic demand, and the Federal Reserve did not adequately accommodate that demand, so banks toppled one-by-one (because they were unable to meet the sudden demand for cash— see Fractional-reserve banking). From the standpoint of the Fisher equation (see above), there was a concommitant drop both in money supply (credit) and the velocity of money which was so profound that price deflation took hold despite the increases in money supply spurred by the Federal Reserve.
Minor deflations
Throughout the history of the United States, inflation has approached zero and dipped below for short periods of time (negative inflation is deflation). This was quite common in the 19th century and in the 20th century before World War II.
Deflation in Hong Kong
Following the Asian financial crisis in late 1997, Hong Kong experienced a long period of deflation which did not end until the 4th quarter of 2004 [2]. Many East Asian currencies devalued following the crisis. The Hong Kong Dollar, however, was pegged to the US Dollar. The gap was filled by deflation of consumer prices. The situation is worsened with cheap commodity goods from Mainland China, and weak consumer confidence. According to Guinness World Records, Hong Kong was the economy with lowest inflation in 2003 [3].
Deflation in Japan
Deflation started in the early 1990s. The Bank of Japan and the government have tried to eliminate it by reducing interest rates (part of their 'quantitative easing' policy), but despite having them near zero for a long period of time, they have not succeeded. In July 2006, the zero-rate policy was ended.
Systemic reasons for deflation in Japan can be said to include:
* Fallen asset prices. There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.
* Insolvent companies: Banks lent to companies and individuals that invested in real estate. When real estate values dropped, these loans could not be paid. The banks could try to collect on the collateral (land), but this wouldn't pay off the loan. Banks have delayed that decision, hoping asset prices would improve. These delays were allowed by national banking regulators. Some banks make even more loans to these companies that are used to service the debt they already have. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law have been suggested (by The Economist) as methods to speed this process and thus end the deflation.
* Insolvent banks: Banks with a larger percentage of their loans which are "non-performing", that is to say, they are not receiving payments on them, but have not yet written them off, cannot lend more money; they must increase their cash reserves to cover the bad loans.
* Fear of insolvent banks: Japanese people are afraid that banks will collapse so they prefer to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in a bank account. This likewise means the money is not available for lending and therefore economic growth. This means that the savings rate depresses consumption, but does not appear in the economy in an efficient form to spur new investment. People also save by owning real estate, further slowing growth, since it inflates land prices.
* Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products are decreasing. Domestic producers must match these prices in order to remain competitive. This decreases prices for many things in the economy, and thus is deflationary. |
